Corporate Hedging

Course:PGCBM 12

Name of the Faculty:

Subject: International Financial Management

Submitted by:

Navneet Kohli

Roll No.2210059

Name of the Center: Cunningham Road, Bangalore

Scope

The project discusses about how hedging can minimize the risk when companies are exposed to various exposures like Interest rate risk exposure, Forex exposure and exchange rate risk exposure. Various instruments such as Natural hedges, Cash management, Adjusting of intra company accounts, International financing hedges, Currency hedges, Forward contracts, Futures contracts, Currency options, Currency Swaps, Foreign debt have been discussed.

The project also throws a light on the actions taken by the companies - Infosys,TCS ,Alok Industries,Hexaware Systems,L&T, RIL when exposed to various risks.

Contents

Corporate Hedging

Without hedging, a company is exposed to the vagaries of the markets and finds it difficult to predict revenues and incomes. In recent times, there have been a number of incidents of companies getting caught on the wrong side of market movements and making losses on hedging. Hexaware Systems booked a loss of Rs 10.3 crore ($2.6 million) on exotic foreign exchange options contracts. Very recently L&T was in the news for booking a Rs 200-crore ($51 million) loss on commodity futures on the London Metals Exchange. Many IT companies were badly hit by the sharp depreciation in the dollar in 2007 due to inadequate hedging. These incidents bring to light the importance of having a clear and coherent policy frame-work for corporate hedging.

These situations should be distinguished from losses that banks (such as ICICI Bank &bulge - bracket US investment banks) have incurred from taking speculative positions in financial markets.

The fundamental principle behind hedging is that it is preventive activity taken to reduce losses in a possible adverse situation. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes. Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. By hedging, in the general sense, we can imagine the company enters into a transaction where sensitivity to movements in financial prices is able to protect the core value addition generated by the business.

Another reason for hedging this financial price risk is to improve or maintain the competitiveness of the firm. Companies do not exist in isolation. They compete with companies located in other countries that produce similar goods for sale in the global marketplace.

Companies that are the most developed in this field recognize that the financial risks that are produced by their businesses present a powerful opportunity to add to their bottom line while prudently positioning the firm so that it is not pejoratively affected by movements in these prices. This level of sophistication depends on the firm's experience, personnel and management approach. It will also depend on their competitors. If there are five companies in a particular sector and three of them engage in a comprehensive financial risk management program, then that places substantial pressure on the more passive companies to become more advanced in risk management or face the possibility of being priced out of some important markets.

Most importantly, hedging is contingent on the preferences of the firm's shareholders. There are companies whose shareholders refuse to take anything that appears to be financial price risk while there are other companies whose shareholders have a more worldly view of such things.

How Hedging is done

For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.Assume that a chana trader "A" has on May 25, 2007 undertaken to supply 10 metric tonnes (mt) of chana to a vendor of sweets on August 25, 2007. He locks in the price of sale on May 25 at the spot price prevailing that day of, say, Rs 2,160 per quintal, which works out to Rs 2,16,000 for 10 mt. Since he plans to buy the chana for delivery to the vendor on August 25, he is exposed to the risk of rising prices of chana between now and August 25. To hedge against this risk "A" buys on May 25 an August contract of 10 mt at Rs 2186 per quintal from the exchange.

If his prediction is correct and chana spot price rises to Rs 2,507 per quintal, it would result in a concomitant rise in the futures price. Let’s assume the futures price on August 20 is Rs 2,650. Now the trader has to buy chana from the spot market at a higher price of Rs 2,507 per quintal where he pays Rs 347 per quintal more or Rs 34,700 for 10 mt. However, since the futures price has risen by 464 per quintal (Rs 46,400 per 10 mt) he makes a profit by squaring off his futures position, ie he sells one lot (10 mt). "A" thus effectively offsets his loss in the spot market by making a gain in the futures market. His net purchase price works out to Rs 2,043, earning him a gain of Rs 117 per quintal.The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

The rules that the top management should frame around corporate hedging are given below.

Difference between speculation and hedging

The former will be understood to mean a transaction undertaken specifically to offset some exposure arising out of the firm’s usual operations while the latter will refer to deliberate creation of a position for the express purpose of generating a profit from exchange rate fluctuations, accepting the added risk. With this definition, a decision not to hedge an exposure arising out of operations is also equivalent to speculation

Typically, the level of financial hedging is more in companies whose main activity is trading (such as investment banks and hedge funds) vis-À-vis ‘brick-and-mortar’ companies that produce something.

The rules that the top management should frame around corporate hedging are given below.

Risk management unit

Setting up an independent, sound risk-management unit which works closely with the Treasury or principal trading unit (for example, in companies like British Petroleum) will identify a group of people who are responsible for all the hedging and risk management in the company. This group should not only have financial whiz-kids, but also people who have a thorough understanding of the business.

The risk management unit will have to work with various departments to mitigate risks (e.g. with corporate Finance and Treasury to hedge interest rate risks and financial investments, with Sales and Marketing to hedge sales-related cash flows, and with Purchases for hedging purchase prices). There should be the in-house consultants who advise other departments on what to hedge for and how. There should be circulation between the risk management unit and the operational units.

Identify the Risks

Risks can be broadly classified into credit, market, liquidity and operational risks. Credit risk arises from the possibility of customers and counter-parties going bust before

fulfilling their commitments. Market risks arise from adverse movements in markets (for instance, interest rates,

commodities and foreign exchange). Liquidity risks crop up when there is a sudden cash crunch that affects the working of

the organization. Operational risks stem from operational processes failing, like machine break-downs,

quality failures, regulatory non-compliance, etc. However, within these broad categories, different organizations face different risks.

The magnitude of the same risk might differ from organization to organization. For example, a low debt, export-dependent organization such as Infosys will not be directly affected by interest rate changes vis-À-vis a leveraged company but is greatly affected by an adverse movement in foreign exchange rates. However, to the extent interest rates affect foreign exchange markets, they will be affected.

Hedging Policy

Once the risks have been identified, a ‘hedging policy’ on how they can be mitigated must be formulated by the Corporate Treasury. This must be approved by the top management, particularly the ‘Finance Committee’ of the Board.

The hedging policy must list out the risks that the company usually faces and guidelines on what hedges can be adopted to mitigate these risks. Some of these will be general guidelines, and some will be specific to certain risks.

Financial hedges (those that work through insurance or market activity) should only be entered into with the approval of the risk management unit, and preferably, only by the Treasury.

Wherever possible, the Treasury should enter into simple contracts where the risk is clear, instead of exotic contracts (e.g. combination of options, cross-currency swaps) where risks are complex or opaque.

Losses/gains on the hedging instrument and the hedged item should be reported as per Indian Accounting Standards AS -30 (Financial Instruments: Recognition and Measurement) and AS 31 (Financial Instruments: Presentation) or IFRS - IAS -39 (Financial Instruments: Recognition and Measurement) or US GAAP – FAS 133 (Hedge Accounting).

When engaging in trading activity, the close relationship between credit, market and liquidity risks should be taken into account.

A losing counter-party (profitable situation for the company) runs credit risk. A big market loss might pose liquidity risks as margin calls will strain liquidity.

As per the RBI Guidelines on risk management and hedging issued in July 2007, banks should ensure board level overview of the risk management policy and ensure that the quantum of the hedge should not be more than the underlying exports or imports.

For example, in the case of L&T, it bought futures in certain metals contracts. The prices fell, and it had to incur a loss (having bought at a higher price). However, as long as it has contracts to sell these at higher prices, or can use the metal as inputs to products or projects which it can sell profitably, the company should be alright, albeit less profitable than it could have been.

Exposure and Hedging

Exposure: A change in a financial value caused by a change in a given variable.•e.g. interest rate exposure, Fx exposure, business cycle exposure, Exchange Rate Risk ExposureExchange rate exposure is the degree to which a company is affected by exchange rate changes.•Effect on firm’s net cash flow or market value.•Effect of unexpected exchange rate changes.Higher exposure means that for a given volatility in exchange rates, your company faces larger risks. Managing exposure is largely a set of methods for reducing exposure (i.e.hedging) and therefore the associated risk. There are several different kinds of exposure.

Transaction Exposure (Contractual exposure.): results from existing contractual obligations in foreign currencies. E.g. accounts payable/receivable, holding/issuing foreign currency debt, etc. Changes in market exchange rates therefore affect our domestic currency cashflows

Operating Exposure (Competitive or strategic exposure): all other effects of unexpected exchange rate changes that alter firm’s cash flows. e.g future sales, costs, taxes, etc. (more detail next week.)

Accounting Exposure (Translation exposure): All other effect of exchange rates on consolidated financial statements. Excludes anything that reflects changes in actual cash flows.

There are a number of ways by which exchange-rate risk exposure can be managed viz. 1) Natural hedges2) Cash management3) Adjusting of intra company accounts4) International financing hedges5) Currency hedges6) Forward contracts7) Futures contracts8) Currency options9) Currency Swaps

Natural Hedges

The relationship between revenues (or pricing) and costs of a foreign subsidiary sometimes provides a natural hedge, giving the firm ongoing protection from exchange-rate fluctuations. The key is the extent to which cash flows adjust naturally to currency changes. It is not the country in which a subsidiary is located that matters, but whether the subsidiary's revenue and

cost functions are sensitive to global or domestic market conditions. At the extremes there are four possible scenarios as given in Table.

Globally Determined Domestically DeterminedScenario 1Pricing XCost XScenario 2Pricing XCost XScenario 3Pricing XCost XScenario 4Pricing XCost XIn Category 1,we might have a copper fabricator in Taiwan. Its principal cost is that for copper, the raw material, whose price is determined m the global market and quoted in U.S. dollars. Moreover, the fabricated product produced is sold in markets dominated by global pricing. Therefore, the subsidiary has little exposure to exchange rate fluctuations. In other words, there is a "natural hedge," because protection of value follows from the natural workings of the global marketplace. The second category might correspond to a cleaning service company in Switzerland. The dominant cost component is labour, and both this and the pricing of the service are determined domestically. As domestic inflation affects costs, the subsidiary is able to pass along the increase in its pricing to customers. Margins, expressed in U.S. dollars, are relatively insensitive to the combination of domestic inflation and exchange rate changes. This situation also constitutes a natural hedge. The third situation might involve a British-based international consulting firm. Pricing is largely determined in the global market, whereas costs, again mostly labor, are determined in the domestic market. If, due to inflation, the British pound should decrease in value relative to the dollar, costs will rise relative to prices, and margins will suffer. Here the subsidiary is exposed. Finally, the last category might correspond to a Japanese importer of foreign foods. Costs are determined globally, whereas prices are determined domestically. Here, too, the subsidiary would be subject to much exposure.

These simple notions illustrate the nature of natural hedging. A company's strategic positioning largely determines its natural exchange-rate risk exposure. However, such exposure can be modified. For one thing, a company can internationally diversify its operations when it is overexposed in one currency. It can also source differently in the production of a product. Any strategic decision that affects markets served, pricing, operations, or sourcing can be thought of as a form of natural hedging. A key concern for the financial manager is the degree of exchange-rate risk exposure that remains after any natural hedging. This remaining risk exposure then can be hedged using operating, financing or currency-market hedges.

Cash Management and Adjusting Intra-company Accounts If a company knew that a country's currency, where a subsidiary was based, were going to fall in value, it would want to do a number of things. First, it should reduce its cash holdings in this

currency a minimum by purchasing inventories or other real assets. Moreover, the subsidiary should try to avoid extended trade credit (accounts receivable). Achieving as quick a turnover as possible of receivables into cash would thus be desirable. In contrast, it should try to obtain extended terms on its accounts payable. It may also want to borrow in the local currency to replace any advances made by the U.S. parent. The last step will depend on relative interest rates. If the currency were going to appreciate in value, opposite steps should be undertaken. Without knowledge of the future direction of currency value movements, aggressive policies in either direction are inappropriate. Under most circumstances we are unable to predict the future, so the best policy may be one of balancing monetary assets against monetary liabilities to neutralize the effect of exchange-rate fluctuations.

International Financing Hedges If a company is exposed in one country's currency and is hurt when that currency weakens in value, it can borrow in that country to offset the exposure. In the context of the framework presented earlier, asset-sensitive exposure would be balanced with borrowings. A wide variety of sources of external financing are available to the foreign affiliate. These range from commercial bank loans within the host country to loans from international lending agencies.

Chief sources of external financing are:

Commercial Bank Loans And Trade Bills

Foreign commercial banks are one of the major sources of financing abroad. They perform essentially the same financing function as domestic commercial banks. One subtle difference is that banking practices in Europe allows longer-term loans than are available in the United States. Another difference is that loans tend to be on an overdraft basis. That is, a company writes a check that overdraws its account and is charged interest on the overdraft. Many of these lending banks are known as merchant banks, whose supply means that they offer a full menu of financial services to business firms. Corresponding to the growth in multinational companies, international banking operations of U.S. banks have grown accordingly. All the principal commercial cities of the world have branches or offices of U.S. banks.

In-addition to Commercial bank loans, "discounting" trade bills is a common method of short-term financing. Although this method of financing is not used extensively in the United States, it is widely used in Europe to finance both domestic and international trade.

Eurodollar Financing

Eurodollars are bank deposits denominated in U.S. dollars but not subject to U.S. banking regulations. Since the late 1950s an active market has developed for these deposits. Foreign banks and foreign branches of U.S. banks, mostly in Europe, actively bid for Eurodollar deposits, paying interest rates that fluctuate in keeping with supply and demand. The deposits are in large denominations, frequently $100,000 or more, and the banks use them to make dollar loans to

quality borrowers. The loans are made at a rate in excess of the deposit rate. The rate differential varies according to the relative risk of the borrower. Essentially, borrowing and lending Eurodollars is a wholesale operation, with far fewer costs than are usually associated with banking. The market itself is unregulated, so supply and demand forces have free rein.

The Eurodollar market is a major source of short-term financing for the working capital requirements of the multinational company. The interest rate on loans is based on the Eurodollar deposit rate and bears only an indirect relationship to the U.S. prime rate. Typically, rates on loans are quoted in terms of the London interbank offered rate (LIBOR). The greater the risk, the greater the spread above LIBOR. A prime borrower will pay about one-half percent over LIBOR for an intermediate term loan. One should realize that LIBOR is more volatile than the U.s. prime rate, owing to the sensitive nature of supply and demand for Eurodollar deposits.

Eurodollar market is part of a larger Eurocurrency market where deposit and lending rates are quoted on the stronger currencies of the world. The principles involved in this market are the same as for the Eurodollar market, so we do not repeat them. The development of the Eurocurrency market has greatly facilitated international borrowing and financial intermediation (he flow of funds through intermediaries like banks and insurance companies to ultimate borrowers).

International Bond Financing

The Eurocurrency market must be distinguished from the Eurobond market. The latter market is a more traditional one, with under writers placing securities. Though a bond issue is denominated in a single currency, it is placed in multiple countries. Once issued, it is traded over the counter in multiple countries and by a number of security dealers. A Eurobond is different from a foreign bond, which is a bond issued by a foreign government or corporation in a local market. A foreign bond is sold in a single country and falls under the security regulations of that country. Foreign bonds have colourful nicknames. For example, non-Americans in the U.S. market issue Yankee bonds, and Samurai bonds are issued by non-Japanese in the Japanese market. Eurobonds foreign bonds, and domestic bond of different countries differ in terminology, in the way interest is computed, and in features. We do not address these differences, because that would require a separate book. Many debt issues in the international arena are floating-rate notes (FRNs). These instruments have a variety of features, often involving multiple currencies. Some instruments are indexed to price levels or to commodity prices. Others are linked to an interest rate, such as LIBOR. The reset interval may be annual, semiannual quarterly or even more frequent. Still other instruments have option features.

Currency-Options and Multiple-Currency Bonds

Certain bonds provide the holder with the right to choose the currency, in which payment is received, usually prior to each coupon or principal payment. Typically, this option is confined to two currencies, although it can be more. For example, a company might issue $-1, OOO-par value bonds with an 8 percent coupon rate. Each bond might carry the option to receive payment

in either U.S. dollars or in British pounds. The exchange rate between the currencies is fixed at the time of bond issue. Bonds are sometimes issued with principal and interest payments being a weighted average, or "basket," of multiple currencies. Known as currency cocktail bonds, these securities provide a degree of exchange-rate stability not found in any one currency. In addition, dual-currency bonds have their purchase price and coupon payments denominated in one currency, whereas a different currency is used to make the principal payments. For example, a Swiss bond might call for interest payments in Swiss francs and principal payments in U.S. dollars.

Impact of Hedging on expected cash flows of the firm Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk.

Forward Contract

• An agreement to buy or sell an asset at a certain future time for a certain price.• Typically between two financial institutions or between a financial institution and a

corporate client.• Normally not traded on an exchange.• One of the parties to a forward contract assumes a long position—by agreeing to

purchase the asset at the specified price in the future; whereas, the other party assumes a short position—agrees to sell the asset on the same date for same price.

• This contract creates for both buyer and seller both the right and the obligation to transact at the specified terms.

• Specified price = ‘delivery price’ determined such that at time of contracting, value of contract is zero.

• Example: Contract today to buy a house for $200,000 with closing in two months. Title to the house and the money are exchanged in two months at terms agreed upon today in the contract.

• Example: Bank A contracts to buy from Bank B and Bank B contracts to sell to Bank A 10 million Euros for $10.2 million, six months from now.

• Usually held to maturity and settled at maturity.• One party looses, one party gains.• The loser may have an incentive to default, so there is always a credit problem.

• Thus, forward contracts are usually written between large institutions with good credit and an ongoing relationship.

Position diagram of forward contract

Futures Futures are forward contracts managed by an exchange. Oldest actively traded derivative instrument. Initially used with agricultural and

commodities; e.g., pork bellies, cattle, sugar, wool, coffee, frozen orange juice, copper, gold, aluminum, gold, tin. Underlying financial assets include stock indices, currencies, Treasuries.

The buyer and seller don’t meet or know each other. The exchange contracts separately with buyer and seller, and then matches them.

The exchange establishes margin accounts for each party to guarantee fulfillment of contract.

The futures market is extremely liquid. Futures contract is an agreement between two parties to buy or sell an asset at a certain

time (delivery) in the future for a certain price. Contracts are standardized, specifying exactly what is to be delivered, where and when. Seller has some choice concerning the delivery date (usually within the final month) The contract is “marked to market,” i.e., there is settlement after every trading day. This

arrangement reduces default risk.

Basis Risk

Basis is defined as the difference between the cash price and futures price of a commodity. It can be either positive or negative

Basis = Spot price –Futures price The basis can improve or worsen the position of the hedger When a hedger is short futures, increases in the basis creates gains

When a hedger is long futures, decreases in the basis creates gains

Long position Short positionBuy a futures contract:Agree to take delivery of the item at the settlement date for the futures price

Sell a futures contractAgree to delivery the item at the settlement date for the futures price

Risk ActionA managers of an index portfolio(S&P500) thinks the market is overvalued

Short hedge; sell S&P500 future contracts (the action effectively sells a portion of the portfolio today at a given price for a futureDeliver.

A pension fund manager fells that the S&P is under valued; he will receive a inflow of funds from the manager in at the end of September.

Long hedge; buy S&P 500 future contracts (the action effectively buys the S&P500 today for a given price with a given delivery date.

A firm needs to borrow 20mm at this time next year to fund the initial stage of a new project; risk rates could be higher.

Short hedge; sell long-term treasury bond future contracts; gain from the close out of the contract (when its price falls) would be used to reduced borrowing needs and hence the effective interest cost of the project.

A firm will receive 20mm at this time next year through the sale of a subsidiay; the funds would be invested for two years until neededfor a new project; rates may fall.

Long hedge; buy 2-yr Treasury note futures; gain from the closeout (when price rises) would be used to increase the pool of investible funds, and hence increase the effective interest on the funds from the sale of the subsidiary.

A bank expects to roll over a sizable volume of retail CDs in November; rates may rise, costing the bank more for those deposits.

Short hedge; sell Eurodollar futures contracts; gain from the closeout (price falls) would be used to reduce the amount of deposits that the bank must retain.

A bank is expecting a sizable loanin November; rates may fallreducing the rate received on theloan

Long hedge; buy Treasury note security closely matching the maturity of the loan; gain from the closeout (price rises) would be used to reduce the amount of funds the bank wouldneed to borrow to make the loan.

A bank expects to roll over a sizable volume of retail CDs in November; rates may fall.

Nothing, this outcome benefits the Bank.

A bank is expecting a sizable loan in November; rates may rise

Nothing; this outcome benefits the bank, though it may want to hedge borrowing costs.

Example: Marking to Market

• A 3 day futures contract (which is marked to market) and a 3 day forward contract (which is not) call for A to buy and B to sell 1000 ounces of silver three days from now $6.00 per ounce.• The price of silver moves to:– $6.10 on day 1– $6.05 on day 2– $6.12 on day 3• Regarding the forward contract, A gains $0.12 *1000 = $120 and B looses $120 since silver is trading at a higher price on settlement day.The forward contract can either be settled by B actually selling to A the 1000 ounces of silver for $6,000 (when it is worth $6,120)or by making a payment of $120 to A.

• Regarding the futures contract, at the end of the trading on the first day, B would pay and A would receive ($6.10 - $6.00) = $0.10*1000 = $100 as the settlement for the first day’s price rise of $0.10. Once this payment is made,the contract is rewritten with a price of $6.10.

• At the end of day 2, A would pay and B would receive ($6.10 - $6.05) =$0.05*1000 = $50 as settlement for the second day’s price decline. The contract would be rewritten at $6.05.• At the end of day 3, B would pay and A would receive a payment of ($6.12 -$6.05) = $0.07*1000 = $70.• Note: The total net payment made by B is the same $120.• If at the beginning of day 3, B had chosen to deliver the silver, B would sell 1000 ounces for $6050 but would have made net settlement payments of $50. A would have paid a net of $6,000 for the silver now worth $6,120.

• B looses $120 and A gains $120 of value.

Options

A currency Option is a contract giving the right, not the obligation,to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes.

Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend.

Example -RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there are two scenarios. If the exchange rate movement isfavourable i.e the dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates compared to today’s spot rate, RIL can exercise the option to purchase it at the agreed strike price. In either case RIL benefits by paying the lower price to purchase the dollar.

Swaps A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined

exchange rate so that the parties end up with their original currencies. The advantages of swaps are that firms with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of foreign currency swaps, while leaving the underlying borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate risk.

Example-Consider an export oriented company that has entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar.The company pays US 6months LIBOR to the bank and receives 11.00% p.a.every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures.

Foreign Debt

Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so,Corporate Hedging for Foreign Exchange Risk to hedge this, he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realised by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.

Costs of hedging There is a risk-return trade-off Lower return due to lower risk Lack of liquidity in the market resulting in impact cost Low liquidity results in higher volatility Margin finance Margins are based on volatility The real cost of hedging is the finance cost of margins

Margins could range from 5% to 50%

Basic Hedging Techniques

Hedge ratio The size of the position in futures contracts relative to the exposure (i.e., the value of the asset being hedged)i.e the number of units of asset in futures contracts per unit of asset being hedged.

Keep Pruning the Hedge

It is said that ‘In the real world, the only perfect hedge exists in a Japanese garden’. And even there, they need a lot of tending. Market-based hedges have to be closely watched and reviewed regularly for effectiveness, because they can go horribly wrong.

Long Term Capital Management

Long Term Capital Management (LTCM) is a case in the point. They had a nice little business model (with two Nobel laureates on their board), making money from pricing inefficiencies in international bonds and other interest rate products. They were short on interest rate swaps (they paid floating) and short on US government bonds — so, when market yields went up, they made money on the government bonds (which have an inverse relationship with yields), and when yields went down, they made money on the swaps.

After the Russian default of 1998, there was a global credit squeeze quite like the one we witnessed in late 2007. Interest rates rocketed. LTCM lost a lot of money on the swaps. In parallel, there was a ‘flight to safety’ (actually it was more of a mad scamper) to US sovereign bonds, so US sovereign bond prices also rose. So, LTCM’s hedges began to compound their losses. They were bailed out by the Fed, and had to close down.

Indian Scenario

Double-edged hedge

A recent string of events and some circumstantial evidence suggest that there is perhaps a systemic failure in the way corporate India is managing its forex exposure. HDFC Bank reported a Rs 43-crore loss in treasury operations during the first half of 2007. An Outlook Business investigation discovered that FX derivative trades of many companies had gone awry, leading to huge mark-to-market losses. Among these were Monnet Ispat and India Glycols, each reported to have suffered losses of Rs 30-50 crore. Deals structured by prominent banks like Standard Chartered, Yes Bank and Kotak Mahindra Bank on behalf of their clients have seen combined mark-to-market losses of Rs 2,000-4,000 crore.

Small firms, big losses

Banks have taken a high exposure to forex contracts. For example, just four banks—Standard Chartered, HSBC, Yes Bank and HDFC Bank—have seen their combined exposure to forex contracts increase from Rs 359,303 crore in 2005 to Rs 962,742 crore in 2007. This is 4.5 times the total combined balance sheet size of these banks.

A large number of corporates, especially mid- and small caps, is likely sitting on a significant mark-to-market loss on forex derivative positions. Lack of adequate understanding of exotic derivatives can result in companies taking risks that are not commensurate with potential rewards." A declining dollar has derived exporters all over the world to seek shelter in forex derivatives.A recent Ernst & Young (E&Y) study of 34 top-rung companies that have a combined m-cap of Rs 1.22 lakh crore revealed that 44% have used exotic derivative products and 35% have resorted to opportunistic hedging, while only 32% have board-level involvement in risk management.

Speculative gains

Forex derivatives, particularly exotic structures, play on greed and fear, both powerful emotions. They provide a possible way out of the fear of losing profitability due to a declining dollar. And they also play on greed, by offering superlative returns. Jain Irrigation, for example, has made a Rs 5-crore profit in its first round of FX hedges worth $20 million.

Foreign banks have enormous structuring strengths. They keep concocting more and more complex structures. Banks always try to come up with exotic structures to optimise any position.

Bending rules

Many old and established rules in the FX market are changing Currency markets are becoming more volatile; Linkages between currencies are changing; New variables are coming into play (like oil and commodity prices); Markets are getting integrated.

In August-November last year, for example, a sharp 10% appreciation of the Swiss franc and the yen (considered to be stable currencies) has pushed many derivative contracts into losses. One example of such a transaction gone wrong is a debt swap—a popular tool to bring down interest costs. (Risk & Return) Here a company could borrow Swiss francs (interest costs is about 5%) and deploy it in the US dollar (interest of 8%). The interest gain of 3% in this transaction could be used to reduce the cost of Indian debt (about 12%). However, the risk here is appreciation of the Swiss franc. Historically, this has been a stable currency. So many companies made the wager. But when the Swiss franc appreciated 10% recently, it wiped out any such interest gains and also eroded part of the capital.

These three factors—

Desperate companies experimenting with derivatives Banks keen to sell exotic structures and A volatile currency environment

threaten to form a potentially dangerous combination. Corporate treasury risk management skills have clearly not kept pace. E&Y’s says -Companies are still dependent on bankers to tell them what to do. Companies are not quite geared up to face the skill and governance challenges being posed by exotic forex derivatives.

Skill to kill

Corporate India is taking more and more global exposure on to its balance sheets. It is dealing with multi-billion dollar cross-border cash flows in the form of export receivables, imports, external borrowings and repayments, acquisition financing, etc. (TCS, for example, is moving to two-to-three-year hedges to mirror the growing trend of long-term revenue contracts with clients. It even has a few eight-year hedges.)

1.Case of Infosys Vs TCS-Hedging against Currency Risk

To live without hedging against currency risks would not be prudent governance. Infosys has been relatively slow to use FX hedging and has covered only $1.03 billion, while TCS has been aggressive and has hedged $2.7 billion. The results are obvious —during the first half 2007, TCS’s operating profit margin (including other income from FX gains) moved from 26.97% to 27.73%, while Infosys, dropped from 48.79% to 33.9% last year. TCS has managed the declining dollar better, thanks to active hedging.

That’s one good reason why India Inc needs to build-up skills in handling FX derivatives. In a one-way rupee movement environment (pre 2003), simple forward contracts may have been adequate. But in today’s volatile scenario, we need options.

2.Case of Alok Industries

In 2007, Alok Industries made a Japanese yen borrowing of $100 million(the yen was trading at 118.) But by the time it brought the money into India, the yen had appreciated to 110.50 and Alok Industries ended up realising about $106 million at the time of the draw-down. Immediately, the treasury team moved in to build a hedge to protect the draw-down rate of 110.50. The team thought the yen was unlikely to appreciate beyond 82. So it structured a knock-in/knock-out option for five years.

Underneath complicated layers, the contract had a simple purpose—if the yen hit 113 during the tenure of the contract, Alok Industries would be protected against any appreciation of the yen up till 82. If the yen did not hit 113, there was no protection. The cost of this option was 1.85% a year. Soon, the yen moved beyond 113 to 117. Alok Industries wound up the contract, pre-paid the ECB, and netted a Rs 36-crore gain. If it had waited more, it could have made a bigger profit on the yen movement. (The yen crossed 120 at one time, but is trading at 111.637 now.) But Alok Industries forex policy dictates that a hedge needs to be wound up if the rate-protection objective has been achieved.

Total control

TCS retains the flexibility of letting some such contracts run even after the transaction is completed, but it has a clear accounting policy that lets investors see the results of its FX hedges. The mark-to-market profit/loss at the end of every quarter is disclosed as other comprehensible income in the financial statement (it was about Rs 300 crore as on September 30, 2007). Profit/loss on every hedge is booked when the underlying revenue from the customer accrues and profits/loss made in hedges that run beyond the transaction is shown as other income.

Experts recommend that companies put in place a three-tier structure for treasury operations—

A dealing room, A middle-tier that clears every deal and A risk management board. That’s the model TCS has used.

Companies also add more checks on actual deal flow. At Alok Industries, every transaction other than a plain-vanilla forward cover has to be signed by the treasury head, the CFO, the JMD and the MD. The risk-management board, comprising mostly board-level members, also looks at every deal regularly. Companies also rope in outside firms to monitor deals. TCS uses Ernst & Young as its internal auditor, Alok Textiles uses Delloitte as its chief risk officer and also runs every deal past consultant Mecklai.

Systematic Hedging Policy

Beyond governance, companies also need to adopt a systematic hedging policy. Every Monday, the marketing team of Alok Industries sends out a mail to the treasury on orders booked. The treasury team then builds hedges to protect the exchange rate at which these deals have been struck. Similarly, forex debt liabilities are also hedged.

Similarly TCS starts off every year with hedges for about 50% of net forex revenue expected. At the beginning of every quarter this is increased to 75-80%. By the end of the quarter, 100% of the net exposure is hedged.

L&T adheres to an overall forex policy while designing hedges for each exposure individually, as its overseas project receipts and payments tend to be lumpy. By spelling out such systematic hedging policies, companies can eliminate all arbitrary and speculative hedging transactions.

Unfortunately, only a few companies have such governance structures in place.

References:

Hindu Business Line

www.rbi.com