ICF Project Report

8/8/2019 ICF Project Report

1/29

Foreign Exchange RiskManagement of

Infosys, Reliance

Industries and MarutiSuzuki

2010

Section A:

Gaurav Budhrani 09P019

Jain Vivek Vikas 09P024

Narender Krishnani 09P033

Nikhil Taneja 09P035

Mohit Rungta 09P093


2/29

2

Table of Contents

Objective of the Project ................................................................................................................................ 3

Background of the project ............................................................................................................................ 3

Introduction .................................................................................................................................................. 4

Foreign Exchange Risk Management ............................................................................................................ 4

Hedging as a tool to manage foreign exchange risk ..................................................................................... 5

Infosys Technologies Ltd. .............................................................................................................................. 6

Revenue .................................................................................................................................................... 6

Currency Risk............................................................................................................................................. 7

Risk Management ..................................................................................................................................... 8

Currency Volatility Clause ......................................................................................................................... 9

Short Term Hedging (Two quarters to Six months) ................................................................................ 10

Use of Exotic Options Understanding the Barrier Option .................................................................... 10

Global Diversification .............................................................................................................................. 13

Significant Accounting Policies for Foreign Currency Transactions and Forward/Options contract ...... 14

Reliance Industries Ltd. ............................................................................................................................... 16

Foreign Currency Transactions ............................................................................................................... 17

Operations .............................................................................................................................................. 18

Binary option ........................................................................................................................................... 20

Crack spread ............................................................................................................................................ 22

Maruti Suzuki India Limited ........................................................................................................................ 24

Revenue .................................................................................................................................................. 24

Major Forex Transactions ....................................................................................................................... 25

Risk Management ................................................................................................................................... 26

Foreign Currency Translation .................................................................................................................. 27

Hedge Reserve ........................................................................................................................................ 27

Bibliography ................................................................................................................................................ 29


3/29

3

Objective of the Project

The objective of the project is to understand the various currency fluctuations a company is subject to in

its operations. The fluctuations in the foreign exchange can be both from upstream or downstream of

the supply chain. Thus it also becomes imperative to consider both aspects. The companies that havebeen identified would serve that purpose.

After getting an understanding of the various risks faced by the company in foreign exchange, the group

would like to understand and comment on the risk management strategies used by the respective

companies.

Background of the project

The sectors and companies that the group has identified is primarily because of the intensive exposure

to foreign currency fluctuations and the need to actively manage the fluctuations.

The companies that have been chosen are leaders in their respective sector.

The sectors that have been identified for the project are:

1. Information technology

2. Oil and gas

3. Automobiles

The companies in the three sectors are:

1. Infosys

2. Reliance Industries

3. Maruti


4/29

4

Introduction

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favor

of market-determination of foreign exchange rates; a regime of fluctuating exchange rates wasintroduced. Besides market-determined fluctuations, there was a lot of volatility in other markets

around the world owing to increased inflation and the oil shock. Corporate struggled to cope with the

uncertainty in profits, cash flows and future costs. It was then that financial derivatives foreign

currency, interest rate, and commodity derivatives emerged as means of managing risks facing

corporations.

In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. The

economic liberalization of the early nineties facilitated the introduction of derivatives based on interest

rates and foreign exchange.

Foreign Exchange Risk Management

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. The process of

identifying risks faced by the firm and implementing the process of protection from these risks by

financial or operational hedging is defined as foreign exchange risk management.

Kinds of Foreign Exchange Exposure:

Accounting exposure, also called translation exposure, results from the need to restate foreign

subsidiaries financial statements into the parents reporting currency and is the sensitivity of net

income to the variation in the exchange rate between a foreign subsidiary and its parent.

Economic exposure is the extent to which a firm's market value, in any particular currency, is sensitive

to unexpected changes in foreign currency. Currency fluctuations affect the value of the firms operating

cash flows, income statement, and competitive position, hence market share and stock price.

Transaction exposure refers to the extent to which the future value of firms domestic cash flow is

affected by exchange rate fluctuations. It arises from the possibility of incurring foreign exchange gains

or losses on transaction already entered into and denominated in a foreign currency.


5/29

5

The degree of transaction exposure depends on the extent to which a firms transactions are in foreign

currency: For example, the transaction in exposure will be more if the firm has more transactions in

foreign currency.

Hedging as a tool to manage foreign exchange risk

There are some explanations backed by theory about the irrelevance of managing the risk of change in

exchange rates. For example, the International Fisher effect states that exchange rates changes are

balanced out by interest rate changes, the Purchasing Power Parity theory suggests that exchange rate

changes will be offset by changes in relative price indices/inflation since the Law of One Price should

hold. Both these theories suggest that exchange rate changes are evened out in some form or the other.

Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate offers the

same expected return and is an unbiased indicator of the future spot rate. But these theories areperfectly played out in perfect markets under homogeneous tax regimes. Also, exchange rate-linked

changes in factors like inflation and interest rates take time to adjust and in the meanwhile firms stand

to lose out on adverse movements in the exchange rates.

In spite of the above argument corporations still go for foreign exchange hedging because of the

existence of different kinds of market imperfections and a hedged firm, being less risky can secure debt

more easily and this enjoy a tax advantage.


6/29

6

Infosys Technologies Ltd.

Infosys is an information technology Services Company headquartered in Bangalore, India. Infosys is one

of the largest IT companies in India with 113,796 employees (including subsidiaries) as of 2010. It has

offices in 22 countries and development centers in India, China, Australia, UK, Canada and Japan.

Revenue

Infosys generates its revenues from across the world with the majority of the earnings in US Dollars.

Infosys reported net revenues of Rs 22,742 Crores for the year ended on March 2010.

Net Income (Million) 2008 2009 2010

In USD 1163 1281 1313

Growth 10.15% 2.50%

In INR 4659 5975 6219

Growth 28.25% 4.08%

The YoY growth in Net Income in 2009 is 10.15% when financial statements are consolidated under IFRS

and 28.25% when the same are consolidated in Indian GAAP. The pattern is similar in 2010. They have

realized a notional gain with the currency exposure.


7/29

7

Geographical Split of Revenue

The majority of the revenue for Infosys comes from sales in North America.

The percentage of revenue in USD is 74.4% while that from India is under 5%. Under such a revenue

model the company faces high amount of uncertainty in terms of foreign exchange.

Currency Risk

Close to 98% of the revenues comes from exports and being denominated in foreign currencies while

most of the development activity happens from India and the costs are denominated in Indian rupees.

So, we carry a higher degree of currency risk. Roughly, 23% of our revenues come from Europe and

hence they carry a considerable amount of cross currency risks also apart from the Indian rupee to US

dollar risk.

For every 1% movement in the Indian rupee to US dollar rate, there is an impact of around 40 basis

points on Infosyss margins.


8/29

8

Risk Management

Infosys has a simple corporate structure and its operations are structured as a branch in most part of the

world. The whole of finance function is centralized in Bangalore, India which is its headquarters.

The treasury function at Infosys is centralized. It has a collection account in most parts of the world

where it has operations. It uses those collection accounts to make payments in the local markets and

hence minimize the currency risk. The surpluses in those collection accounts are pooled on a regular

basis and transferred to India. Most of its cash surpluses are kept and invested in India. The long term

direction for the Indian currency is to appreciate and also the interest rates in India are high. So, it

makes sense for them to keep our surpluses in Indian rupee denominated.

Infosys hedges its foreign currency risk in different currencies as different currencies do notappreciate/depreciate similarly. For ex. while US dollar appreciated 11.2% against INR, Pound sterling

appreciated only 6.4% and Euro appreciated just 1.8%.

Infosys uses forward and options (including exotic options like Barrier Options) to hedge its currency

risk. Infosys outstanding forwards and options contract as of March 2010 are:

Infosys does not use foreign exchange forward contracts or options for trading or speculation purpose.

Foreign Exchange gains and losses 2010 2009

Transaction and Translation -237 294

Option/Forward Contracts 277 -666

Net 40 -372


9/29

9

Figures in Crores of INR

To hedge its currency exposure, Infosys uses following the methods:

1.

Currency Volatility Clause2. Short term hedging ( Two quarters or Six months)3. Global Diversification

Currency Volatility Clause

Impact: Cheaper than other hedging products

Usually, clients or buyers based in the US or Europe are not impacted by the movement of the rupee

against the dollar or euro as billing is done in their currencies. A volatility clause in the contract is one

way of sharing the risk and also gaining from changes in the foreign exchange rate.

For a year now, Infosys has tried to include this clause in its contracts. According to the clause, if the

rupee appreciates 5% against the dollar, the client will pay 5% extra to Infosys. And if the rupee

depreciates 5%, Infosys will charge 5% less. We do try that [the forex volatility clause] because the

cross-currency volatility is too high now, V Balakrishnan, CFO, Infosys, explained in a recent conference

call with analysts. In some of the contracts we have clauses to protect us for a movement of plus or

minus 5% on the currency front but not all customers agree to it because currency is something which

we have to manage.

Forex experts say such clauses may work out cheaper for companies compared to hedging product like

options, which have an upfront premium. At the same time, its not possible to convince clients of textile

and garment exporters to include such clauses; orders are spread over many suppliers in many

countries. Clients who have long-term working relationships with a service exporter would be willing to

include such clauses in the contract. Even otherwise, contracts do have clauses that enable firms to ask

for repricing when the rupee has appreciated fast, says a senior official at a software firm, who cannot

be named as he is not authorised to talk to the media.

In general, Japanese companies are more willing to have such clauses. Importers from Japan will

compensate to an extent if the rupee fluctuates violently. The clause says the matter will be discussed.


10/29

10

But even without the clause, its a gentlemans understanding. Its almost taken for granted that a

Japanese company will help you, says PV Raghunathan, a forex expert.

Short Term Hedging (Two quarters to Six months)

Impact: Hedges up to 100% of net earnings for two quarters, amounting to around $1 billion. Infosys

made a foreign exchange gain of $63 million from derivative financial instruments in fiscal year 2010,

compared to a loss of $165 million the previous year.

Infosys trusts a short-term outlook when it comes to forex hedges. Its policy is to cover 100% of its net

earnings (dollar earnings less dollar expenses) for the next two quarters. Given the volatile forex

environment today, we think it best to take a short-term view. If your calculations go wrong, the pain

will last only for one or two quarters. Also, its much easier to shift to a new strategy, says V

Balakrishnan, Senior Vice-President and Chief Financial Officer, Infosys.

In terms of hedging products, the software services firm uses both forwards and options. Under options,

it subscribes to both vanilla options as well as exotics like barrier options (where the option to exercise

depends on the underlying unit reaching a given level).

The stakes are pretty high for Infosys as a 1% appreciation of the rupee would adversely impact its

operating margin by 40 basis points (one basis point is one hundredth of a percentage point). For a

company with revenues in excess of Rs 22,742 crore, that works out to Rs 90 crore.

Explaining the rationale behind taking a short-term view, especially after what happened during the

2007-08 forex crisis, Balakrishnan says: If you think the rupee will appreciate on a sustained basis and

work with that assumption in mind, you can get into serious trouble. The second learning we had is that

India is far more globalised than we thinkso global developments will haunt the rupee even if we are

on a strong wicket at home.

Use of Exotic Options Understanding the Barrier Option

Barrier options are a modified form of standard call and put options. A call owner benefits from an

upward stock move while a Put owner benefits from a downward stock move. So in case of standard

options the pay off depends on the strike price, while in case of barrier options there is a strike price and

a barrier price.


11/29

11

The barrier contract specifies that the payoff depends on whether the stock price ever crosses

the barrier level during the life of the option. In addition, if the barrier is crossed, some barrier option

contracts specify a rebate to be paid to the option holder.

Barriers come in two types. We call a barrier above the current stock level an up barrier if it is evercrossed, it will be from below. We call a barrier below the current stock level the down barrier, if it is

ever crossed, it will be from above.

Barrier Options come in two types: in options and out options.

An in barrier option, or knock-in option, pays off only if the stock finishes in the money and if

the barrier is crossed some-time before expiration. When the stock crosses the barrier, the

in barrier` option is knocked in and becomes a standard option of the same type with the same strikeand expiration, if the stock never crosses the barrier, the option expires worthless.

A down barrier option, or knockout option, pays off only if the stock finishes in the money and

the barrier is never crossed before expiration. As long as the stock never crosses the barrier, the out

barrier option remains a standard option of the same type (call or put) with the same strike and

expiration. If the stock crosses the barrier, the option is knocked out and expires worthless.

Therefore barrier options can be of 8 types

1. Up & In2. Up & Out3. Down & In4. Down & Out

Where each type can take the form of a call or a put, giving us a total of 8 single barrier types.

Option Type Location Crossed Not Crossed

Call Down and Out Below Spot Worthless Standard Call

Down and In Below Spot Standard Call Worthless

Up and Out Above Spot Worthless Standard Call

Up and In Above Spot Standard Call Worthless


12/29

12

Put Down and Out Below Spot Worthless Standard Put

Down and In Below Spot Standard Put Worthless

Up and Out Above Spot Worthless Standard Put

Up and In Above Spot Standard Put Worthless

Advantages of using barrier options

There are three basic reasons to use barrier options:

1 Options are valued by conducting scenario analysis of the future stock prices. We calculate expected

value of their payoffs averaging over all the stock scenarios. By buying a barrier option, you can

eliminate paying for those scenarios you think are unlikely. Alternatively, you can enhance your return

by selling a barrier option that pays off only on scenarios you think are improbable.

2 Suppose you own a stock and have decided that if it ever rises by more than 5% over the next year,

you will sell it, but you still want protection against market declines of more than 5%. You can buy a

standard put option struck at 95% of spot, but then you get protection even when the market rises more

than 5% and you no longer need it. Instead, it would be better to buy an up-and-out put with strike at

95%, barrier at l05%, and no cash rebate. This put will disappear as soon as you sell the stock and have

no further need of it

3 Barrier Options are often attractive to investors because their premium is lower than corresponding

standard options. Knockout options wont pay off until the stock crosses the knockout barrier.

Therefore, they are cheaper than an otherwise identical option without the knockout feature. If you

think the chance of knockout is small, you can take advantage of the lower premium and get the same

benefits. Or, you can even pay more premium to receive a cash rebate if the option is knocked out.

Why barrier options are cheaper?

Consider the example of a plain vanilla 1.55 US dollar Call/Canadian dollar put that gives the holder the

right to buy USD against Canadian dollars at a rate of 1.55 for 1 month's maturity. Spot is currently

trading at 1.54. Consider now the 1.55 US dollar call/Canadian dollar put expiring in 1 month that has a

knockout trigger at 1.50.


13/29

13

The knockout option will be cheaper than the plain vanilla option because it might get knocked out and

the holder of the option should be compensated for this risk with a lower up front premium. However, it

is not very likely that 1.50 will trade, so the difference in price is not that great. If we move the trigger to

1.53, the knockout option becomes considerably cheaper than the plain vanilla option because 1.53 is

much more likely to trade in the next month. We would expect the difference in price between the plain

vanilla price and the knockout price to increase with moves higher in implied volatility. A higher implied

volatility means that spot is more likely to trade at the trigger than if spot were less volatile. A greater

likelihood of trading at the trigger means a greater likelihood of getting knocked out.

Global Diversification

Beyond trading currencies, large corporations diversify against currency risk by establishing global

businesses within several different countries. For example, Coca Cola's international profits stabilize thefirm when the American economy and dollar are weak. Individual investors, however, may lack the

financial resources and expertise to establish overseas businesses. Smaller investors may purchase

shares of stock in multinational corporations, such as Coca Cola, or buy global mutual funds to protect

themselves against currency risks.

Infosys has been steadily increasing its contribution from Europe and UK in an attempt to diversity its

business and earning more revenues from countries other than North America. Since the currencies of

various countries show a co-relation coefficient of less than 1, having an international diversification

helps in mitigating the foreign exchange risk.

Infosys is also looking at new markets like China, Middle East, South America and Latin America with a

host of new services.

According to Infosys CEO and MD, Kris Gopalakrishnan, Infosys was also ready for acquisition across

various geographies. "We are open for geographical acquisitions as well as service based acquisitions.

The key is, it should happen at the right place at right time."


14/29

14

Significant Accounting Policies for Foreign Currency Transactions and Forward/Options contract

1. Foreign Currency TransationsForeign currency denominated monetary assets and liabilities are translated into the relevant

functional currency at exchange rates in effect at the Balance Sheet date. The gains or lossesresulting from such translations are included in the Profit and Loss account. Non-monetary

assets and non-monetary liabilities denominated in a foreign currency and measured at fair

value are translated at the exchange rate prevalent at the date when the fair value was

determined. Non-monetary assets and non-monetary liabilities denominated in a foreign

currency and measured at historical cost are translated at the exchange rate prevalent at the

date of transaction. Revenue, expense and cash-flow items denominated in foreign currencies

are translated into the relevant functional currencies using the exchange rate in effect on the

date of the transaction. Transaction gains or losses realized upon settlement of foreign currency

transactions are included in determining net profit for the period in which the transaction is

settled. The functional currency of Infosys and Infosys BPO is the Indian Rupee. The functional

currencies for Infosys Australia, Infosys China, Infosys Consulting, Infosys Mexico, Infosys

Sweden, Infosys Brazil and Infosys Public Services are their respective local currencies. The

translation of financial statements of the foreign subsidiaries from the local currency to the

functional currency of the Company is performed for Balance Sheet accounts using the exchange

rate in effect at the Balance Sheet date and for revenue, expense and cash-flow items using a

monthly average exchange rate for the respective periods and the resulting difference is

presented as foreign currency translation reserve included in Reserves and Surplus. When a

subsidiary is disposed of, in part or in full, the relevant amount is transferred to profit or loss.

2. Forward Contracts and Options in foreign CurrenciesThe Group uses foreign exchange forward and options contracts to hedge its exposure to

movements in foreign exchange rates. The use of these foreign exchange forward and options

contracts reduces the risk or cost to the Group. The Group does not use those for trading or

speculation purposes. Effective April 1, 2008, the Group adopted AS 30, Financial Instruments :

Recognition and Measurement, to the extent that the adoption did not conflict with existing

accounting standards and other authoritative pronouncements of Company Law and other

regulatory requirements. Forward and options contracts are fair valued at each reporting date.

The resultant gain or loss from these transactions is recognized in the Profit and Loss account.


15/29

15

The Group records the gain or loss on effective hedges, if any, in the foreign currency fluctuation

reserve until the transactions are complete. On completion, the gain or loss is transferred to the

consolidated Profit and Loss account for that period. To designate a forward or options contract

as an effective hedge, the Management objectively evaluates and evidences with appropriate

supporting documents at the inception of each contract whether the contract is effective in

achieving offsetting cash flows attributable to the hedged risk. In the absence of a designation

as effective hedge, a gain or loss is recognized in the consolidated Profit and Loss account.

Currently, the hedges undertaken by the Group are all ineffective in nature and the resultant

gain or loss consequent to fair valuation is recognized in the consolidated Profit and Loss

account at each reporting date.


16/29

16

Reliance Industries Ltd.

Reliance Industries Limited is India's largest private sector conglomerate company by market value, with

an annual turnover of US$ 44.6 billion and profit of US$ 3.6 billion for the fiscal year ending in March

2010 making it one of India's private sector companies, being ranked at 264th position in the Fortune

Global 500 (2009) and at the 126th position in the Forbes Global 2000 list (2010).

Reliance was founded by the Indian industrialist Dhirubhai Ambani in 1966. Ambani has been a pioneer

in introducing financial instruments like fully convertible debentures to the Indian stock markets.

Ambani was one of the first entrepreneurs to draw retail investors to the stock markets. Critics allege

that the rise of Reliance Industries to the top slot in terms of market capitalization is largely due to

Dhirubhai's ability to manipulate the levers of a controlled economy to his advantage. Reliance

Industries Limited has a wide range of products from petroleum products, petrochemicals, to garments

(under the brand name of Vimal), Reliance Retail has entered into the fresh foods market as Reliance

Fresh and launched a non-veg chain called Delight Reliance Retail and NOVA Chemicals have signed a

letter of intent to make energy-efficient structures.

The primary business of the company is petroleum refining and petrochemicals. It operates a 33 million

tonne refinery at Jamnagar in the Indian state of Gujarat. Reliance has also completed a second refinery

of 29 million tons at the same site which started operations in December 2008. The company is also

involved in oil & gas exploration and production. In 2002, it struck a major find on India's eastern coast

in the Krishna Godavari basin. Gas production from this find was started on 2 April 2009. As of the end

of 3rd quarter of 2009-2010, gas production from the KG D6 ramped up to 60 MMSCMD.

Major subsidiaries

Reliance Petroleum Limited (RPL) was a subsidiary of Reliance Industries Limited (RIL) and wascreated to exploit the emerging opportunities, creating value in the refining sector

worldwide.Currently, RPL stands amalgamated with RIL.

Reliance Life Sciences is a research-driven, biotechnology-led, life sciences organization thatparticipates in medical, plant and industrial biotechnology opportunities.

Reliance Industrial Infrastructure Limited (RIIL) is engaged in the business of setting up /operating Industrial Infrastructure that also involves leasing and providing services connected

with computer software and data processing.


17/29

17

Reliance Logistics (P) Limited is a single window solutions provider for transportation,distribution, warehousing, logistics, and supply chain needs, supported by in house state of art

telematics and telemetry solutions.[10]

Reliance Solar, The solar energy initiative of Reliance aims to bring solar energy systems andsolutions primarily to remote and rural areas and bring about a transformation in the quality of

life.

Infotel Broadband is a broadband service provider, it is wholly owned by RIL for 4,800 crore. Reliance retail is a fast growing retail chain created to tap fast growing organised retail market

of India.

Finance Committee

Finance Committee at Reliance is a three member committee. They Review the companys financialpolicies, risk assessment and minimisation procedures, strategies and capital structure, working capital

and cash flow management and make such reports and recommendations to the Board with respect

thereto as it may deem advisable.

The committee meets regularly and asses the risks to its operations including Foreign exchange risk that

includes total exposure to different currencies and the way those are hedged. Forex Risk management

has been the integral part of the Reliance as more than 50% of the revenues come from outside India.

Foreign Currency Transactions

Transactions denominated in foreign currencies are recorded at the exchange rate prevailing on the

date of the transaction or that approximates the actual rate at the date of the transaction.

Monetary items denominated in foreign currencies at the yearend are restated at year end rates. In case

of items which are covered by forward exchange contracts, the difference between the year end rate

and rate on the date of the contract is recognised as exchange difference and the premium paid on

forward contracts is recognised over the life of the contract.

Non monetary foreign currency items are carried at cost.

In respect of branches, which are integral foreign operations, all transactions are translated at rates

prevailing on the date of transaction or that approximates the actual rate at the date of transaction.

Branch monetary assets and liabilities are restated at the year end rates.


18/29

18

Any income or expense on account of exchange difference either on settlement or on translation is

recognised in the Profit and Loss account except in case of long term liabilities, where they relate to

acquisition of fixed assets, in which case they are adjusted to the carrying cost of such assets.

In respect of derivative contracts, premium paid, gains / losses on settlement and provision for losses forcash flow hedges are recognised in the profit and loss account except in case where they relate to the

acquisition or construction of fixed assets, in which case, they are adjusted to the carrying cost of such

assets.

Operations

The above graph shows the growth in revenue and forex earnings for Reliance in the past four years and

we can see that there has been a significant growth in the numbers. Foreign exchange earnings have

increased from Rs. 58,531 crores to Rs. 102,655 crores by FY10.

198,869.38

144,334.91137,204.63

112,825.60102,655.60

86,827.5275,974.22

58,531.32

2010200920082007

Revenue and Forex Trend

Revenue Forex earning


19/29

19

The above graph shows the fluctuations in the forex earnings as a percentage of revenue. It is noticeable

that there has been a constant increase in the revenue from exports except in the last year and this

could be because of the sluggish growth in the exports market.

The amount of currency exposure being hedged has increased considerably in last few years and though

there has been a growth in terms of unhedged currency in absolute terms it has been remarkably

outpaced by the hedged exposure both in absolute terms and as a percentage of total exposures.

51.62

60.16

55.37

51.88

2010200920082007

Forex Earning as a percentage of

Revenue

Forex earning as a percentage of total revenue

123,430.42

60,373.04

30129.415,383.09

50,442.3051,432.57

23,561.7614,367.34

2010200920082007

Hedged and Unhedged Exposure

Nominal amount of hedged currency Unhedged Forex exposure


20/29

20

These are the instruments used by the Reliance to hedge its Foreign currency exposure. There are

remarkable patterns in the usage of these instruments.

There has been a huge increase in interest rate swaps being used by the company. In fact the increase is

close to ten times in the period of just four years. Interest rate swaps have two main uses, the first one

is to secure cheaper debt (explained by the comparative advantage) and the other is to hedge the

Interest rate exposure for which these swaps are used by Reliance.

Currency swaps are similar to interest rate swaps but there are some differences because of two

different currencies involved. The Currency swaps are primarily used for two purposes and those include

securing cheaper debt and to hedge the currency exposure. There has not been a marked increase in

use of currency swaps because of limited overseas liabilities that could be hedged by the currency

swaps.

Options usage has seen a phenomenal increase and the reason could be attributed to the fact that

options have uneven payoff and unlike forwards, one can profit from the positive change in the

exchange rate. Though it comes at a price that known as option premium. Reliance is also known to use

binary option.

Binary option

It is a type of option where the payoff is either some fixed amount of some asset or nothing at all. The

two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary

2010200920082007

Interest Rate Swaps 48,361.0823,215.5010,201.645,614.74

Currency Swaps 4,199.764,435.15643.481,064.49

Options (net) 44,853.832,492.71975.22,939.76

Forward Contracts 26,015.7530,229.6818,309.085,764.10

0.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

Hedging instruments and their value


21/29

21

option. The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-

money while the asset-or-nothing pays the value of the underlying security. Thus, the options are binary

in nature because there are only two possible outcomes. They are also called all-or-nothing options,

digital options (more common in forex/interest rate markets), and Fixed Return Options (FROs) (on the

American Stock Exchange). For example, a purchase is made of a binary cash-or-nothing call option on

XYZ Corp's stock struck at $100 with a binary payoff of $1000. Then, if at the future maturity date, the

stock is trading at or above $100, $1000 is received. If its stock is trading below $100, nothing is

received. Binary options are usually European-style - for a call, the price of the underlying must be above

the strike at the expiration date. American options also exist, but these automatically exercise whenever

the price "touches" the strike price, yielding very different behaviour. In financial markets, expected

returns on a stock or other instrument are already priced into the stock. However, a binary options

market provides other information. Just as the regular options market reveals the market's estimate ofvariance (volatility), i.e. the second moment, a binary options market reveals the market's estimate of

skew, i.e. the third moment.

Another instrument being used by the company is forwards. The growth in the usage of the forwards

has not been like that of the options and the reason could be attributed to the fact that though forwards

dont have an initial cost, it doesnt let the company profit from the positive exchange rate fluctuations.

72,700

30,650

15,820

36,750

2010200920082007

Refinery margin hedges (KBBL)


22/29

22

This is a hedge used by the reliance to lock in its margins. In the futures markets, the "crack spread" is a

specific spread trade

Crack spread

Crack spread is a term used in the oil industry and futures trading for the differential between the price

of crude oil and petroleum products extracted from it - that is, the profit margin that an oil refinery can

expect to make by "cracking" crude oil (breaking its long-chain hydrocarbons into useful shorter-chain

petroleum products). In the futures markets, the "crack spread" is a specific spread trade involving

simultaneously buying and selling contracts in crude oil and one or more derivative products, typically

gasoline and heating oil. Oil refineries may trade a crack spread to hedge the price risk of their

operations, while speculators attempt to profit from a change in the oil/gasoline price differential.

Factors affecting crack spread

One of the most important factors affecting the crack spread is the relative proportion of various

petroleum products produced by a refinery. Refineries produce many products from crude oil, including

gasoline, kerosene, diesel, heating oil, aviation fuel, asphalt and others. To some degree, the proportion

of each product produced can be varied in order to suit the demands of the local market. Regional

differences in the demand for each refined product depend upon the relative demand for fuel for

heating, cooking or transportation purposes. Within a region, there can also be seasonal differences in

demand for heating fuel versus transportation fuel.

The mix of refined products is also affected by the particular blend of crude oil feedstock processed by a

refinery, and by the capabilities of the refinery. Heavier crude oils contain a higher proportion of heavy

hydrocarbons composed of longer carbon chains. As a result, heavy oil is more difficult to refine into

lighter products such as gasoline. A refinery using less sophisticated processes will be constrained in its

ability to optimize its mix of refined products when processing heavy oil.

For integrated oil companies that control their entire supply chain from oil production to retail

distribution of refined products, there is a natural economic hedge against adverse price movements.

For independent oil refiners which purchase crude oil and sell refined products in the wholesale market,

adverse price movements can present a significant economic risk. Given a target optimal product mix,

an independent oil refiner can attempt to hedge itself against adverse price movements by buying oil


23/29

23

futures and selling futures for its primary refined products according to the proportions of its optimal

mix.

The above graph shows the assets, liabilities and translation exposure of the Reliance. With the growth

of the company, there has been an increase in the assets and liabilities abroad thus increasing the

translation exposure but still it is too small for the company like Reliance and there has been no

information that they hedge this exposure.

249,417.81238,637.79

170,736.56

130,953.36

41,572.5736,865.9125,581.7619,609.25

2010200920082007

Assets and Liabilities in India

Assets Liability

10,025.05

7,433.99

4,220.371,576.81

9,012.03

5,427.89

2,935.44

934.43 1,013.022,006.101,284.93642.38

2010200920082007

Asset, Liabity and Translation exposure

Assets Translation exposure Liability


24/29

24

Maruti Suzuki India Limited

Maruti Suzuki India Limited is a publicly listed automaker in India. It is the largest automobile

manufacturer in South Asia. Suzuki Motor Corporation of Japan holds a majority stake in the company. It

is largely credited for having brought in an automobile revolution to India. It is the market leader in India

and on 17 September 2007, Maruti Udyog Limited was renamed Maruti Suzuki India Limited. The

company's headquarters are located in Delhi.

Revenue


25/29

25

Maruti Suzuki reported revenues of Rs. 203,583 million, with PAT of Rs. 12,187 million. The total number

of units sold in FY09 was 792,167. Of this, domestic sales accounted for 722,144 units and 70,023 units

were exported.

Major Forex Transactions

1. Royalty and Loan Payments ( Yen)One of the major expenditures of Maruti Suzuki in Yen is the royalty payment. The royalty payment for

FY09 was Rs. 6791 million. The royalty payment was significantly hiked in the beginning of FY11, from


26/29

26

3.6% of sales to 5.9% of sales. The interest payment on the foreign currency (Yen) loan of Rs. 6328

million was Rs. 484 million.

2. Technical Expertise, Components and Material Purchase (Yen)Another major component of forex expenditure is the purchase of raw materials, components and

capital goods. The raw materials and components purchase was Rs. 16,842 million and the capital goods

purchased were worth Rs. 10,817 million.

3. Vehicle exports ( Mainly Euro)Since 80% of Marutis exports head towards Europe, it receives most of its export income in Euros. The

export income in FY09 was Rs. 12,648 million.

To hedge its foreign currency exposure, Maruti Suzuki uses forwards.

Risk Management

Maruti Suzuki performs foreign exchange hedging only via forwards. It is yet to subscribe to currency

options. It hedges around 50% of its exposure.

Maruti Suzuki faces currency risk on two fronts. It has to make payments in yen for import of key auto

components from its parent company and other suppliers in Japan. And the bulk of its exports are to

Europe, where the receipts are in euros.

At the start of every financial year, Maruti budgets a rate at which it expects to manage its forex

transaction. Thereafter the companys treasury wing ensures that 50% of the net exposure in export

earnings and import payments are hedged. Interestingly, Maruti hedges almost 100% of its net

receivables in the first quarter, reduces it to two-thirds in the second quarter and lowers it to a third in

the fourth quarter. Thus it covers short and then gradually builds up positions for the rest of the year.This also gives it an opportunity to participate in any upside while hedging at the budgeted rates with

50% covered exposure.

Maruti however plans to increase the hedging ratio and try currency options.


27/29

27

Foreign Currency Translation

The accounting treatment of foreign currency translations and derivative instruments on Maruti Suzukis

financial statements is

1. Foreign currency transactions are recorded at the exchange rates prevailing at the date of thetransaction. Exchange differences arising on settlement of transactions, are recognised as

income or expense in the year in which they arise.

2. At the balance sheet date, all monetary assets and liabilities denominated in foreign currencyare reported at the exchange rates prevailing at the balance sheet date by recognizing the

exchange difference in profit and loss account. However, the exchange difference arising on

foreign currency monetary items that qualify and are designated as hedge instrument in a cash

flow hedge is initially recognized in 'hedge reserve' and subsequently transferred to profit & loss

account on occurrence of the underlying hedged transaction.

Hedge Reserve

Derivative contracts are fair valued at each reporting date. The Company records the gain or loss on

effective hedges, if any, in a "Hedge Reserve", until the transaction is complete. On completion, the gain

or loss is transferred to the profit and loss account of that period. Change in fair value relating to the

ineffective portion of the hedges and derivatives not qualifying or not designated as hedge is recognized

in the profit and loss account in the accounting period in which it arises.

In case of forward foreign exchange contracts where an underlying asset or liability exists at the balance

sheet date, the difference between the forward rate and the exchange rate at the inception of the

contract is recognised as income or expense over the life of the contract. Profit or loss arising on

cancellation or renewal of a forward contract is recognised as income or expense in the year in which

such cancellation or renewal is made.

In respect of derivative instruments which qualify for hedge accounting, the net unrealised profit/loss is

accounted for as a Hedging Reserve to be ultimately recognized in the profit and loss account when the

underlying transaction arises, as against the earlier practice of recognizing the same in the profit and

loss account, on valuation at the end of each period. Other derivative instruments that do not qualify for


28/29

28

hedge accounting have been recorded at fair value at the reporting date and the resultant loss/ gain has

been accounted in the profit and loss account


29/29

Bibliography

1. Annual Report Infosys Technologies2. Annual Report Reliance Industries3. Annual Report Maruti Suzuki4. ISI Emerging Markets5. Prowess Database6. Outlook India7. www.financeasia.com8. www.debtkid.com9. www.ehowto.com10.www.allbusiness.com11.www.wikipedia.org12.finance.yahoo.com13.www.financialexpress.com

Documents

ICF Project Report