1. Describe the deal between TT Textiles and ABC bank.

The deal between TT Textiles and ABC bank was a currency swap deal. The swap was on
the US Dollar and Swiss Francs, as these two currencies traditionally had stable exchange
rates in comparison to the Rupee and Dollar. The start date for the swap was October 19,
2006 and the expiration date was October 15, 2009, with a delivery date of October 19,
2009.
The notional principal amount for the contract was INR 225 million = USD 4965791.22 =
CHF 6306554.84. The contract implied that TT textiles would receive a fixed interest of 1.77
per cent semi-annually on the notional amount of INR 225 million and would not pay any
interest on the notional amount of CHF 6306554.84 to ABC bank. There was no initial
principal exchange in this swap however, at the end of the swap TT Textiles had to pay CHF
6306554.84 to ABC bank. ABC bank was also offering TT Textiles a credit limit of INR 80
million on the basis of its balance sheet to cover the margins and mark-to-market losses.
The swap also had a partial barrier on the CHF/USD rate of 1.04 within the window of
September 15, 2009 to October 15, 2009 which meant that if the CHF/USD rate fell below
1.04, the payouts would be according to the spot rate.

2. What is the instrument in this deal? What is the nature of the pay-outs?

The currency swap deal was designed using options. According to the deal, TT Textiles
received a USD Put/CHF Call option at strike 1.27 for USD 4965791.22 with knock out at
1.04 which implied that TT Textiles had an option to sell USD at 1.27 if the USD/CHF did not
trade at or below 1.04 at any time between September 15, 2009 and October 15, 2009. TT
Textiles also had an obligation to sell USD at 1.27 if USD/CHF went above 1.27 on maturity.
For this option, as long as the USD/CHF is above 1.04, there is nothing to worry about as
there will be no losses, however, once the rate falls below 1.04 TT Textile will incur huge
losses. Also, in this option, if the rate goes above 1.27, TT Textiles would not be able to
realize those gains as it has an obligation to sell at 1.27.

TT Textiles also had the option of buying (long call) USD 4965791.22 at 46.25 if the
USD/INR exchange rate was above INR 46.25 at maturity. TT Textiles had the obligation to
buy (short put) USD 4965791.22 at INR 45.00 if the USD/INR exchange rate was below
45.00 at maturity. TT Textiles would buy at the spot rate if the USD/INR rate was between
INR 45.00 and INR 46.25. For this option, if the rate goes above 46.25, TT Textiles would
still be able buy the US Dollars at 46.25. Also, if the rate falls below 45, TT Textiles would
not be able to buy those US Dollars cheaply as it has an obligation to buy at 45.00.

3. What is the motivation for TT Textiles to get into a deal with ABC bank?

In late 2006, when the Indian Rupee was appreciating and the dollar was depreciating, the
Indian textile industry was reeling under severe currency pressures. As the appreciation in
the Rupee was not driven by global factors, Indian exporters were losing out in
competitiveness. For a low-margin (5% – 6%) industry like textiles, this threatened the very
viability of exporters. To remain competitive as TT Textiles’ 75% revenue came from exports
and majority is billed in US Dollars, it decided to protect itself from currency risk using
currency swaps. It enabled the company to limit its exposure to fluctuations in the rate of US
Dollar. The swap was on the US Dollar and Swiss Francs, as these two currencies
traditionally had stable exchange rates in comparison to the Rupee and Dollar. When the
swap deal was designed, it was based on the fact that, historically, the US Dollar had never
gone below the exchange rate of 1.09 CHF, making the latter a very stable currency. To be
doubly sure, TT Textiles kept the strike rate in the swap deal at 1.04 CHF as it was confident
that the likelihood of the strike rate bypassing the set 1.04 mark would be next to impossible
and TT Textiles was virtually assured of an earning of INR 12 million (fixed interest of 1.77%
semi-annually) over the life of the deal. This would provide a much-needed buffer against the
squeeze in margins that the appreciating rupee would imply for TT Textiles.

4. Is this a hedge? Why or Why not?

Hedging is a method used by companies to eliminate or "hedge" their foreign exchange risk
resulting from transactions in foreign currencies. In this case also, the primary objective for
TT Textiles to agree on currency swap deal with ABC bank was to protect itself from the
currency risks arising due the appreciating Indian Rupee against US Dollar. The
competitiveness of the company was getting impacted which would hurt the company a lot
as approximately 75 per cent of its revenues come from exports. Currency swap would
minimize the foreign exchange risk as the receipts in USD would be protected from adverse
changes in exchange rates.

5. With 3 months left on the contract, what would be your advice to Sanjay Jain?

The currency swap arrangement in which the TT Textiles has entered can have positive as
well as negative impacts on the profitability of the company. Currently, Mr. Jain has two
options, either terminate the agreement or hold the positions till delivery and make all the
payments in the end. Initially, the swap was profitable to TT Textiles as it was receiving INR
2 million interest payment but the recession has changed everything. The general economic
environment in the United States as well as across the world has caused negative impacts
on the US Dollar. However, as the CHF/USD rates have started to rise again, it is highly
uncertain what is going to happen. TT Textiles have already incurred huge mark-to-market
losses due to the depreciation of US Dollars.

My suggestion would be to terminate the currency swap as there is a high probability that
CHF might start appreciating again which would increase TT Textiles mark-to-market losses.
Also, the purpose of hedging is to minimize risk which in this case is possible by terminating
the contract as the losses are less as compared to holding the swap till delivery & buy
appreciated US Dollars and incur huge losses.