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Corporate Hedging for Foreign

Exchange Risk in India
 Introduction
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• In 1971, fixed foreign exchange rates was abolished and

fluctuating rates was introduced.

• In 1993, the exchange rates was deregulated and were

allowed to be determined by markets.

• Currently Forwards, Swaps and options are available in

India and use of Foreign currency derivatives is
permitted for Hedging purpose only.

• To provide a perspective on managing the risk that the

firm’s face due to fluctuating exchange rates
 Foreign Exchange Risk Management
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It is the process of identifying risks faced

by the firm and implementing the process
of protection from these risks by financial
or operational hedging.
 Kinds of Foreign Exchange Exposure
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• Accounting Exposure- To reinstate foreign subsidiaries

financial statements into parent’s reporting currency.

• Economic Exposure- It is the extent to which a firm’s

market value, in any particular currency, is sensitive to
unexpected changes in foreign currency.

• Exchange rate Exposure- It is the sensitivity of the

value of the firm, proxied by firm’s stock return, to an
unanticipated change in an exchange rate.
 Foreign Exchange Risk
Management Framework
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Forecasts

Risk Estimation

Benchmarking

Hedging

Stop loss

Reporting & Review

 Forecast
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The first step for a firm is to develop a forecast

on the market trends and what the main
direction/trend is going to be on the foreign
exchange rates. The period for forecasts is
typically 6 months. It is important to base the
forecasts on valid assumptions. Along with
identifying trends, a probability should be
estimated for the forecast coming true as well as
how much the change would be.
 Risk Estimation
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Based on the forecast, a measure of the Value

at Risk (the actual profit or loss for a move in
rates according to the forecast) and the
probability of this risk should be ascertained.
The risk that a transaction would fail due to
market-specific problems should be taken into
account.
 Benchmarking
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Given the exposures and the risk

estimates, the firm has to set its limits for
handling foreign exchange exposure. The
firm also has to decide whether to manage
its exposures on a cost centre or profit
centre basis.
 Hedging
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Based on the limits a firm set for itself to

manage exposure, the firms then decides
an appropriate hedging strategy. There
are various financial instruments available
for the firm to choose from: futures,
forwards, options and swaps and issue of
foreign debt.
 Stop Loss
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The firms risk management decisions are

based on forecasts which are but
estimates of reasonably unpredictable
trends. It is imperative to have stop loss
arrangements in order to rescue the firm if
the forecasts turn out wrong.
 Report & Review
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Risk management policies are typically subjected

to review based on periodic reporting. The
reports mainly include profit/ loss status on open
contracts after marking to market, the actual
exchange/ interest rate achieved on each
exposure, and profitability vis-à-vis the
benchmark and the expected changes in overall
exposure due to forecasted exchange/ interest
rate movements.
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Hedging Strategies/
Instruments
 Forwards
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A forward is made to measure agreement

between the two parties to buy/sell a specified
amount of a currency at a specified rate on a
particular date in the future. The depreciation of
the receivable currency is hedged against by
selling a currency forward. If the risk is that of a
currency appreciation (if the firm has to buy that
currency in future say for import), it can hedge
by buying the currency forward.
 Futures
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A futures contract is similar to the forward

contract but is more liquid because it is
traded in an organized exchange i.e. the
futures market. Depreciation of a currency
can be hedged by selling futures and
appreciation can be hedged by buying
futures. Advantages of futures are that
there is a central market for futures which
eliminates the problem of double
coincidence.
 Options
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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.
 Swaps
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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.
 Determinants of Hedging Decisions
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• Production and Trade vs. Hedging Decisions- An

important issue for multinational firms is the allocation of
capital among different countries production and sales
and at the same time hedging their exposure to the
varying exchange rates.

• Cost of Hedging- Hedging can be done through the

derivatives market or through money markets (foreign
debt). In either case the cost of hedging should be the
difference between value received from a hedged
position and the value received if the firm did not hedge.
 Factors affecting the Decision to
Hedge Foreign currency Risk
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• Firm Size- The book value of assets is used as a measure of Firm

Size.

• Leverage- firms with high leverage have greater incentive to engage

in hedging because doing so reduce the probability, and thus the
expected cost of financial distress.

• Liquidity & Profitability- Liquidity is measured by the quick ratio,

i.e. quick assets divided by current liabilities). Profitability is
measured as EBIT divided by book assets.

• Sales Growth- The measure of sales growth is obtained using the

3-year geometric average of yearly sales growth rates.
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An Overview
of Corporate Hedging
in India
 Foreign Exchange Market in India
•The origin of the foreign exchange market in India could be traced to the year 1978 when
banks in India were permitted to undertake intra-day trade in foreign exchange.
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•It was in the 1990s that the Indian foreign exchange market witnessed far reaching changes
along with the shifts in the currency regime in India. The exchange rate of the rupee,that was
pegged earlier was floated partially in March 1992 and fully in March 1993.

•The Indian foreign exchange market is a decentralised multiple dealership market

comprising two segments – the spot and the derivatives market. In the spot market, currencies
are traded at the prevailing rates and the settlement or value date is two business days ahead.
The derivatives market encompasses forwards, swaps and options.

•Forward contracts exist for maturities up to one year, majority of forward contracts are for
one month, three months, or six months. Forward contracts for longer periods are not as
common because of the uncertainties involved and related pricing issues.

•Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in
foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers
– individuals, corporates, who need foreign exchange for their transactions.

•The Reserve Bank intervenes in the market essentially to ensure orderly market conditions.
The Reserve Bank undertakes sales/purchases of foreign currency in periods of excess
demand/supply in the market.

•Daily trade volume in the OTC market is about $34bn.

 Measures Initiated to Develop Foreign Exchange
Market
Increase in Instruments in the Foreign Exchange Market:
•The rupee-foreign currency swap market was allowed.
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• Additional hedging instruments such as foreign currency-rupee options, cross-currency

options, interest rate swaps (IRS) and currency swaps, caps/ collars and forward rate
agreements (FRAs) were introduced.
•Introduction of Exchange Traded Currency Futures
Liberalisation Measures:
•Authorised dealers were permitted to initiate trading positions, borrow and invest in overseas
market, subject to certain specifications and ratification by respective banks’ Boards. Banks
were also permitted to (i) fix net overnight position limits and gap limits (with the Reserve
Bank formally approving the limits); (ii) determine the interest rates (subject to a ceiling) and
maturity period of FCNR(B) deposits with exemption of inter-bank borrowings from
statutory preemptions; and (iii) use derivative products for assetliability management.
•Participants in the foreign exchange market, including exporters, Indians investing abroad,
and FIIs were permitted to avail forward cover and enter into swap transactions without any
limit, subject to genuine underlying exposure.
•FIIs and NRIs were permitted to trade in exchangetraded derivative contracts, subject to
certain conditions.
•Foreign exchange earners were permitted to maintain foreign currency accounts. Residents
were permitted to open such accounts within the general limit of US $ 25,000 per year, which
was raised to US $ 50,000 per year in 2006, has further increased to US $ 1,00,000 since
April 2007.
 Introduction to Currency Futures
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• Foreign Exchange rates like any other asset class

move depending on various factors like demand
supply, interest rates parity, and capital flows.
Speculators taking positions, clients hedging risk
arising from their trade and capital flows etc.
• Introduction of Currency futures will complete the
suite the instruments available for trading and
hedging to the Indian residents.
• The strong correlation that foreign exchange has to
interest rates, equity flows, and commodities will
translate to opportunities to trade currency futures
independently or in conjunction with equities,
commodities like gold or oil etc.
 Contract Specification
Underlying USD-INR
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Trading Hours (Monday to 9.00 a.m to 5.00 p.m

Friday)
Contract Size USD 1000
Tick Size INR 0.0025
Contracts Available Future 12 months
Contract Expiration Date Last working day of the month
Last Trading Day Two working days prior to Contract Expiration
date.
Daily M-T-M The daily mark-to-market settlement shall be done
on T+1 day basis.
Settlement Mechanism Cash Settled in Indian Rupees.
Settlement Price The settlement price would be the Reserve Bank
Reference Rate on the date of expiry.
Brokerage Rs.3000/crore
Initial Margin 2% per lot
 How lucrative will it be for a customer to trade on
currency futures?
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The OTC forex market is a fairly commoditised and liquid market. Hence,
the price discovery benefits may not be substantial. The important benefit
will be that this will for the first time allow individuals/business entities to
take on forex risk, whether as a proactive risk management measure or to
profit from currency movements.

Invest: Take a view on USDINR appreciating or depreciating over a

specified time frame. For example, if an investor expects oil prices to rise
and impact India’s import bill, he would buy USDINR with a view to INR
depreciating. Alternately if an investor believe that strong exports from the
IT sector, combined with strong FII flows will translate to INR
appreciation, he would sell USDINR.

Hedge: An importer having USD payments to make at a future date, can

hedge its foreign exchange exposure by buying USDINR and fixing pay
out rate today. He would hedge if view that USDINR is going to
depreciate.
 Advantages compared to Forward Market
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•Transparency in Prices.
•Low Cost of Entry & Exit.
•Low Margin.
•Accessible to all, without any exposure
requirement.
•Huge potential in Future with entry of Euro-INR,
JPY-INR etc.
 How to Trade In Currency Futures
View INR will depreciate against USD, caused by FII’s equity
outflows & rise in hope of US Interest Rate hike:
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Trade:

USDINR 27 Oct 2017 contract: 64.9900

Current spot rate as on 24th Oct 17 :64.9500
Buy 1 October contract: Value Rs. 64,990
($1000*64.9900)
Hold contract till expiry: RBI fixing rate as on 27th
Oct = 65.0539
Contract Settled at RBI Reference Rate
Economic Return: Profit Rs.60 (65050-64990)
 Why Futures and Not Forwards
For an Exporter having a receivable of $ 1 mn in the month of October 17.
When hedged with NSE:
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No. of contracts :1000

USDINR 27 OCT 17 contract: 64.9900
Current spot rate as on 24th October: 64.9500
Sell 1000 OCT contract: Value Rs. 6.49 crs. [$1000*46.60*($1 mn/$1000)]
Hold contract till expiry: RBI fixing rate as on 23rd Oct- 65.02
Buy 1000 OCT Contract: Value Rs.6.50 crs.
Gross Profit from NSE= 0.01crs (6.50-6.49)

Brokerage Rate= 0.02%

Total Brokerage cost for buying & selling= Rs.25980 (12980+13000)
Margin Requirement: 2% i.e Rs.13 lacs (Rs.6.49 crs*2%)
Cost of capital for 1 month @ 12% = 13000.
Net Profit from NSE= Rs. 61020 (100000-25980-13000)

Current spot rate as on 24th OCT: 64.95

Convert $ 1 mn at the spot rate with Bank: Rs.6.495 crs.
Net realization: Rs.6.495 crs+ Rs.0.610 lacs

Effective USDINR rate: 64.9500

 Why Futures and Not Forwards
For an Exporter having a receivable of $ 1 mn in the month of October 17.
When hedge with Banks using Forwards:
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Forward book with Bank = 65.0000

Spread charged by bank= 0.010paise.
Loss incurred on spread charges= 10000
Forward Booking Charges= Rs.600.
Net amount realized: Rs.6.50 crs-10000-600.

Effective USDINR rate=64.9500

Note:
Spread charges are the hidden cost, which a bank charges while giving quotes
to its clients. For example, to an importer the bank may give a quote of
Rs.65.0000/$ but the actual prevailing rate may be less than that say
Rs.64.9950/$. Thus a bank earn a spread of Rs.0.0050/$.
 Position Limits

There is a limit of USD 100 million on the open

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interest applicable to trading members who are banks

and the USD 50 million limit for other trading
members. So, larger exporters and importers might
continue to deal in the OTC market, where there is no
limit on the hedges.
 Tax Implications

Profits from trading in currency futures are treated as

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business income.