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Summer project
On
Foreign Exchange Risk Management
By
Paresh S. Mahajan
Atharva Institute of Management StudiesMarve Road, Malad (W), Mumbai 4000 95.
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July 2005
Summer project
On
ForeignExchangeRiskManagement
By
Paresh S. Mahajan
Submitted to:
Mr. Satish Kamat
Finance Manager
Mahindra Intertrade Limited
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Mahindra Intertrade is part of the Mahindra Group, a global manufacturing
conglomerate with annual revenues in excess of US $1 billion. The Mahindra Group
has a significant presence in key sectors of the Indian economy. A consistently high
performer, M&M has been ranked among the top ten private-sector companies in the
country for several years.
A corporate history spanning from 1945, the group expanded its operations from
automobiles and tractors to secure a significant presence in many more important
sectors - hospitality, trade and financial services, automotive components,
information technology, telecom and infrastructure development. The group
employs more than 12,600 people and has six state-of-the-art manufacturing
facilities spread over 500,000 square meters. It has 33 sales offices that are
supported by a network of over 500 dealers across the country. This network is
connected to the company's plants by an extensive IT infrastructure. The M&M
philosophy of growth is centered on a belief in people. As a result, the company has
put in place initiatives that seek to reward and retain the best talent in the industry.
Mahindra Intertrade is a wholly owned subsidiary of the Mahindra & Mahindra
group, one of the 10 largest industrial houses in India. MIL undertakes imports,
exports, third country business, domestic trading & marketing & distribution
activities. The product portfolio is wide and diversified and includes steel, steel raw
material, technical and application-engineering products, metals (non-ferrous),
commodities, consumer products and engineering products.
Mahindra Intertrade was incorporated from a division into a separate company in
1999 to pursue unhindered & fast growth leveraging our skills & competencies.
Mission Statement
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"Build a Global trading Organization based on the Mahindra brand promises of
reliability and credibility towards delivering a distinct value proposition to our
business affiliates, customers, employees and shareholders. We seek to achieve this
through continuously enhancing and leveraging our human and knowledge capital
across products and services"
Our Competencies
Straddled across a wide range of products & services, Intertrade has efficiently
leveraged its competencies in -
Business Understanding
Transaction Management
Risk Management
Relationship Management
Financial Supporting Capabilities
Trading Skills
MIL have grown across products & services leveraging our skills & business
acumen, supported by our rich parentage whenever we have needed it.
And today, we deal in -
Steel & Steel raw materials
Non Destructive testing equipment
Application Engineering products
Consumer Goods
Engineering Exports
We have over 300 customers and principals across 4 continents in over 15 countries.
Intertrade enjoys a strong presence in India with offices in all regions. We have
robust business process integrated in SAP- capable of managing the complexities of
international trade. We have a non-compromising focus on Good Corporate
Governance.
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Foreign Exchange RiskManagement Policy
A. Normal Trade:
Minimum of 50% of net exposure including cross currency exposure
will stay covered. (Net Exposure = Imports + other remittances -
Exports - Other Forex Earnings) and net open position in excess of
50% of net exposure including cross currency exposure or US $ 2.5 M
whichever is lower requires prior approval of MD.
Hedging of anticipatory position requires prior approval of MD.
Open position limit
Treasury Manager US $ 1.50 M
FC US $ 2.50 M
MD US $ 10.00 M
Stop loss limit restricted to Rs.100 Lakhs p.a. throughout the year net
of exchange losses booked during the year. The stop loss is dynamic.
B. Structured Trades:
Maximum open position up to 50% of transaction value in respect of
large value structured trade e.g. Merchanting/ Transit Trade and
Export Performance.
Open position limit:
FC 50% of transaction value
MD open position over 50% of transaction value
within US $ 10 M per A above
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Stop loss limit restricted to Rs.25 Lakhs p.a. throughout the year net of
exchange losses booked during the year. The stop loss is dynamic.
C. Overall Stop Loss Limit:
Normal Trade Rs. 100 Lakhs
Structured Trade Rs. 25 Lakhs
Total Rs. 125 Lakhs
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Foreign Exchange Exposure
Definition
Adler and Dumas defines foreign exchange exposure as the sensitivity of changes in
the real domestic currency value of assets and liabilities or operating income to
unanticipated changes in exchange rate.
To understand the concept of exposure, we need to analyze this definition in detail. The
first important point is that both foreign and domestic assets and liabilities could be
exposed to exchange rate movements. E.g. if an Indian resident holds a dollar deposit and
dollars value vis--vis the rupee changes, the value of deposit in terms of rupees changes
automatically. On the other hand, if a person is holding a debenture in an Indian company,
the value of the debenture may change due to an increase in general rates, which in turn
may be the effect of depreciating rupee. Thus, even though no conversion from one
currency to another in involved, a domestic asset can be exposed to movements in the
exchange rates, albeit indirectly.
The second important point is that only assets and liabilities, but even operating incomes
can be exposed to exchange rate movements. A very simple example would be of a firm
exporting its products. Any change in the exchange rate is likely to result in a change in the
firms revenue in domestic currency terms.
Thirdly, exposure measures the sensitivity of changes in real domestic-currency value of
assets, liabilities and operating incomes. That is, it is the inflation adjusted values
expressed in domestic currency terms that are relevant. Though this is theoretically a sound
way of looking at exposure, practically it is very difficult to measure and incorporate
inflation in the calculations.
The last point to be noted is that exposure measures the responses only to the unexpected
changes in the exchange rate as the expected changes are already discounted by the market.
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In simple terms, definition means that exposure is the amount of assets; liabilities and
operating income that is ay risk from unexpected changes in exchange rates.
Sensitivity can be measured by the slope of the regression equation between two variables.
Here are the two variables are the unexpected changes in the exchange rates and the
resultant change in the domestic currency value of assets, liabilities and operating income.
The second variable can be divided into four categories for the purpose of measurement of
exposure. These are:
Foreign currency assets and liabilities which have fixed foreign currency values.
Foreign currency assets and liabilities with foreign-currency values that change
with an unexpected change in the exchange rate.
Domestic currency assets and liabilities.
Operating incomes.
Exposure When Assets and Liabilities Have Fixed Foreign
Currency Values
The measurement of exposure for the first category is category is comparatively simpler
than for the remaining three. Let us see an example to understand the process of
measurement. Assume that an Indian resident is holding a $1 million deposit. As the dollar
appreciates by Rs.0.10, the value of the deposit also increases by Rs.0.1 million. Similarly,
an unexpected depreciation of the dollar by Rs.0.10 will reduce the value of the deposit by
Rs.0.1 million. This gives an upward sloping exposure line. On the other hand, if there
were foreign liability which had its value fixed in terms of the foreign currency, it would
give a downward sloping exposure line.
When the foreign currency value of asset or liability does not change with a change in the
exchange rate, the exposure is equal to the foreign currency value. While an exposure with
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Operating Incomes
Measurement of exposure on operating profits is the most difficult of all. Let us examine
the case of a company using imported raw materials, whether it is selling its product in the
domestic market or the international market. Let us say there is appreciation of the foreign
currency. Firstly, whether the domestic price of the imported raw material will increase or
not will depend on the response of the seller. The international price may or may not get
reduced, depending upon the conditions prevailing in the international market. Even if we
assume that the international price is not reduced and hence, the domestic currency price of
the raw material increases, the effect on the operating profit is not easily predictable.
Though the quantity of the raw material the company wants to purchase at the increased
price would appear to be in its own hands, in reality it is dependent on several factors.
These include availability and the price of the same or substitute raw materials in the
domestic market, the possible response of the consumers in case the company wants to pass
on the increased costs to them etc.
Even companies which do not operate in the international markets, either as exporters or as
importers, may be exposed to exchange rate changes. This could be due to presence of
competitors. One way exchange rate movements affect such players is by affecting the
production costs and/or prices of their competitor. Another way exchange rate changes may
affect the domestic companies is by making its foreign competitors operations more or
less profitable, thereby either driving it out of the market, or by acting as an inducement for
more competitors to enter the market.
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Types of Exposure
Exposure can be classified into three kids on the basis of the nature of the item that is
exposed, measurability of the exposure and the timing of estimation of exposure.
Transaction Exposure
Translation Exposure
Operating Exposure
Transaction Exposure
Transaction exposure is the exposure that arises from foreign currency denominated
transactions which an entity is committed to complete. It arises from contractual, foreign
currency, future cash flows. For example, if a firm has entered into a contract to sell
computers at a fixed price denominated in a foreign currency, the firm would be exposed to
exchange rate movements till it receives the payment and converts the receipts into
domestic currency. The exposure of a company in a particular currency is measured in net
terms, i.e. after netting off potential cash inflows with outflows.
Translation Exposure
Translation exposure is the exposure that arises from the need to convert values of assets
and liabilities denominated in a foreign currency, into the domestic currency. Any exposure
arising out of exchange rate movement and resultant change in the domestic-currency value
of the deposit would classify as translation exposure. It is potential for change in reported
earnings and/or in the book value of the consolidated corporate equity accounts, as a result
of change in the foreign exchange rates.
Operating Exposure
Operating exposure is defined by Alan Shapiro as the extent to which the value of a firm
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stands exposed to exchange rate movements, the firms value being measured by the
present value of its expected cash flows. Operating exposure is a result of economic
consequences. Of exchange rate movements on the value of a firm, and hence, is also
known as economic exposure. Transaction and translation exposure cover the risk of the
profits of the firm being affected by a movement in exchange rates. On the other hand,
operating exposure describes the risk of future cash flows of a firm changing due to a
change in the exchange rate.
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Management of Transaction and Translation Exposure
Transaction exposure introduces variability in a firms profits. For example, the price
received in rupee terms by an Indian exporter for goods exported will not be known by him
till he converts the foreign currency receipts into rupees. This price varies with changes in
the exchange rate. While transaction exposure arises out of the day-to-day activities of a
firm, translation exposure arises due to the need to translate the foreign currency values of
assets and liabilities into domestic currency.
These differences in the two types of exposures result in some basic differences in the way
they are required to be managed. Management of transaction exposure is essentially a day-
to-day operation carried out by the treasurer. It involves continuous monitoring of
exchange rates and the firms exposure, along with an evaluation of effectiveness of
hedging techniques employed. On the other hand, management of translation exposure is a
periodic affair, coming into the picture at the time of preparation of financial statements.
This makes the management of translation exposure more of a policy decision, rather than
a day-to-day issue to be handled by the treasurer.
Management of exposure essentially means reduction or elimination of exchange rate risk
through hedging. It involves taking a position in the forex and/or money market which
cancels out the outstanding position. The hedging instruments are classified as external and
internal instruments. Internal instruments are those which are a part of day-to-day
operations of the company, while external instruments are the ones which are undertaken
for the purpose of hedging exchange rate risk.. The various internal hedging techniques are:
Exposure netting,
Leading and lagging,
Choosing the currency of invoice,
Sourcing.
Exposure Netting
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Exposure netting involves creating exposures in the normal course of business which offset
the existing exposures. The exposures so created may be in the same currency as the
existing exposures, or in any other currency, but the effect should be that any movement in
exchange rates that results in a loss on the original exposure should result in a gain on the
new exposure. This may be achieved by creating opposite exposure in the same currency or
a currency which moves in tandem with the currency of the original exposure. It may also
be achieved by creating a similar exposure in a currency which moves in the opposite
direction to the currency of the original exposure.
Leading and Lagging
Leading and lagging can also be used to hedge exposures. Leading involves advancing a
payment i.e. making a payment before it is due. Lagging, on he other hand, refers to
postponing a payment. A company can lead payments required to be made in a currency
that is likely to appreciate, and lag the payments that it needs to make in a currency that is
likely to depreciate.
Hedging by Choosing the Currency of Invoicing
One very simple way of eliminating transaction and translation exposure is to invoice all
receivables and payables in the domestic currency. However, only one of the parties
involved can hedge itself in this manner. It will still leave the other party exposed as it will
be leading in a foreign currency. Also, as the other party needs to cover its exposure, it is
likely to build in the cost of doing so in the price it quotes/ it is willing to accept.
Another way of using the choice of invoicing currency as a hedging tool relates to the
outlook of a firm about various currencies. This involves invoicing exports in a hard
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currency and imports in a soft currency. The currency so chosen may not be the domestic
currency for either of the parties involved, and may be selected because of its stability.
Another way the parties involved in international transactions may hedge the risk by
sharing the risk. This may be achieved by denominating the transaction partly in each of
the parties involved. This way, the exposure for both the parties gets reduced.
Hedging through Sourcing
Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials
in the same currency in which it sells its products. This results in netting of the exposure, at
least to some extent. This technique has its own disadvantages. A company may have to
buy raw material which is costlier or of lower quality than it can otherwise buy, if it
restricts the possible sources in this manner. Due to this technique is not used very
extensively by firms.
The various external hedging techniques are:
Forwards,
Futures,
Options, and
Money markets.
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Hedging through the Forward Market
In order to hedge the transaction exposure, a company having a long position in a currency
(having a receivable) will sell the currency forward, i.e., go short in the forward market,
and a company having a short position in a currency (having a currency) will buy the
currency forward i.e. go long in the forward market.
The idea behind buying or selling a currency in the forward market is to lock the rate at
which the foreign currency transaction takes place, and hence the costs or profits. For
example, if an Indian firm is importing computers from the USA and needs to pay $1,
00,000 after 3 months to the exporter, it can book a 3-month forward contract to buy $1,
00,000. If the 3-month forward rate is Rs.42.50/$, the cost to the Indian firm will be locked
at Rs.42, 50,000. Whatever be the actual spot price at the end of three months, the firm
needs to pay only the forward rate. Thus, a forward contract eliminates transaction
exposure completely.
Hedging through Futures
The second way to hedge exposure is through futures. The rule is the same as in the
forward market i.e. go short in the futures if you are long in the foreign currency and vice
versa. Hence, if the importer needs to pay $2, 50,000 after four months, he can buy dollar
futures for the required sum and maturity. Futures can be similarly used for hedging
translation exposure. As the gain or loss on the futures contract gets canceled by the loss or
gain on the underlying transaction, the exposure gets almost eliminated. The main
difference between hedging through forwards ands through futures is that while under a
forward contract the whole receipt/payment takes place at the time of maturity of the
contract, in case of futures, there has to be an initial payment of margin money, and further
payments/receipts during the tenure of the contract on the basis of market movements.
Hedging through Options
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Options can prove to be a useful and flexible tool for hedging exposures. A firm having a
foreign currency receivable can buy a put option on the currency, having the same maturity
as the receivable. Conversely, a firm having a foreign currency payable can buy a call
option on the currency with the same maturity.
Hedging through options has an advantage over hedging through forwards or futures.
While the latter fixes the price at which the currency will be bought or sold, options limit
the downside loss without limiting the upside potential. That is, since the firm has the right
to buy or sell the foreign currency but not the obligation, it can let the option expire by not
exercising the right.
Hedging through Money Market
Money markets can also be used for hedging foreign currency receivables or payables, Let
us say, a firm has a dollar payable after three months. It can borrow in the domestic
currency now, convert it at the spot rate into dollars, invest those dollars in the money
markets, and use the proceeds to pay the payables after three months.
Open Position
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It is a net long or short foreign currency or forward position whose value will change with
the change in foreign exchange rate or futures price.
Position means net commitment in a currency. It is square if sales equal purchases, long if
purchases exceeds sales and short if sales exceeds purchases.
Stop Loss Limit
Stop loss indicates an amount of money that a particular portfolios single period market
loss should not exceed. A limit violation occurs when a portfolios single period market
loss exceeds stop loss limit. In such event, trader is usually required to unwind or hedge the
material exposures.
Stop Loss Order
A stop loss order is an order to buy or sell when the price reaches a specified level. A stop
loss order to buy, enter above the prevailing market price, becomes a market order when
the contract is either traded or bid at or above the price. A stop loss order to sell, enter
below the prevailing market price, becomes a market order when the contract is either
traded or offered at or below the stop price. It is an order to sell at the market when a
definite price is reached. It is usually used as a method of limiting losses by traders.
MIL and Forex Risk Management
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Mahindra Intertrade Limited is basically an import driven company. Approximately 90-
95 % of its business is based on imports and rest on exports.
International trade involves various complexities and problems. This may be due to various
reasons. The parties to a sale contract are located in different countries and are governed by
different legal systems. Also, the currencies of two countries are different. Further, the
trade and exchange regulations applicable to both the parties may differ. In such a situation,
a seller who ships goods will be apprehensive whether he will receive the payment from
the buyer. The buyer, on the other hand, will be concerned whether the seller will ship the
goods ordered for and deliver them in time. That is why documentary credit, commonly
known as letter of credit came into existence as an ideal method for settling the
international trade payments.
HowLetter of Credit operates
In order to make payment to the overseas supplier, the buyer of goods approaches his bank
for opening a letter of credit in favor of the supplier. Mahindra Intertrade Limited is the
importer i.e. importer in this illustration.
After considering the request of the buyer and fulfillment of the necessary formalities, the
issuing bank (i.e. the buyers bank) opens the letter of credit in favor of the supplier.
The letter of credit is transmitted to the advising bank (usually an intermediary bank
located in suppliers country) with a request to advise the credit to the beneficiary. After
being satisfied with the authenticity of the credit, the advising bank advises the credit to the
beneficiary (i.e. the supplier).
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The beneficiary verifies the letter of credit and checks for any discrepancies vis--vis, the
sales contract. If any discrepancies are noticed, the buyer is asked to incorporate the
necessary changes/amendments to the LC. The supplier then proceeds to ship the goods.
Shipment of goods is followed by submission of necessary documents by the supplier to
the negotiating bank in order to obtain payment for the goods. The negotiating bank, upon
receipt of commercial documents, and the bill of lading from the exporter, scrutinizes the
documents in relation to the LC and if found to be in order, negotiates the bill and makes
the payment to the supplier,
The negotiating bank then claims reimbursement from the issuing bank by mailing the
documents to it or any other bank authorized for the said purpose.
The commercial invoice and other documents are presented by the issuing bank to the
buyer of goods, who, on receipt of the same, checks the documents and accepts pays the
bill. On acceptance/payment, the shipping documents covering the goods purchased are
handed over to him.
After completion of import procedures and receiving the goods, the other leg of transaction
comes into picture. That is the import payment. Usually there is time lag between the
import of the goods and payments for the same which exposes the parties to the exposure
such as cross currency exposure due to possibility of changes in foreign exchange rate.
Exposure is calculated in following manner:
Net Exposure = Imports + other remittances - Exports - Other Forex Earnings
Imports involve basically steel products such as billets, blooms, wire rods, angles,
beams, coils/sheets of cold rolled, hot rolled etc., scrap, metal, alloys and
equipments.
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Other remittances involve expenses such as royalty and marketing services fees.
Exportsbasically involve steel products such as raw material or semi finished steel
products (pig iron, slabs), flat rolled steel products (Hot rolled Coil, Strip and
Sheet, ElectricalSteel Sheets), and long steel products (Wire rods).
Other Forex Earnings is in the form of agency commission.
The trade at the MIL is divided into two categories, Normal Trade and Structured Trade.
Normal Trade is in the form of import and exports of steel, metals etc. which is the
regular and core activity of the company.
Structured Trade is the trade which is not regular in the nature. These are not the core
activities of the company and not the normal business of the company. This is the activity
undertaken for the purpose of liquidity, cash flows and forex earnings. In structured trade,
MIL acts between two legs of the transaction. For example, Merchanting involves a
principal and a customer situated in different countries apart form MIL. Customer is inneed of goods manufactured by the principal. In this transaction MIL handles entire
procedure right from securing orders to payment of proceeds including documentation. For
such role, MIL gets commission.
The regularity and the quantum of business involved in both types of trade differ. That is
why the stop loss limit in both the cases is different. It is less in structured trade because
the margins are very thin. It will not be meaningful to keep a stop loss limit on a higher
side.
Such kind of business brings into picture foreign exchange exposure. There are many
instruments by which the foreign exchange risk can be hedged. But at Mahindra Intertrade,
Only forward contracts are used to cover the exposure.
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At MIL, amounts exceeding US $ 1, 00,000 are covered. If many payments are becoming
due on the same date, then they are summed up so that the total exceeds the limit. It is not
profitable to enter into forward contract to cover the small amounts because of the expenses
like stamping charges which eat away the margins (profits).
Suppose there is an import Letter of credit of US $ 1, 25,000 the payment of which is going
to due on 15th Nov 2005. Whether to go for forward cover on a particular day depends on
the spot rate. If Rupee is expected to appreciate against Dollar, then it is advisable to
postpone the decision to cover the payables.
Suppose to go for forward cover on 14th July 2005 for the above payment. The spot rate of
1 US $ is Rs.43.5725. The premium for November forward contract is 0.1425. Then 1 paisa
i.e. 0.01 is added as a commission. That means you have entered into forward contract for
Rs.43.7250. No matter what will be the exchange rate on 15 th Nov 2005, company will be
paying at this rate only.
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