Narang RP

Currency Derivatives and its Impact on Export Receivables with Special focus on Indian IT Sector
CHAPTER – 1
INTRODUCTION
International Institute of Foreign Trade & Research 1

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was
abolished in favour of market-determination of foreign exchange rates; a regime of
fluctuating exchange rates was introduced. Besides market-determined fluctuations, there
was a lot of volatility in other markets around the world owing to increased inflation and the
oil shock. Corporates 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. However derivative use is still a
highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps
and options are available in India and the use of foreign currency derivatives is permitted for
hedging purposes only.
This study aims to provide a perspective on managing the risk that firm’s face due to
fluctuating exchange rates. It investigates the prudence in investing resources towards the
purpose of hedging and then introduces the tools for risk management. These are then
applied in the Indian context. The motivation of this study came from the recent rise in
volatility in the money markets of the world and particularly in the US Dollar, due to which
Indian exports are fast gaining a cost disadvantage. Hedging with derivative instruments is a
feasible solution to this situation..

INTRODUCTION TO INDIAN IT SECTOR
It was in the mid 80s that the Indian IT talent started attracting the attention of the Indian
Government and industry analysts and soon everybody realised the potential of Indian talent
in computer software and services sector.
Realising the high potential of employment, modernisation and contribution to economy

provided by the software industry the Government of India announced the first computer
software policy and since then, computer software and services sector has been identified as
a thrust area. In the year 1998 Government of India not only put computer software and
services on its National Agenda, but also created a National Task Force under the order of
the office of Prime Minister of India. This Task Force consisted of ministers, senior
bureaucrats, scientists, academicians and industry representatives. The task force gave path-
breaking recommendations to remove the bottlenecks and boost growth in export. Today
over 14 state governments have already announced their IT policies and seven more have
announced IT task Forces and Special Committees. There is almost a computer software
revolution in the Country and both government and industry are getting more and more
determined to strengthen the brand equity of Indian software industry and make the country
as an IT superpower.
The software industry is not only growing exponentially, it is moving up the value chain. It is
evolving, from the initial staffing to software development - where it is currently the worlds
major supplier of engineers - to integration and IT business consulting.
STRENGTHS OF INDIAN IT INDUSTRY
• One of the largest pool of technically qualified high class IT manpower

• Enormous skilled human resource compared to developed countries leading to lower
manpower cost nearly one tenth of those in developed nations, thus giving India a
comparative advantage.
• Offers a wide range of services from support / data processing to sophisticated
software systems etc.
• Rich experience of working with large global companies and enjoy high credibility

• Expertise on a wide variety of platforms

• Accommodating nature of Indian IT workforce
QUALITY OF INDIAN IT EXPERTISE
Today the world recognises India as a source of high quality IT manpower. 151 out of total
379 SEI CMM level 5 certified companies worldwide are Indian. The Capability Maturity
Model (CMM) for Software describes the principles and practices underlying software
process maturity and is intended to help software organizations improve the maturity
of their software processes in terms of an evolutionary path from ad hoc, chaotic processes to
mature, disciplined software processes.
Over 300 Indian computer software and services have already obtained ISO 9000 or CMM
level 2 certification. It is because of this high quality of Indian IT sector that the majority of
multinational companies in IT have either their software development or research center in
India. One third of the e-commerce start-ups in the Silicon Valley continue to be lead by
Indian. Over half of the Fortune 500 companies are outsourcing their software requirements
to India.

Research Rationale
The gradual liberalization of Indian economy has resulted in substantial inflow of foreign
capital into India. Simultaneously dismantling of trade barriers has also facilitated the
integration of domestic economy with world economy. With the globalization of trade and
relatively free movement of financial assets, risk management through derivatives products
has become a necessity in India also, like in other developed and developing countries. As
Indian businesses become more global in their approach, evolution of a broad based, active
and liquid forex derivatives markets is required to provide them with a spectrum of hedging
products for effectively managing their foreign exchange exposures.
The Indian IT Industry is one of the fastest growing sectors of the Indian Economy with a
compounded annual growth rate (CAGR) of 18 per cent. The IT sector accounts for near
about 5.55% of the GDP of India. It is an export driven industry which derives nearly 79 per
cent of its revenues from exports, exposing it to a substantial amount of foreign exchange
exposure. During the past one year the rupee has become much volatile against major foreign
currencies and especially against US dollar and has caused serious financial damage to the IT
sector. Major IT companies have written-off huge amount of forex losses, during the past
four quarters. Also such volatility is expected to continue in the near to medium term, which
is a word of caution for these companies.
Therefore the need of the hour is to effectively and efficiently manage the forex risk, faced
by these companies by properly utilizing the various hedging instruments & techniques
available in the market. This study will provide valuable information regarding hedging
instruments, hedging decisions and hedging strategies of the major Indian IT companies.

Objectives of the Study
There are a diverse set of objectives to do this research. Primarily to understand the concepts
of derivatives, especially forex derivatives and their implicaions in various economic and
financial circumstances. Secondly to understand the nature of export oriented firms,
especially IT firms, in Indian context and their vulnerability to foreign exchange fluctuation.
A brief summary of the objectives of this research are listed below:
To establish a relationship between exchange rate fluctuation and internaional trade.

To understand the nature and uses of forex derivatives.
To get a broad and clear picture of Indian Derivatives Market.
To understand the need and importance of Risk Management.
To understand the Risk Management framework.
To develop measures to estimate foreign exchange exposure of domestic firms.
To understand the vulnerability of export oriented firms, especially Indian IT firms
towards exchange rate fluctuation.
To articulate hedging strategies of major IT firms in India.

Methodology of Research
Basically this is a desk research work, which implemented the extensive use of seconadary
data available through various media. Qualitative researches were done to collect, analyse
and interpret the data and arrive at various models which can be directly implemented at
various situations.
Sources of Data
Published Media
o Journals
o Magzines
o Newspapers
o Company Annual Reports
Electronic Media
o Internet

Limitations
This research work is limited to the study of only one of the several risks (Excahnge rate
risk) that a firm is exposed to in these times of extensive globalisation around the world.
Also, the research work is limited to the prospects of hedging and risk management process
only at Indian IT firms.
Several hurdles came across accomplishing this research.
Availability of data regarding average daily turnover of OTC market inIndia

Technical failures
Time Constraint

CHAPTER - 2
FOREIGN EXCHANGE & INTERNATIONAL TRADE

1. INTRODUCTION TO FOREIGN EXCHANGE

Foreign Exchange is the mechanism by which the currency of one country gets converted
into the currency of another currency. Exchanging currencies can take two basic forms: an
outright or a swap. When two parties exchange one currency for another the transaction is
called an outright. When two parties agree to exchange and re exchange (in future) one
currency for another, it is called a swap.
1.1 Exchange Rate
The exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between
two currencies specify how much one currency is worth in terms of the other. It is the value
of a foreign nation’s currency in terms of the home nation’s currency. For example: An
exchange rate of 1US$ for 50.67 INR, means 1US$ can be exchanged for 50.67 INR. The
spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an
exchange rate that is quoted and traded today but for delivery and payment on a specific
future date
2. FOREIGN EXCHANGE MARKET
The foreign exchange market (currency, forex, or FX) is where currency trading takes place.
It is where banks and other official institutions facilitate the buying and selling of foreign
currencies. FX transactions typically involve one party purchasing a quantity of one currency
in exchange for paying a quantity of another. The foreign exchange market that we see today
started evolving during the 1970s when world over countries gradually switched to floating
exchange rate from their erstwhile exchange rate regime, which remained fixed as per the
Bretton Woods system till 1971.
The foreign exchange (currency or forex or FX) market exists wherever one currency is
traded for another. It is the largest and most liquid financial market in the world, with an
average traded value that exceeds $1.9 trillion per day and includes all of the currencies in
the world. There is no central marketplace for currency exchange; trade is conducted over the

counter. The forex market is open 24 hours a day, five days a week, and currencies are traded
worldwide among the major financial centers of London, New York, Tokyo, Zürich,
Frankfurt, Hong Kong, Singapore, Paris and Sydney. The forex is the largest market in the
world in terms of the total cash value traded, and any person, firm or country may participate
in this market.
2.1. Foreign Exchange Market in India
Globally, operations in the foreign exchange market started in a major way after the
breakdown of the Bretton Woods system in 1971, which also marked the beginning of
floating exchange rate regimes in several countries. Over the years, the foreign exchange
market has emerged as the largest market in the world. 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. However, 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 following the recommendations of the Report of the
High Level Committee on Balance of Payments. The unification of the exchange rate was
instrumental in developing a market-determined exchange rate of the rupee and an important
step in the progress towards current account convertibility, which was achieved in August
1994.
The Indian foreign exchange market has grown manifold over the last several years. The
daily average turnover impressed a substantial pick up from about US $ 5 billion during
1997-98 to US $ 18 billion during 2005-06.
Market Players
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.
The licences for ADs are issued to banks and other institutions, on their request, under
Section 10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided into
different categories. All scheduled commercial banks, which include public sector banks,
private sector banks and foreign banks operating in India, belong to category I of ADs. All
upgraded full fledged money changers (FFMCs) and select regional rural banks (RRBs) and
co-operative banks belong to category II of ADs.
Exhibit 1.1 Authorised Dealers (Category-I) in the Foreign Exchange Market

(As on March 31, 2007)
Category Number
Public Sector Banks 27
Private Sector Banks 31
Of which:
Co-operative Banks 5
Foreign Banks 23
Total 86
Source: Reserve Bank of India
The customer segment of the foreign exchange market comprises major public sector units,
corporates and business entities with foreign exchange exposure. It is generally dominated by
select large public sector units such as Indian Oil Corporation, ONGC, BHEL, SAIL, Maruti
Udyog and also the Government of India (for defence and civil debt service) as also big
private sector corporates like Reliance Group, Tata Group and Larsen and Toubro, among
others. In recent years, foreign institutional investors (FIIs) have emerged as major players in
the foreign exchange market.

3. INTERNATIONAL TRADE
International trade is exchange of capital, goods, and services across international borders or
territories. International trade refers to two broad activities viz, exports and imports.
Exports: A function of international trade whereby goods produced in one country are
shipped to another country for future sale or trade. The sale of such goods adds to the
producing nation's gross output. If used for trade, exports are exchanged for other products or
services. Exports are one of the oldest forms of economic transfer, and occur on a large scale
between nations that have fewer restrictions on trade, such as tariffs or subsidies.
Imports: A function of international trade, where one country buys goods from another
country. Example: Goods that are made in Japan and sold in the US are imported into the
US.
4. EXCHANGE RATE RISK
Exchange rate risk is a form of risk that arises from the change in price of one currency
against another. Whenever investors or companies have assets or business operations across
national borders, they face currency risk if their positions are not hedged. It is the
unanticipated price change of one currency against another. It can also be defined as the risk
of an investment's value changing due to changes in currency exchange rates. It is also
known as currency risk. The upward/ downward movement of domestic currency against a
foreign currency is called appreciation/depreciation of domestic currency.
4.1. Implications of Exchange-Rate Movements
Exchange rate movements has serious implications on business especially international

business, where payment is made/ or realized in foreign currency. Generally an
appreciation of home currency is favourable for imports and unfavourable for exports, as
importers will have to pay less and exporters will realize less in terms of home currency
and vice versa. The impact of exchange rate fluctuation is summarised in Exhibit 1.2.

Exhibit 1.2..
Exchange Rate Movement Impact
Appreciation Favourable for Imports & Unfavourable

for Exports
Depreciation Favourable for Exports & Unfavourable
for Imports
4.2. Impact of Exchange Rate Fluctuations on Export Receivables
Exchange rate fluctuations have a direct and major impact on exports and in turn export
receivables. An appreciation of home currency against foreign currency impacts revenues
of an export firm negatively as the firm would be able to realise less in terms of home
currency, and hence end up making unanticipated losses. On the other hand, if the home
currency depreciates against foreign currency it impacts the export firm’s revenues
positively and the firm ends up making unanticipated profits.
Hence exchange rate risk needs to be properly managed in order to avoid unanticipated
losses. Because these losses directly impacts the company’s bottomline and in turn the
earnings per share.

CHAPTER - 3
INDIAN IT INDUSTRY: AN OVERVIEW

SIZE
India is the leading destination for providing IT and IT-Enabled Services (ITeS), with
revenues of about US$40 billion in 2006-07 of which:
IT Services and Software constituted 58%, ITeS about 21%, and the domestic
market about 21%
Exports constituted 79% of the total IT and ITeS revenues
STRUCTURE
The industry has 3 broad categories of companies:
Indian IT and ITeS companies ranging from large companies (Tata Consultancy
Services, Infosys, Wipro, HCL) to small niche companies
Global IT companies such as IBM, Dell, Microsoft, HP, Accenture, etc. all of
whom have set up development centres in India
Captive back office operations of large global corporations like JP Morgan,
American Express, GE, HSBC, British Airways, etc.
POLICY
100% FDI is permitted in this sector under the automatic route
SEZs, EOUs and Software Technology Parks have been set up across India.
Income tax exemptions are available for units in these designated areas/zones
IT Act, 2000 legalizes the acceptance of electronic records and digital signatures.
Providing a legal backbone to e-c.ommerce.
OUTLOOK
The Indian IT and ITeS industry is expected to grow to US$ 77 billion
by 2010.
Over 25% p.a. CAGR expected.
Exports expected to reach US$ 60 billion in 2010.

POTENTIAL
India’s inherent IT capabilities - talented workforce and world-class companies.

Availability of technically skilled and English-speaking labour force at a
fraction of the costs in USA and Europe.
Quality orientation, project and process management expertise
Enhanced global service delivery capabilities of Indian companies through a
combination of greenfield initiatives, M&A, alliances and partnerships with
local players.
International recognition of India’s strengths
Increasing awareness among global companies about India’s capabilities in
higher, value-added activities and in the Global Delivery Model.
Leading international companies have identified custom application
development and maintenance as priority areas due to a high offshoreable
component.
High growth of domestic IT & ITeS market due to several regulatory and
technological factors.
Increased investments by enterprises in IT infrastructure, applications and IT
outsourcing
Demand for domestic BPOs has been largely driven by faster GDP growth and
by sectors such as telecom, banking, insurance, retail, healthcare, tourism and
automobiles.
Opportunity to supply to the global market in addition to serving the growing
domestic demand.
PRODUCTION
Production of Computer Software and Services during the year 2007-08 is

estimated to be Rs. 2.22,300 crores (US$ 55.22 billion) registering a growth of 21.48
percent (30.51. in US$ terms) over the year 2006-07 when the total production of
Computer software / Services was estimated to be Rs. 1,83,000 crores (US$ 42.31 billion).

Production of Computer Software / Services has been growing at an annual average growth
rate of 29.98 percent (34.86 percent in US$ terms) during the past five years.
IT GDP RATIO
Computer Software / Services production accounts for a share of 5.55 percent in India’s
GDP at current prices during the year 2007-08.
EXPORT OF IT SERVICES
Export of Computer Software / Services (including ITES / BPO) registered a growth of 20
percent (29 percent in US$ terms) during the year 2007-08 over the year 2006-07. In value
terms, export of this sector during 2007-08 is estimated to be Rs. 175000 crore (US$ 43.46
billion) up from Rs. 146000 crore (33.75 billion) estimated in the year 2006-07.
MAJOR EXPORT DESTINATIONS
North America remains the top destination for India’s export of Computer Software /
Services during the year 2007-08 as well. Although there has been a slight decline of 0.22
percent in percentage share of computer software and services exports, there has been a
growth of 19.4 percent (28.31 percent in US$ terms) in export to North America during
the year 2007-08 over the year 2006-07. In value terms, export to North America
increased from Rs. 90109 crore (US$ 20.83 billion) estimated in 2006-07 to Rs. 107625
crore (US$ 26.73 billion) in the year 2007-08.
Export to EU Countries registered a growth of 19 percent (27 percent in US$ terms) during
the year 2007-08. In value terms, export of software and services from India to EU
countries during 2007-08 is estimated to be Rs. 46725 crore (US$ 11.6 billion) up from Rs.
39420 (US$ 9.11 billion) estimated in the year 2006-07. With a high growth of 44.44
percent ( 55.17 percent in US$ terms) Singapore, Hong Kong and other South Asian
countries have emerged as 3rd top destinations for India’s software and services exports
during the year 2007-08. Export to this region increased from 4500 crore (US$ 1040
million) estimated in 2006-07 to Rs. 6500 crores (US$ 1614 million) in the year 2007-08.

Japan, Korea and other Far East countries are the 4th top destination for export Computer
Software / Services from India during 2007-08.

CHAPTER - 4
FOREX DERIVATIVES AND ITS MARKET IN INDIA

1. INTRODUCTION
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, foreign exchange, commodity or any other asset. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk
of a change in prices by that date. Such a transaction is an example of a derivative. The
price of this derivative is driven by the spot price of wheat which is the "underlying".
Similarly forex (currency) derivative is a product whose value is derived from the value of
currency/ foreign exchange underlying such as US dollar, GBP, Yen etc.
1.1. Uses of Derivatives

Derivatives can be used to mitigate the risk of economic loss arising from changes in the
value of the underlying. This activity is known as hedging. Alternatively, derivatives can
be used by investors to increase the profit arising if the value of the underlying moves in
the direction they expect. This activity is known as speculation. Hence Derivatives can be
used for three main purposes:
Hedging
Speculation
Arbitration
Hedging
In finance, a hedge is a position established in one market in an attempt to offset exposure
to the price risk of an equal but opposite obligation or position in another market —
usually, but not always, in the context of one's commercial activity. Hedging is a strategy
designed to minimize exposure to such business risks as a sharp contraction in demand for
one's inventory, while still allowing the business to profit from producing and maintaining
that inventory.

Speculation
In finance, speculation is a financial action that does not promise safety of the initial
investment along with the return on the principal sum. Speculation typically involves the
lending of money or the purchase of assets, equity or debt but in a manner that has not
been given thorough analysis or is deemed to have low margin of safety or a significant
risk of the loss of the principal investment.
Arbitration
Arbitrage is the practice of taking advantage of a price differential between two or more
markets: striking a combination of matching deals that capitalize upon the imbalance, the
profit being the difference between the market prices. When used by academics, an
arbitrage is a transaction that involves no negative cash flow at any probabilistic or
temporal state and a positive cash flow in at least one state; in simple terms, a risk-free
profit. A person who engages in arbitrage is called an arbitrageur—such as a bank or
brokerage firm. The term is mainly applied to trading in financial instruments, such as
bonds, stocks, derivatives, commodities and currencies
1.2. Derivative Products
Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. Let’s take a brief look at various derivatives contracts that have
come to be used.
Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that they are standardized exchange traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before
a given future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are
called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form of
basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A

receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed, and receive floating.
1.3. Need of Derivatives
Increased volatility in asset prices in financial markets,

Increased integration of national financial markets with the international markets,
Marked improvement in communication facilities and sharp decline in their
costs,
Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns, reduced
risk as well as transactions costs as compared to individual financial assets.
2. FOREX DERIVATIVES MARKET IN INDIA
The gradual liberalization of Indian economy has resulted in substantial inflow of foreign
capital into India. Simultaneously dismantling of trade barriers has also facilitated the
integration of domestic economy with world economy. With the globalization of trade and
relatively free movement of financial assets, risk management through derivatives products
has become a necessity in India also, like in other developed and developing countries. As
Indian businesses become more global in their approach, evolution of a broad based, active
and liquid forex derivatives markets is required to provide them with a spectrum of
hedging products for effectively managing their foreign exchange exposures.
The global market for derivatives has grown substantially in the recent past. The Foreign
Exchange and Derivatives Market Activity survey conducted by Bank for International
Settlements (BIS) points to this increased activity. The total estimated notional amount of
outstanding OTC contracts increasing to $111 trillion at end−December 2001 from $94
trillion at end June 2000. This growth in the derivatives segment is even more substantial
when viewed in the light of declining activity in the spot foreign exchange markets. The
turnover in traditional foreign exchange markets declined substantially between 1998 and
2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion

in April 1998, a 14% decline when volumes are measured at constant exchange rates.
Whereas the global daily turnover during the same period in foreign exchange and interest
rate derivative contracts, including what are considered to be "traditional" foreign
exchange derivative instruments, increased by an estimated 10% to $1.4 trillion.
3. EVOLUTION OF FOREX DERIVATIVES MARKET IN INDIA
This tremendous growth in global derivative markets can be attributed to a number of

factors. They reallocate risk among financial market participants, help to make financial
markets more complete, and provide valuable information to investors about economic
fundamentals. Derivatives also provide an important function of efficient price discovery
and make unbundling of risk easier.
In India, the economic liberalization in the early nineties provided the economic rationale
for the introduction of FX derivatives. Business houses started actively approaching
foreign markets not only with their products but also as a source of capital and direct
investment opportunities. With limited convertibility on the trade account being introduced
in 1993, the environment became even more conducive for the introduction of these hedge
products.
Hence, the development in the Indian forex derivatives market should be seen along with
the steps taken to gradually reform the Indian financial markets.
4. INTRODUCTION OF CURRENCY FUTURES IN INDIA

In 2007, a panel appointed by the central bank, the Reserve Bank of India, recommended
that trading in currency futures be allowed at dedicated exchanges.
Subsequently, following the tabling of a recent report by a standing technical committee

comprising members of the RBI and India's capital market watchdog, the Securities and
Exchange Board of India (SEBI), detailed guidelines for setting up a currency futures
market were put in place by the two bodies.
On August 30, 2008 Currency Futures trading began in India, Finance Minister
inaugurated o, the country's first trading platform in currency futures at the National Stock

Exchange (NSE) in Mumbai.
According to market analysts, introduction of currency futures in the Indian market will
give companies greater flexibility in hedging their underlying currency exposure and will
bring in more liquidity into the market as currency future or forex derivative contract will
enable a person, a bank or an institution to buy or sell a particular currency against the
other on a specified future date, and at a price specified in the contract.
Till date, most companies, big and small, could hedge their underlying currency exposure
by getting into forward contracts with banks. These are basically over-the-counter (OTC)
traded contracts where a company can buy or sell a currency at a future date based on a
predetermined or pre-agreed price. However, due diligence carried out by banks to
determine whether the companies are in a position to settle the contract or not tended to
delay matters.

CHAPTER – 5
FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

1. 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 was introduced. Besides market-determined fluctuations, there was a lot of
volatility in other markets around the world owing to increased inflation and the oil shock.
Corporates struggled to cope with the uncertainty in profits, cash flows and future costs.
In India, the New Economic Policy (NEP) announced by Dr. Manmohan Singh, the then
Finance Minister, brought the concept of LPG i.e., liberalization, globalisation, &
privatization. Due to globalization foreign firms were allowed to operate in India and also
Indian firms were allowed o operate in foreign countries via different modes viz, exports,
direct investment etc. This led to a substantial increase in exposure of Indian firms to foreign
countries and also foreign currency.
In the backdrop of economic liberalization & globalization, Indian IT sector also grew at a
rapid pace in 21st century. The Indian IT sector grew at a compounded annual growth rate
(CAGR) of 18% between the year 2000 to the year 2007. The revenues grew from US$12.1
billion (exports US$8.1bn) in year 2000 to US$39.6 billion (US$31.4bn) in the year 2007 out
of which exports took a major chunk. As the Indian IT industry derives a major chunk of
revenues from exports, it is crystal clear that the Indian IT industry is substantially exposed
to foreign exchange risk.
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. Exposure
is defined as a contracted, projected or contingent cash flow whose magnitude is not certain
at the moment and depends on the value of the foreign exchange rates. 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.
This research project limits its scope to hedging only the foreign exchange risks faced by
firms.

2. KINDS OF FOREIGN EXCHANGE EXPOSURE
Risk management techniques vary with the type of exposure (accounting or economic) and
term of exposure. Therefore the different kinds of foreign exchange exposure to which a firm
may be exposed have been discussed here.
Translation (Accounting) Exposure

Translation Exposure results from the need to restate foreign subsidiaries’ financial
statements into the parent’s reporting currency and is the sensitivity of net income to the
variation in the exchange rate between a foreign subsidiary and its parent. Altogether it
impacts only the book of accounts.
Economic exposure
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 firm’s operating cash flows, income statement, and competitive
position, hence market share and stock price. Currency fluctuations also affect a firm's
balance sheet by changing the value of the firm's assets and liabilities, accounts payable,
accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign
banks; this type of economic exposure is called balance sheet exposure.
Transaction Exposure
Transaction Exposure is a form of short term economic exposure due to fixed price
contracting in an atmosphere of exchange-rate volatility.
The most common definition of the measure of exchange-rate exposure is the sensitivity of
the value of the firm, proxied by the firm’s stock return, to an unanticipated change in an
exchange rate. This is calculated by using the partial derivative function where the dependant
variable is the firm’s value and the independent variable is the exchange rate.
3. NECESSITY OF MANAGING FOREIGN EXCHANGE RISK
A key assumption in the concept of foreign exchange risk is that exchange rate changes are
not predictable and that this is determined by how efficient the markets for foreign exchange
are. Research in the area of efficiency of foreign exchange markets has thus far been able to

establish only a weak form of the efficient market hypothesis conclusively which implies that
successive changes in exchange rates cannot be predicted by analysing the historical
sequence of exchange rates. However, when the efficient markets theory is applied to the
foreign exchange market under floating exchange rates there is some evidence to suggest that
the present prices properly reflect all available information. This implies that exchange rates
react to new information in an immediate and unbiased fashion, so that no one party can
make a profit by this information and in any case, information on direction of the rates
arrives randomly so exchange rates also fluctuate randomly. It implies that foreign exchange
risk management cannot be done away with by employing resources to predict exchange rate
changes.
4. RISK MANAGEMENT
Risk is inherent in any business activity and cannot be completely eliminated without
eliminating the rewards too. The approach to risk management is to optimise the risk reward
balance by building competence and leverage the opportunity. Risk management
incorporates an integrated group-wide approach to identify, assess measure, manage, and
monitor the risks to which our businesses are exposed.
There are three basic questions every organization must continuously pose to itself:
What are the worst things that can happen to us?

How likely are they to happen?
Are we taking the right and adequate steps to prevent them?
Exposure to a risk may have multiple impact points. These may be categorised into five
types:
Strategic risks: exposures that fundamentally impact the competitive position of the
industry in general or a company in particular.
Financial risks: exposures that primarily and directly impact the profitability.
Operational risks: exposures that primarily impact customer satisfaction and

operational efficiency.

Compliance risks: exposures that initially attract penalties and subsequently restrict
flexibility of operations.
Reporting risks: exposures that affect the credibility of the organization with
stakeholders.
Managing the above mentioned risks effectively and efficiently is very essential because
these are the basic essential pillars of an organization.
4.1 Hedging as a tool to manage foreign exchange risk
There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel
hedging techniques are speculative or do not fall in their area of expertise and hence do not
venture into hedging practices. Other firms are unaware of being exposed to foreign
exchange risks. There are a set of firms who only hedge some of their risks, while others are
aware of the various risks they face, but are unaware of the methods to guard the firm against
the risk. There is yet another set of companies who believe shareholder value cannot be
increased by hedging the firm’s foreign exchange risks as shareholders can themselves
individually hedge themselves against the same using instruments like forward contracts
available in the market or diversify such risks out by manipulating their portfolio. (Giddy and
Dufey, 1992).
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 are perfectly
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.

The existence of different kinds of market imperfections, such as incomplete financial

markets, positive transaction and information costs, probability of financial distress, and
agency costs and restrictions on free trade make foreign exchange management an
appropriate concern for corporate management. (Giddy and Dufey, 1992) It has also been
argued that a hedged firm, being less risky can secure debt more easily and this enjoy a tax
advantage (interest is excluded from tax while dividends are taxed). This would negate the
Modigliani-Miller proposition as shareholders cannot duplicate such tax advantages. The
MM argument that shareholders can hedge on their own is also not valid on account of high
transaction costs and lack of knowledge about financial manipulations on the part of
shareholders.
There is also a vast pool of research that proves the efficacy of managing foreign exchange
risks and a significant amount of evidence showing the reduction of exposure with the use of
tools for managing these exposures. In one of the more recent studies, Allayanis and Ofek
(2001) use a multivariate analysis on a sample of S&P 500 non-financial firms and calculate
a firms exchange-rate exposure using the ratio of foreign sales to total sales as a proxy and
isolate the impact of use of foreign currency derivatives (part of foreign exchange risk
management) on a firm’s foreign exchange exposures. They find a statistically significant
association between the absolute value of the exposures and the (absolute value) of the
percentage use of foreign currency derivatives and prove that the use of derivatives in fact
reduce exposure.
4.2. Foreign Exchange Risk Management Framework
Once a firm recognizes its exposure, it then has to deploy resources in managing it. A
heuristic for firms to manage this risk effectively is presented below which can be modified
to suit firm-specific needs i.e. some or all the following tools could be used.
Forecasts: After determining its exposure, 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: 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 problems4 should be taken into account. Finally, the Systems Risk that can
arise due to inadequacies such as reporting gaps and implementation gaps in the
firms’ exposure management system should be estimated.
Benchmarking: 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. A cost centre approach is
a defensive one and the main aim is ensure that cash flows of a firm are not adversely
affected beyond a point. A profit centre approach on the other hand is a more
aggressive approach where the firm decides to generate a net profit on its exposure
over time.
Hedging: 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. Hedging strategies and instruments are explored in a section.
Stop Loss: 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. For this, there
should be certain monitoring systems in place to detect critical levels in the foreign
exchange rates for appropriate measure to be taken.
Reporting and Review: 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. The review analyses whether the benchmarks set are valid and
effective in controlling the exposures, what the market trends are and finally
whether the overall strategy is working or needs change.

4.3. Hedging Instruments and their Relative Strategy
As we have already seen that a derivative is a financial contract whose value is derived from
the value of some other financial asset, such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of prices. The main role of derivatives is that
they reallocate risk among financial market participants, help to make financial markets more
complete. This section outlines the hedging strategies using derivatives with foreign
exchange being the only risk assumed. To give a clear picture about the hedging instruments
and their relative strategies, example of Reliance Industries Ltd (RIL) has been taken as it is
one of those companies which has huge amount of foreign exchange exposure and is an
active player in the forex derivatives market.
Forwards: A forward is a made-to-measure agreement between 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.
Example: If RIL wants to buy crude oil in US dollars six months hence, it can enter into
a forward contract to pay INR and buy USD and lock in a fixed exchange rate for INR-
USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this
example the downside is an appreciation of Dollar which is protected by a fixed forward
contract. The main advantage of a forward is that it can be tailored to the specific needs
of the firm and an exact hedge can be obtained. On the downside, these contracts are not
marketable, they can’t be sold to another party when they are no longer required and are
binding.
Futures: 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. Futures require a small initial outlay (a
proportion of the value of the future) with which significant amounts of money can be

gained or lost with the actual forwards price fluctuations. This provides a sort of
leverage.
Example: The previous example for a forward contract for RIL applies here also just that
RIL will have to go to a USD futures exchange to purchase standardized dollar futures
equal to the amount to be hedged as the risk is that of appreciation of the dollar. As
mentioned earlier, the tailor ability of the futures contract is limited i.e. only standard
denominations of money can be bought instead of the exact amounts that are bought in
forward contracts.
Options: A currency Option is a contract giving the right, not the obligation, to buy
or sell a specific quantity of one foreign currency in exchange for another at a fixed
price; called the Exercise Price or Strike Price. The fixed nature of the exercise price
reduces the uncertainty of exchange rate changes and limits the losses of open
currency positions. Options are particularly suited as a hedging tool for contingent
cash flows, as is the case in bidding processes. Call Options are used if the risk is an
upward trend in price (of the currency), while Put Options are used if the risk is a
downward trend.
Example: Suppose RIL which needs to purchase crude oil in USD in 6 months, if RIL
buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a
specified amount of dollars at a fixed rate on a specified date, there are two scenarios. If
the exchange rate movement is favourable i.e. the dollar depreciates, then RIL can buy
them at the spot rate as they have become cheaper. In the other case, if the dollar
appreciates compared to today’s spot rate, RIL can exercise the option to purchase it at
the agreed strike price. In either case RIL benefits by paying the lower price to purchase
the dollar.
Swaps: A swap is a foreign currency contract whereby the buyer and seller exchange
equal initial principal amounts of two different currencies at the spot rate. The buyer
and seller exchange fixed or floating rate interest payments in their respective
swapped currencies over the term of the contract. At maturity, the principal amount is
effectively re-swapped at a predetermined exchange rate so that the parties end up
with their original currencies. The advantages of swaps are that firms with limited
appetite for exchange rate risk may move to a partially or completely hedged position

through the mechanism of foreign currency swaps, while leaving the underlying
borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms
to hedge the floating interest rate risk. Consider an export oriented company that has
entered into a swap for a notional principal of USD 1 mn at an exchange rate of
42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00%
p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would
have earnings in Dollars and can use the same to pay interest for this kind of
borrowing (in dollars rather than in Rupee) thus hedging its exposures.
Foreign Debt: Foreign debt can be used to hedge foreign exchange exposure by
taking advantage of the International Fischer Effect relationship. This is demonstrated
with the example of an exporter who has to receive a fixed amount of dollars in a few
months from present. The exporter stands to lose if the domestic currency appreciates
against that currency in the meanwhile so, to hedge this; he could take a loan in the
foreign currency for the same time period and convert the same into domestic
currency at the current exchange rate. The theory assures that the gain realised by
investing the proceeds from the loan would match the interest rate payment (in the
foreign currency) for the loan.
4.4. Choice of Hedging Instruments
The literature on the choice of hedging instruments is very scant. Among the available
studies, Géczy et al. (1997) argues that currency swaps are more cost-effective for hedging
foreign debt risk, while forward contracts are more cost-effective for hedging foreign
operations risk. This is because foreign currency debt payments are long-term and
predictable, which fits the long-term nature of currency swap contracts. Foreign currency
revenues, on the other hand, are short-term and unpredictable, in line with the short-term
nature of forward contracts. A survey done by Marshall (2000) also points out that currency
swaps are better for hedging against translation risk, while forwards are better for hedging
against transaction risk. This study also provides anecdotal evidence that pricing policy is the
most popular means of hedging economic exposures.

These results however can differ for different currencies depending in the sensitivity of that
currency to various market factors. Regulation in the foreign exchange markets of various
countries may also skew such results.
5. DETERMINANTS OF HEDGING DECISIONS
The management of foreign exchange risk, as has been established so far, is a fairly
complicated process. A firm, exposed to foreign exchange risk, needs to formulate a strategy
to manage it, choosing from multiple alternatives. This section explores what factors firms
take into consideration when formulating these strategies.
5.1. 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. Research in this area suggests that the elements of exchange rate uncertainty
and the attitude toward risk are irrelevant to the multinational firm's sales and production
decision. Only the revenue function and cost of production are to be assessed, and, the
production and trade decisions in multiple countries are independent of the hedging decision.
The implication of this independence is that the presence of markets for hedging instruments
greatly reduces the complexity involved in a firm’s decision making as it can separate
production and sales functions from the finance function. The firm avoids the need to form
expectations about future exchange rates and formulation of risk preferences which entails
high information costs.
5.2. 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. In the presence of efficient
markets, the cost of hedging in the forward market is the difference between the future spot
rate and current forward rate plus any transactions cost associated with the forward contract.
Similarly, the expected costs of hedging in the money market are the transactions cost plus
the difference between the interest rate differential and the expected value of the difference

between the current and future spot rates. In efficient markets, both types of hedging should
produce similar results at the same costs, because interest rates and forward and spot
exchange rates are determined simultaneously. The costs of hedging, assuming efficiency in
foreign exchange markets result in pure transaction costs. The three main elements of these
transaction costs are brokerage or service fees charged by dealers, information costs such as
subscription to Reuter reports and news channels and administrative costs of exposure
management.
5.3. Factors affecting the decision to hedge foreign currency risk
Research in the area of determinants of hedging separates the decision of a firm to hedge
from that of how much to hedge. There is conclusive evidence to suggest that firms with
larger size, R&D expenditure and exposure to exchange rates through foreign sales and
foreign trade are more likely to use derivatives. First, the following section describes the
factors that affect the decision to hedge and then the factors affecting the degree of hedging
are considered.
Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale.
Risk management involves fixed costs of setting up of computer systems and
training/hiring of personnel in foreign exchange management. Moreover, large firms
might be considered as more creditworthy counterparties for forward or swap
transactions, thus further reducing their cost of hedging. The book value of assets is
used as a measure of firm size.
Leverage: According to the risk management literature, firms with high leverage
have greater incentive to engage in hedging because doing so reduces the probability,
and thus the expected cost of financial distress. Highly levered firms avoid foreign
debt as a means to hedge and use derivatives.
Liquidity and profitability: Firms with highly liquid assets or high profitability have
less incentive to engage in hedging because they are exposed to a lower probability of
financial distress. 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: Sales growth is a factor determining decision to hedge as opportunities
are more likely to be affected by the underinvestment problem. For these firms,

hedging will reduce the probability of having to rely on external financing, which is
costly for information asymmetry reasons, and thus enable them to enjoy
uninterrupted high growth. The measure of sales growth is obtained using the 3-year
geometric average of yearly sales growth rates.

CHAPTER - 6
FOREX EXPOSURE & RISK MANAGEMENT – AN INDIAN

IT INDUSTRY PERSPECTIVE

1. INDIAN IT SECTOR – AN OVERVIEW
Indian IT sector is one of the fastest growing sectors of the Indian economy with a
compounded annual growth rate (CAGR) of 18% p.a. since the year 2000. The consolidated
revenues of the Indian IT industry crossed US$ 45 billion in the year 2007 of which IT
Services and Software constituted 58%, ITeS about 21%, and the domestic market about
21%. The industry has 3 broad categories of companies:
Indian IT and ITeS companies ranging from large companies (Tata Consultancy
Services, Infosys, Wipro, HCL) to small niche companies.
Global IT companies such as IBM, Dell, Microsoft, HP, Accenture, etc. all of whom
have set up development centers in India.
Captive back office operations of large global corporations like JP Morgan, American
Express, GE, HSBC, British Airways, etc.
The annual consolidated revenues of the major Indian IT & ITeS companies and foreign IT
companies in FY 08 are as under.
Exhibit 6.1
Revenues (US$ million) (FY 08) Nos. of Employees
Domestic Private Companies
Tata Consultancy Services 5,676 85,582
Wipro 4,970 67,800
Infosys 4,144 59,831
Satyam 2,103 40,000
International Private
Companies
IBM 98,786 386,558
Accenture 19,696 170,000

2. IT EXPORTS FROM INDIA

India is one of the largest IT & ITeS services exporters in the world. Indian IT companies are
recognized worldwide for providing top class products & services to its global and domestic
clients. There is a huge demand of Indian IT services IT professionals’ world over. Broadly
the Indian IT industry is an export oriented industry, as a major chunk of the revenues of
Indian IT companies are derived from foreign clients. As a result the IT industry is one of the
largest foreign exchange earners of India. The domestic revenues have grown from US$ 4
billion in the FY ‘00 to US$ 8.2 billion in FY 07(10.91% CAGR). On the other hand, export
revenues have grown from US$ 8.1 billion in FY ‘00 to US$ 31.4 billion in FY 07 (21.4%
CAGR). In this research a ratio of foreign sales to total sales has been established to make the
picture more lucid.
Exhibit 6.2. (all figures in US$ bn)
40
30
20
10
0
2000 2007
Exports Domesic
3. FOREX RISK EXPOSURE – MEASURES
3.1. Foreign Sales to Total Sales Ratio of Indian IT Companies
FSR = Foreign Sales/ Total Sales
Where, FSR represents - foreign sales ratio
FSR is also helpful to arrive at the forex exposure of a company and/or sector. The FSR of
the Indian IT industry in FY 07 was 0.7929 (US$ 31.4 bn/US$ 39.6 bn). The total sales
during FY 07 were US$ 39.6 billion out of which export sales were US$ 31.4 billion. Hence
79% of the total sales were derived from exports. Exhibit 4.1 shows the foreign sales ratio of
major Indian IT firms.

Exhibit 6.3.
Company Total Sales (Rs.cr) Export Sales FSR
TCS 18553.72 16776.48 0.9042
Infosys 15,648 15,429 0.9806
Wipro 13641.70 9896.10 0.7254
Satyam 8,137.28 7,889.10 0.9695
Source: Company Annual Reports
20,000
15,000
10,000
5,000
0
INFOSYS SATYAM WIPRO TCS
Total Sales Export Sales 3-D Column 3
3.2. Net Foreign Exchange Exposure
From the foreign sales ratio of Indian IT companies, it is quite clear that these companies are
exposed to substantial foreign exchange risk. All the major four IT companies mentioned
above have an average FSR of nearly 0.89, which shows that 89% of their sales are derived
from exports. But in contrast to export sales, an important determinant of foreign exchange
risk is Net Foreign Exchange Earnings (NFE). NFE is estimated by deducting foreign
exchange outgo from foreign exchange earned. This is a more appropriate measure of
estimating foreign exchange exposure because it offsets the risk of forex inflows from forex
outflows. Hence net forex exposure is simply the net forex earnings (NFE).
Net Forex Earnings (NFE) = Forex Earned – Forex Outgo

Exhibit 6.4. shows the net forex earnings of the major Indian IT companies.
(all figures in Rs. crores)
Company Forex Earnings Forex Outgo Net Forex Earnings (NFE)
TCS 16,776.48 6421.96 10355.48
Infosys 14,490 6788 7,702
Wipro 12,885.20 5202.80 7,682.40
Satyam 6,535.43 4,728.86 1806.57
Source: Company Annual Reports
20,000
15,000
10,000
5,000
0
INFOSYS SATYAM WIPRO TCS
Forex Earnings Forex Outgo NFE
4. IMPACT OF EXCHANGE RATE FLUCTUATION ON INDIAN IT COMPANIES
Exchange rate fluctuations adversely impact the balance sheet of Indian IT companies due to
their export oriented nature. We have already seen that the Indian IT sector derives 79% of
its revenues from exports. If the INR appreciates against the foreign currency these
companies end up making forex losses, if not properly hedged. The company’s top line as
well as bottom line both gets hit depending on exchange rate movement and hedging strategy
of the company. Therefore these companies need to place an effective & efficient hedging
strategy to mitigate this risk.

5. RISK MANAGEMENT POLICY OF MAJOR INDIAN IT COMPANIES
Different companies adopt different risk management policies depending upon the kind of
risk they are exposed to and the magnitude of the risk. Also company policy has a bearing on
such decisions. This research project limits itself by discussing only the foreign exchange
risk management policy of these companies. The forex risk management (hedging) policy of
the major IT companies has been subsequently discussed below.
5.1. Risk Management @ Infosys Technologies Limited
Infosys has implemented an Enterprise Risk Management (ERM) program to manage the
diverse set of risks it faces in this challenging business environment. The Enterprise Risk
Management (ERM) program at Infosys aims toward appropriately evaluating and managing
risks holistically, so as to enable the organization to meet or exceed the expectations of
multiple stakeholders. The program seeks to eliminate negative surprises that may affect the
achievement of our business objectives and impact our stakeholders’ expectations. Further,
effective risk management practices at Infosys are geared toward sustaining and enhancing
our competitive advantage.
Risk management landscape at Infosys
The risk management landscape consists of various risk-related initiatives and activities
including the following:s
• Risk identification: A periodic or trigger-based assessment is sundertaken to identify our

significant risks and prioritize the risks for action. This assessment is based on a risk
perception survey, business environment scanning, and inputs from key stakeholders.
• Risk measurement and control: The key risks are tracked and risk mitigation and control
activities are defined, to align the risk exposure levels to the risk appetite. Owners are
identified for mitigation and control measures.
• Risk reporting: Periodic reporting on the identified risks is an integral part of the risk
management process at Infosys. Besides risk reporting, and control functions embedded in
the business operations of each unit and function, the identified material risks are reported to
the Risk Council periodically. Further, a quarterly report is presented to the Risk

Management Committee, which additionally reviews the ERM program, the status, and
trends available on the material risks highlighted.
FX Risk Management @ Infosys
During the year, 98.6% of our revenues were derived from exports. It has established a
substantial direct marketing network around the world, including North America, Europe and
Asia Pacific. This depicts substantial forex exposure of the company. The composition of
currency wise revenues for fiscal 2008 and 2007 are given below:
Exhibit 6.5.
Currency 2008 (%) 2007 (%)
US Dollar (US$) 70.7 70.37
UK Pound (GBP) 14.1 11.6
Euro (EUR) 5.7 4.9
Australlian Dollar (AUD) 4.6 4.9
Others 4.9 4.9
Source: Company Annual Report
Sensitivity to rupee movement. The company has established a sensitivity rate which gives
the following relationship. Every 1% movement in the Rupee against the US Dollar has an
impact of approximately 50 basis points on operating margins.
Hedging Strategy of Infosys
The Company uses foreign exchange forward contracts and options to hedge its exposure to
movements in foreign exchange rates. The use of these foreign exchange forward contracts
and options reduces the risk or cost to the Company and the Company does not use the
foreign exchange forward contracts or options for trading or speculation purposes.

The Company records the gain or loss on effective hedges in the foreign currency fluctuation
reserve until the transactions are complete. On completion, the gain or loss is transferred to
the profit and loss account of that period. To designate a forward contract or option as an
effective hedge, 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 profit and loss account.
The details of foreign exchange gain / (losses) are as follows:
Exhibit 6.6. (in Rupees crores)
Exposure 2008 2007
Transaction & Translation losses (98) (21)
Options, forward contracts – gains/(losses) 103 63
Net 5 42
5.2. Risk Management @ Tata Consultancy

Services (TCS)
The Company has put in place an Enterprise-wide Risk

Management (ERM) process and reports on the risks it is
faced with, to the Board of Directors. The Company believes
that it has robust and "fit for purpose" risk management processes in place. : To make ERM
processes available globally, a section for ERM was created on KNOWMAX, the
Company’s global knowledge management system.

FX Risk Management
TCS has clearly been the leader has been in the realm of foreign exchange management,
where the company hedged its exposure to multiple currencies during a highly volatile
period. It managed through developing clear policies and having an active Risk Management
Board. The company defined its objectives clearly – that of protecting the currency exchange
rates at the level it budgeted. It relies on simple structures and has budgets the premium
expenses in its business plan. The company takes views, builds up positions gradually and
attempts to minimize its costs – without resorting to “exotic” structures. The gains from
foreign exchange management have been evident in the financial results for FY08 when the
Indian Rupee appreciated by 11%.
Hedging Strategy of TCS
The Company has used various types of foreign currency forward and options contracts to
hedge the risks associated with fluctuations in these currencies. The Company has laid down
appropriate policies and processes for the use of financial derivative instruments consistent
with its risk management strategy. Also, the Company has developed software products to
monitor, manage and report the exposures on a daily basis.
The Company, in accordance with its risk management policies and procedures, enters into
foreign currency forward contracts and currency option contracts to manage its exposure in
foreign exchange rates. The counter party is generally a bank. These contracts are for a
period between one day and eight years. The Company uses foreign currency forward
contracts and currency options to hedge its risks associated with foreign currency fluctuations
relating to certain firm commitments and forecasted transactions.
The use of hedging instruments is governed by the Company's policies approved by the
board of directors, which provide written principles on the use of such financial derivatives
consistent with the Company's risk management strategy. Changes in the fair value of these
derivatives that are designated and effective as hedges of future cash flows are recognised
directly in shareholders' funds and the ineffective portion is recognised immediately in profit
and loss account.

In a volatile currency environment, an exchange gain (net) of Rs.256.62 crore in fiscal 2008
(Rs.46.09 crore in fiscal 2007) is the result of the successful implementation of the foreign
exchange hedging strategy of TCS.
5.3. Risk Management at Satyam Computer Services Limited
Enterprise Risk Management (ERM) @ Satyam
ERM is a structured and disciplined approach that aligns strategy,

process, people, technology, and knowledge which helps in
evaluating and managing uncertainties the enterprise faces while it creates value for its
stakeholders. Satyam’s ERM framework is broadly aligned to the Committee of Sponsoring
Organizations of the Tread way Commission (COSO) and the organization design.
ERM Process:
The Enterprise Risk Management is carried out at four levels, namely, (i) Project Level, (ii)
FLCB Level, (iii) Unit Level and (iv) Company Level. The residual risks at each of these
levels are rolled up to the next level.
Risk Management:
Company’s risk management strategy envisages the risk appetite of potential events and its
significant impact on the Company. Response strategies to the identified risks may include -
1. Risk Mitigation - Methods to reduce the severity of the loss;
2. Risk Transfer - Cause another party to accept the risk;
3. Risk Avoidance - Not performing an activity that could carry risk;
4. Risk Accept - Accepting the loss when it occurs.
FX Risk Management
Satyam operates internationally and is exposed to foreign exchange risk arising from various
currency exposures. Majority of the company’s revenues are generated in U.S. dollars and a
significant portion of the expenses, including personnel costs as well as capital and operating

expenditures, continues to be denominated in Indian rupees. Consequently, the results of

operations are affected to the extent the rupee appreciates/depreciates against the foreign
currencies. Foreign exchange risk arises from future commercial transactions and recognised
assets and liabilities.
Satyam manages foreign exchange through treasury operations. Its risk management strategy
is to identify risks it’s exposed to, evaluate and measure those risks, decide on managing
those risks, regular monitoring and reporting to management. The objective of its risk
management policy is to minimize risk arising from adverse currency movements by
managing the uncertainty and volatility of foreign exchange fluctuations by mitigating the
risk to achieve greater predictability and stability. The risk management policies include
implementing strategies for foreign currency exposures, specification of transaction limits;
specifying authority and responsibility of the personnel involved in executing, monitoring
and controlling such transactions.
Sensitivity to Rupee Movement
The company has also established a sensitivity ratio against exchange fluctuation which
exhibits the following relationship.
A 2% increase/decrease in the value of the Indian rupee against US dollar would

decrease/increase the gains on outstanding foreign exchange forward and option
contracts by US$4.5 and US$2.1.
A 3% increase/decrease in the value of the Indian rupee against UK pound, Euro and
Australian dollar would decrease/ increase the gains on outstanding foreign exchange
forward and option contracts by US$0.1.
Hedging Strategy of Satyam
The group purchases foreign exchange forward contracts and options to mitigate the risk of
changes in foreign exchange rates associated with certain payables, receivables and
forecasted transactions denominated in certain foreign currencies. These derivative contracts
do not qualify for hedge accounting under IAS 39, and are initially recognized at fair value
on the date the contract is entered into and subsequently re-measured at their fair value.

Gains or losses arising from changes in the fair value of the derivative contracts are
recognized in the income statement.
Exhibit 6.7. (all figures in crores of Rs.)
Gains/(losses) on outstanding contracts FY 08
Forward contracts (0.7)
Option contracts (1.6)
Net (2.3)
5.4. RISK MANAGEMENT AT WIPRO LIMITED

At Wipro, responsibility for risk management resides at all levels,
starting from the Leadership and extending across the organisation -
with each business, functional and operational manager. The Risk
management initiative is coordinated by an Enterprise Risk
Management team, led by the Chief Risk Officer.
Strategic Business units have embedded risk management system with dedicated risk officers
for localised sensing and response to the business flows. Business Heads are responsible for
the identification of risk and selecting the risk-reward option in their businesses which are
subjected to a robust and effective review.
At a Strategic Level risk management focuses its attention to:
Providing re-assurance to our customer.

Partnering Business in Growth by optimising risks, literacy & Engagement of
employees.
Enabling Board of Directors/Audit Committee to achieve superior governance
practices.

FX Risk Management @ Wipro
The Company is exposed to foreign currency fluctuations on foreign currency assets and
forecasted cash flows denominated in foreign currency. The company is exposed to
substantial forex risk as it derives 73 per cent of it total revenues from exports (0.7254 FSR).
Also the Net foreign exchange (NFE) of the company stands at Rs. 7682.40 crores in FY 08.
Therefore, the company has implemented a defensive FX Risk Management strategy to
mitigate such risks. The Company follows established risk management policies, including
the use of derivatives to hedge foreign currency assets/liabilities, foreign currency forecasted
cash flows and net investments in foreign operations. The counter party in these derivative
instruments is a bank and the Company considers the risks of non-performance by the
counterparty as non-material.
Hedging Strategy of Wipro
The Company purchases forward foreign exchange contracts/option contracts (derivatives) to

mitigate the risk of changes in foreign exchange rates on accounts receivable and forecasted
cash flows denominated in certain foreign currencies. The strategy also includes purchase of
series of short-term forward foreign exchange contracts which are replaced with successive
new contracts up to the period in which the forecasted transactions are expected to occur
(roll-over hedging). The Company also designates zero-cost collars, which qualify as net
purchased options, to hedge the exposure to variability in expected future foreign currency
cash inflows.

SUGGESTIONS
“Nature is just enough; but men and women must comprehend and accept her
suggestions.”
While working on this project I found certain IT firms do not utilize currency futures which
are actively traded on major stock exchanges like National Stock exchange (NSE), Multi
Commodity Exchange (MCX) etc.
These exchange traded futures are much more beneficial then currency forwards as there is
no counterparty risk. The exchange itself acts as the counter party.
Secondly, derivative trading in India is almost limited to the OTC market and there is a need
to develop more complex and exotic products, traded on exchanges which can be utilized by
the corporates to hedge themselves. Some of such products are exchange traded currency
options, currency swaps etc.

CONCLUSION
Forex derivatives play a key role in the risk management process, particularly hedging which
is very necessary for export oriented firms to protect themselves from unanticipated losses.
Although hedging is a protective measure, it too comes at a cost to the company. Hence
perfect hedging is practically not possible. In these volatile times when export oriented firms,
typically IT firms in this research, should be rational in their approach towards hedging their
forex exposure and avoid unnecessary cost. The financial managers at these firms must be
capable of taking calculated risks. After all hedging does not lead to a better outcome but
only to a predictable outcome.
“Hedging is like a marriage and one should never expect it to be perfect”
Direction of Future Study
In future, further study can be conducted pertaining to this research overcoming the
limitations discussed in the previous section. Hedging of interest rate risk and credit risk can
be an important part of the study in future. Also the research can be more extensive covering
a wide range business sectors and organisations.

REFERENCES
Bibliography
Foreign Exchange & Risk Management, C Jeevnandanam, Sultanchand & Sons

Publication (Ninth Edition 2004).
Derivatives and Alternative Investments, CFA Level 1, Volume 6, Pearson Custom
Publishing.
FEDAI NSE Currency Futures (Basic) Module, Published by National Stock

Exchange of India Limited (NSEIL)
Report on “Foreign Exchange Derivatives Market in (India− Status and Prospects)

”By Neeraj Gambhir & Manoj Goel.
Business Newspapers including “The Economic Times” , “The Financial Times”,
“Business Standard”, “DNA Money” etc.
Magazines including “The Economist”, “Business World”, “Business Today”, “Green
money”, “Business Week” etc
Journals including “Wall Street Investment Journal”, “The Foreign Trade Journal” etc
Webliography
http://www.scribd.com/doc/12241467
http://www.escindia.in/htmlsite/AboutUs.aspx?Id=35
http://www.nasscom.org
http://www.rbi.org.in
http://www.reuters.com
http://www.asiancerc.com/researhreports.html

Narang RP

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Currency Derivatives and its Impact on Export Receivables with Special focus on Indian IT Sector

International Institute of Foreign Trade & Research 1

International Institute of Foreign Trade & Research 2

INTRODUCTION TO INDIAN IT SECTOR

Realising the high potential of employment, modernisation and contribution to economy

STRENGTHS OF INDIAN IT INDUSTRY

• One of the largest pool of technically qualified high class IT manpower

International Institute of Foreign Trade & Research 3

• Expertise on a wide variety of platforms

QUALITY OF INDIAN IT EXPERTISE

International Institute of Foreign Trade & Research 4

International Institute of Foreign Trade & Research 5

Objectives of the Study

To establish a relationship between exchange rate fluctuation and internaional trade.

International Institute of Foreign Trade & Research 6

International Institute of Foreign Trade & Research 7

Several hurdles came across accomplishing this research.

Availability of data regarding average daily turnover of OTC market inIndia

International Institute of Foreign Trade & Research 8

International Institute of Foreign Trade & Research 9

1. INTRODUCTION TO FOREIGN EXCHANGE

1.1 Exchange Rate

2. FOREIGN EXCHANGE MARKET

International Institute of Foreign Trade & Research 10

2.1. Foreign Exchange Market in India

International Institute of Foreign Trade & Research 11

Bank undertakes sales/purchases of foreign currency in periods of excess demand/supply in

Exhibit 1.1 Authorised Dealers (Category-I) in the Foreign Exchange Market

Public Sector Banks 27

Private Sector Banks 31

Source: Reserve Bank of India

International Institute of Foreign Trade & Research 12

4. EXCHANGE RATE RISK

4.1. Implications of Exchange-Rate Movements

Exchange rate movements has serious implications on business especially international

International Institute of Foreign Trade & Research 13

Appreciation Favourable for Imports & Unfavourable

4.2. Impact of Exchange Rate Fluctuations on Export Receivables

International Institute of Foreign Trade & Research 14

INDIAN IT INDUSTRY: AN OVERVIEW

International Institute of Foreign Trade & Research 15

International Institute of Foreign Trade & Research 16

India’s inherent IT capabilities - talented workforce and world-class companies.

Production of Computer Software and Services during the year 2007-08 is

International Institute of Foreign Trade & Research 17

MAJOR EXPORT DESTINATIONS

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FOREX DERIVATIVES AND ITS MARKET IN INDIA

International Institute of Foreign Trade & Research 20

1.1. Uses of Derivatives

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1.2. Derivative Products

Forwards: A forward contract is a customized contract between two entities, where

International Institute of Foreign Trade & Research 22

International Institute of Foreign Trade & Research 23

1.3. Need of Derivatives

Increased volatility in asset prices in financial markets,

2. FOREX DERIVATIVES MARKET IN INDIA

International Institute of Foreign Trade & Research 24

3. EVOLUTION OF FOREX DERIVATIVES MARKET IN INDIA

This tremendous growth in global derivative markets can be attributed to a number of

4. INTRODUCTION OF CURRENCY FUTURES IN INDIA