INSTITUTE FOR TECHNOLOGY AND MANAGEMENT

PGDM (FINANCE) 2012-14

Capstone Project Report On

Currency Hedging A Trend in India

By: Brajesh Vir ID: 2111 PGDM Finance

Under The Guidance of Prof. Joginder Nanda ITM Business School Navi Mumbai

DECLARATION
I, hereby declare that the project entitled, Currency Hedging A Trend in India, is completed by me during the Semester IV of the Post Graduate Diploma in Management Financial course 2012 14 as a part of my capstone project in partial fulfilment of the course. The report content and conclusions drawn are original. The facts stated in the report are correct to the best of my knowledge and belief.

Date:

Sincerely,

(Signature of the Student) Name: Brajesh Vir Roll No.:2111 PGDM Finance (2012-14) ITM Business School Navi Mumbai.

Signature: Academic Coordinator

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ACKNOWLEDGEMENT

First of all I would like to thank the Almighty God for His blessing enabling me to stand in any facets of my life & my parents for their continuous support.

I am also grateful to our Prof. Joginder Nanda who guided us throughout the capstone program & was on my side to help me when I encountered any difficulty.

I also express my sincere thanks to all those who has directly/indirectly helped me in this project & in the preparation of my project report.

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INDEX

Sr. No.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Contents
Abstract Introduction Objective of Study Literature Review History of Currency Derivative Research Design Introduction of Derivatives Currency Derivative Products Foreign Exchange Quotation Advantages of Currency Future Disadvantages of Currency Future Determinants of Hedging Decision Data Analysis TCS Infosys Wipro Pharmaceutical Industry Limitations Conclusion References

Page No.
4 5 6 6 8 11 13 14 22 24 25 26 28 29 32 34 36 37 38 39

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ABSTRACT
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, currency hedging 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 (Foreign Exchange) derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. This report attempts to evaluate the trend followed by the Indian corporate for hedging currency risks. By studying the use of various hedging instruments by major Indian firms, the report concludes that forwards and options are preferred as short term hedging instruments while swaps are preferred as long term hedging instruments. The high usage of forward contracts by Indian firms as compared to firms in other markets underscores the need for rupee futures in India. In addition, the report also looks at the necessity of managing foreign currency risks, and looks at ways by which it is accomplished. A review of available literature results in the development of a framework for the risk management process design, and a compilation of the determinants of hedging decisions of firms.

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INTRODUCTION
Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another. With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency risk has become substantial for many business firms that was the reason behind development of currency derivatives. The financial environment today in India has more risks than earlier. Successful business firms are those that are able to manage these risks effectively. Due to changes in the macroeconomic structures and increasing internationalization of businesses, there has been a dramatic increase in the volatility of economic variables such as interest rates, exchange rates, commodity prices etc. Firms that monitor their risks carefully and manage their risks with judicious policies enjoy a more stable business than those who are unable to identify and manage their risks. There are many risks including currency risk, which are influenced by factors external to the business and therefore suitable mechanisms to manage and reduce such risks need to be adopted. One of the modern day solutions to manage financial risks is hedging. This study aims to provide a perspective on managing the risk that firms face due to fluctuating exchange rates. It investigates the prudence in investing resources towards the purpose of currency hedging. 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 imports are fast gaining a cost disadvantage. Hedging with derivative instruments is a feasible solution to this situation.

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OBJECTIVE OF STUDY
Covering different aspects of Currency Hedging Identifying keys for effective Hedging Strategies To understand the challenges and impact of Currency Hedging To analyse the current progress of Currency Hedging in India The main objective of the study is to apply the Theoretical Knowledge into practical Applications

LITERATURE REVIEW
The optimal degree of currency hedging is controversial and depends on the motivation of investors demands for currency. Currency exposure affects portfolio risk but also affects returns to the extent that returns on foreign currency are not zero. Based on risk considerations, full hedging of currency risk, i.e. zero demand for currencies, is optimal assuming that foreign currencies are uncorrelated with other assets. Perold and Shulman (1988) recommend full hedging of investment related currency risk based on the assumption that currency returns are zero in the long-run and that correlations of currencies with other asset classes are close to zero on average. They proclaim currency hedging as a free lunch for investors arguing that it reduces risk without affecting returns. The additional risk reduction from hedging currency exposure is estimated to be as large as the gains from diversifying abroad in the first place. Similarly, Eun and Resnick (1988) show that currency risk is largely un-diversifiable and that it reduces the gains from international diversification. In their study, they highlight the practical problem of estimating the right amount to hedge. That is, the return on a foreign equity investment is unknown at the time the hedge arrangement is put into place. Investors can only hedge the expected return not the actual return. This effect is often neglected, particularly in studies using a log-return representation which implies continuous hedging. Campbell et al. (2010) find that the U.S. Dollar, the Euro, and the Swiss France have moved against world equity markets over the period 1975to 2005. Therefore they suggest that risk minimizing equity investors should seek exposure to these currencies. For bonds full hedging tends to be optimal in their sample, a finding that we confirm. Similarly, Glen and Jorion (1993) find that optimal currency hedging substantially reduces risk for equity investors. Froot (1993) makes the case for not hedging exchange rate risk over long investment horizons. His argument is based on mean-reversion of real exchange rates to purchasing power parity (PPP). He tests the hypothesis that PPP provides an automatic hedge on 200 years of data for a U.K. based investor investing in the U.S. For equities, Froot finds that for investment horizons beyond two years full hedging does not reduce the variance of returns compared to no hedge. For bonds, hedging appears to be more useful as full hedging significantly reduces the variance of returns over holding horizons of up to five years.

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Practitioners tend to be pragmatic in determining hedge ratios. Often they use simple hedge ratios of 0, 50, and 100 percent. For example, providers of major hedged indices such as MSCI and S&P hedge each foreign currency in an index fully back into the base currency using beginning-of-period investment values. A likely reason for practitioners not determining optimal hedge ratios in a portfolio context is the instability of the approach. We are sympathetic to the notion of ignoring potential correlations of currencies with equities. In our dataset we find that currency-equity correlations are unstable and fluctuate from plus 40 percent in one decade to minus 40 percent in the next decade for some currency-equity pairs. Similarly, Black (1989a) shows that, depending on the input data, hedge ratios over a very wide range of values can be optimal. Much of the hedging literature naturally focuses on risk. However, the evidence on the failure of uncovered interest rate parity (see, for example, Fama (1984) and Engel (1996)) suggests that currency excess returns are not always zero. The literature finds that currencies of countries with low interest rates tend to not appreciate as much as suggested by the parity condition. The opposite holds for currencies of countries with high interest rates. This effect is behind the global currency carry trade where investors borrow in a low yielding currency and lend the proceeds in a high yield currency. Hedging currency risk associated with foreign investments removes these carry trade profits for investors from low interest rate currencies while it may enhance the returns to high interest rate currency investors. We find the effect of currency excess returns to be economically large but statistically insignificant. A second, speculative impact of currencies and hence hedging on returns results from currency returns to investors in different countries being quoted in terms of different numeracies currencies. Black (1989) points out that each party in a currency trade can simultaneously perceive positive returns. This manifestation of Jensens inequality is known as Siegels paradox and can explain symmetric speculative demands for currencies. Campbell. (2010) highlight that the demand for currency generated by this effect is quite small in practice given the high volatility of currencies.

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HISTORY OF CURRENCY DERIVATIVES

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a system of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world due to increased inflation and the oil shock. Corporates struggled to cope up with the uncertainty in profits. It was then that financial derivatives foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. The Chicago Mercantile Exchange (CME) created FX futures, the first ever financial futures contracts, in 1972. The contracts were created under the guidance and leadership of Leo Melamed, CME Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II. By creating another type of market in which futures could be traded, CME currency futures extended the reach of risk management beyond commodities, which were the main derivative contracts traded at CME until then. The concept of currency futures at CME was revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman.

DEVELOPMENT IN INDIA:
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 favourable 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. The first step towards introduction of derivatives trading in India was the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options securities. SEBI set up a 24 member committee under the chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that the derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of derivatives. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. RBI and SEBI jointly constituted a standing technical committee to analyse the currency market around the world and lay down the guidelines to introduce Exchange Traded Currency Futures in the Indian market. The committee submitted its report on May 29, 2008. Further RBI and SEBI issued circulars in this regard on August 06, 2008. Currently, India is USD 100 billion Currency market, where all the major currencies like USD, EURO, YEN and POUND are traded.

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The rationales for introducing futures in the Indian context has been outlined in the report of the
internal working group of Currency Futures (Reserve Bank of India, April 2008) as follows: The rationale for establishing currency futures market is diverse. Both residents and nonresidents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non-residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long-run, which is typically inter generational in the context of exchange rates. As such, there is a strong need to hedge currency risk and this need has grown diversely with fast growth in cross-border trade and investment flows. The argument for hedging currency risks appear to be natural in case of assets and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need of hedging currency risks but there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns. There are strong arguments to use instruments to hedge currency risks.

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DERIVATIVES IN INDIA: A CHRONOLOGY

Date 14 December 1995 18 November 1996 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 31 August 2000 June 2001 July 2001 9 November 2002 June 2003 13 September 2004 1 January 2008 1 January 2008 6 August 2008 29 August 2008 2 October 2008 7 October 2008 Progress NSE asked SEBI for permission to trade index futures. SEBI setup L. C. Gupta Committee to draft a policy framework for index futures L. C. Gupta Committee submitted report. RBI permitted OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX Trading of Equity Index Options at NSE Trading of Stock Options at NSE Trading of Single Stock futures at BSE Trading of Interest Rate Futures at NSE Weekly Options at BSE Trading of Chhota (Mini) Sensex at BSE Trading of Mini Index Futures & Options at NSE Circulars regarding Currency Futures by RBI & SEBI Trading of Currency Futures at NSE Trading of Currency Futures at BSE MCX-SX came into existence with USD/INR pair

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RESEARCH DESIGN:
Research Methodology refers to search of knowledge. One can also define research methodology as a scientific and systematic search for required information on a specific topic. The word research methodology comes from the word advance learners dictionary meaning of research as a careful investigation or inquiry especially through research for new facts in my branch of knowledge for example some author have define research methodology as systematic effort to gain new knowledge.

Research Approach: Economic analysis

Company Analysis

Finding Risk Exposure

Hedging Strategies

Finding Hedging Impact

Key factors determining hedge framework:

HEDGING OBJECTIVES

LINE-OF-BUSINESS RISK Typically minor, frequent mis-matches between funds allocated to recipient agencies and final local currency allocation. Leads to minor under/overfunding of projects. 11 | P a g e

TAIL RISK Significant, infrequent FX movements, which cause major funding shortfalls. Magnitude may cause projects to be suspended or cancelled.

HEDGING IMPACT

PROFIT -AND-LOSS Typically hedging smoothens the profile since hedging returns and the underlying portfolio returns are negatively correlated.

CASH FLOWS Hedging creates the potential for cash flows at the time of rolling over the hedges.

Method to be used: Secondary Data

Internet research: It mainly includes the research reports of different companies and their strategies. Annual reports of different companies. Websites to be used as of now:

Tools to be used in Research:

Microsoft Office Excel: It is the tool which can be used for: Collection of real time currency rates Analysis of trend of its prices Choose the hedging strategies Impact of the volatility of currency

Microsoft Office Word: It is to be used for different data collection and making the report.

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INTRODUCTION OF DERIVATIVE
There is no universally satisfactory definition available for the term Derivative. But in general it can be said that, "Derivative" is an instrument which does not have its own independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. The Underlying Securities for Derivatives are : 1. Commodities: Castor seed, Grain, Pepper, Potatoes, etc. 2. Precious Metal: Gold, Silver 3. Short Term Debt Securities: Treasury Bills 4. Interest Rates 5. Common shares/stock 6. Currency derivatives Derivative includes forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of securities.

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CURRENCY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. FORWARD The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both the purchaser and the seller from any risk of loss which might incur due to fluctuations in the price of underlying asset. A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate.

FUTURE
A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts. SWAP Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The currency swap entails 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. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap. In a swap normally three basic steps are involve: 1. Initial exchange of principal amount 2. Ongoing exchange of interest 3. Re - exchange of principal amount on maturity

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 OPTIONS Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ) In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to 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 OTC. In India only currency forwards and currency futures are only allowed. Currency swaps and currency option is yet not allowed in India. Recently MCX-SX has started to offer currency futures contracts in US Dollar-Indian Rupee (USD-INR,) Euro-Indian Rupee (EUR-INR), Pound Sterling-Indian Rupee (GBP-INR) and Japanese Yen-Indian Rupee (JPY-INR). Clearing and Settlement is conducted through the MCX Stock Exchange Clearing Corporation Ltd (MCX-SX CCL).

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DIFFRENCE BETWEEN FORWARDS & FUTURES

Standardization:In forward contracts, the amount of the assets to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor made, while in futures contract amount of the asset and maturity date both are standardized by the exchange on which the contract is to be traded.

Margins:Trading in futures requires keeping the margin money with the broker while purchasing the futures contract, but in the forward contract there is no margin money to be kept at the time of purchase of the forward contract because it is between buyer and seller.

Mark to market:Buyers of the futures contract have to provide with the additional margin, if the price of the futures contract decreases or increases, but in the case of forwards contract such margin is not settled on daily basis.

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UTILITY OF CURRENCY DERIVATIVES

Traders in the foreign exchange market make thousands of daily trade, buying and selling currencies while exchanging market information may be used for varied purposes: For the import and export needs of companies and individuals For direct foreign investment To profit from the short-term fluctuations in exchange rates To manage existing positions or To purchase foreign financial instruments

Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk. When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many effects on an economy: Affects the prices of imported goods Affects the overall level of price and wage inflation Influences tourism patterns May influence consumers buying decisions and investors long-term commitments.

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents strategies, they can act first and beat the competition. Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later. Trader purchases a lot of currency Trader sells a lot of a currency long on the currency Short on the currency

To predict the movements of currencies, traders often try to determine whether the currencys price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the countrys economy helps them make a determination. Currency underpriced Currency overpriced Price will go up Price will go down

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level.
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Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency by obtaining a derivative contract while hoping to buy the currency at a low rate in the future. Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting to sell the appreciating currency at a high future rate. In either case, they are exposed to the risk of currency fluctuations in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations. The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices. Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage.

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Currency futures provide an additional tool for hedging currency risk.

Further development of domestic foreign exchange market. Permit trades other than hedges with a view to moving gradually towards fuller capital account convertibility. Provide a platform to retail segment of the market to ensure broad based participation based on equal treatment. Efficient method of credit risk transfer through the Exchange. Create a market to facilitate large volume transactions to go through on an anonymous basis without distorting the levels.

THE FORWARD MARKET

The rupee-dollar forward market is a bilaterally negotiated market: there was no pre-trade or post-trade transparency in 2006-2007, 85,106 numbers of forward transactions came to CCIL for settlement, with notional value of $342 billion. In late 2006, forward market turnover was nudging $2 billion a day. There are three remarkable features about the Indian currency forwards market: Even though trading is negotiated off exchange, there is netting by novation at CCIL, so that credit risk is eliminated. Even though it an OTC market, it trades standardized contracts that expire on the last business day of each month. Ordinarily, currency forward markets have pricing that is controlled by Covered Interest Parity (CIP). However, the system of capital controls involves considerable barriers on CIP arbitrage. Hence, it is often the case that the forward price strays away from fair value. In addition to the onshore rupee-dollar forward market; there is active trading for cash-settled rupee-dollar forwards in Hong Kong, Singapore, Dubai and London on what are termed no deliverable forwards (NDF).

THE CURRENCY FUTURE MARKET

A futures contract is a promise to buy or to deliver a certain quantity of a standardized good by a specific future date. A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price.
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 When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a commodity futures contract. When the underlying is an exchange rate, the contract is termed a currency futures contract. In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfil their obligations on the settlement date. Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profit and loss in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what is the value of tick (minimum trading price differential at which traders are able to enter bids and offers)? A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlying. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paisa or 0.0025 Rupees. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs.62.2500. One tick move on this contract will translate to Rs.62.2475 or Rs.62.2525 depending on the direction of market movement Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price: Rs. 62.2500 +Rs. 00.0025 Rs.62.2525 Rs.62.2500 Rs. 00.0025 Rs.62. 2475

The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 ticks, he/ she make Rupees 50. Step 1 : Step 2 : Step 3 : 62.2600 62.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50

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FUTURES TERMINOLOGY
Spot price: The price at which an asset trades in the spot market. In the case of USD/INR, spot value is T + 2 days (T = Trading day). Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelvemonth expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time. Value Date/Final Settlement Date: The last business day of the month will be termed the Value date/ Final Settlement date of each contract. The last business day would be taken to the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including those for known holidays and subsequently declared holiday would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI). Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the Value date / Final Settlement Date. Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. In the case of USD/INR it is USD 1000. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures (in commodity markets) the storage cost plus the interest that is paid to finance or carry the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

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FOREIGN EXCHANGE QUOTATIONS

Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. It means exchange rate is relative price.

For example, if one US dollar is worth of Rs. 62 in Indian rupees then it implies that 62 Indian
rupees will buy one dollar of USA, or that one rupee is worth of 0.015 US dollar which is simply reciprocal of the former dollar exchange rate.

QUOTATION

DIRECT
Types of exchange rates

INDIRECT

The number of units of Domestic/Foreign currency stated against one unit of currency per unit of Foreign/Domestic currency. Rs./$ = 62.7250 (or) Rs. 1 = $ 0.0159 $1 = Rs. 62.7250

There are two ways of quoting exchange rates:

1. Direct and 2. Indirect. Most countries use the direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique feature of this market. It should be noted that where the bank sells dollars against rupees, one can say that rupees against dollar. In order to separate buying and selling rate, a small dash or oblique line is drawn after the dash. For example, If US dollar is quoted in the market as Rs. 62.3500/3550, it means that the forex dealer is ready to purchase the dollar at Rs. 62.3500 and ready to sell at Rs 62.3550. The difference between the buying and selling rates is called spread.
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It is important to note that selling rate is always higher than the buying rate. Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers.

Base Currency / Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. That is the expression Dollar-Rupee, tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency. Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis--vis the second currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated.

For example: If Dollar Rupee moved from 62.00 to 62.25. The Dollar has appreciated and the
Rupee has depreciated. And if it moved from 62.0000 to 61.7525 the Dollar has depreciated and Rupee has appreciated. The transactions in the interbank market may place for settlement1. On the same day; or 2. Two days later; or 3. Some day late: say after a month. Where the agreement to buy and sell is agreed upon and executed on the same day, the transaction is known as: Ready or cash value today, Tomorrow (tom) value tomorrow, or next working day. The transaction where the exchange of currencies takes place two days after the date of the contract is known as spot transaction value two business days after the trading day. Thus, for a spot transaction done Monday, currencies will change hands the following Wednesday assuming this is a working day in both the centers. Similarly, for a spot transaction done Thursday, currencies will change hands the following Monday. The transaction in which the exchange of currencies takes place at a specified future date, subsequent to the spot date, is known as a forward transaction. Forward rate may be the same as the spot rate for the currency. Then it is said to be at par with the spot rate. But this rarely happens. More often the forward rate for a currency may be costlier or cheaper than its spot rate.

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ADVANTAGES OF CURRENCY FUTURES

EASY ACCESSIBILITY: Currency future is being offered on the recognized exchanges in India. NSE (National Stock Exchange), MCX (Multi-Commodity Exchange), BSE (Bombay Stock Exchange) have commenced currency futures trading. Small investors would get an easy access to currency futures trading on the popular exchanges. It is as easy as trading in a blue chip stock on any of your favorite exchange.

EASY AFFORDABILITY: Margins are very low and the contract size is very small. As per the specification of NSE, USD-INR currency future contract, lot size is 1000$. Margin is 1.75%.

LOW TRANSACTION COSTS: When you trade in INT currency futures on NSE in India, you have to pay a small amount of brokerage fees and statutory duties and taxes. In overseas Forex trading you have to pay commissions to the banks or foreign exchange agents in the form of spread. Spread is the difference in the buy/sell price over the reference rate, which can be very high.

TRANSPERANCY: It is possible for you to verify trade details on NSE if you have a doubt that the broker has tried to cheat you.

EFFICIENT PRICE DISCOVERY: Internationally it has been established that currency future is a better and efficient mechanism for price discovery. With its state of the art automated electronic trading system where the orders are executed on the basis of price-time priority, NSE is well poised to offer efficient price discovery.

COUNTER-PARTY DEFAULT RISKS: All the trades done on the recognized exchanges are guaranteed by the clearing corporations and hence it eliminates the risks associated with counter party default. NSCCL (National Securities Clearing Corporation Limited) carries out all the novation, clearing and settlement process of currency futures trading.

STANDARDIZED CONTRACTS: Exchange Traded currency futures are standardized in respect of lot size (1000$) and maturity (12 monthly contracts). Retail investors with their limited
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resources would find it tremendously beneficial to take positions in standardized USD INR futures contracts

DISADVANTAGES OF CURRENCY FUTURES

The futures are also disadvantageous in a few areas when compared to OTC market. The major disadvantages are: 1. Standardization: It is not possible to obtain a perfect hedge in terms of amount and timing. 2. Cost: Forwards have no upfront cost, while margining requirements may effectively drive the cost of hedging in futures up. 3. Small lots: Not possible to hedge small exposures generally

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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. 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 decisions (Broll, 1993). Only the revenue function and cost of production are to be assessed, and, the production and trade decisions in multiple countries are independent of hedging decision. The implication of this independence is that the presence of markets for hedging instruments greatly reduces the complexity involved in a firms 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. 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. 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. (Allayanis and Ofek, 2001) First, the following section describes the factors that affect the decision to hedge and then the factors affecting the degree of hedging are considered.

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 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.

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EVIDENCE OF DERIVATIVE USE FOR HEDGING FOREIGN EXCHANGE RISK BY CORPORATE IN INDIA:
The following table has given as an evidence for implementation of Hedging Technique by some Indian corporate.

IT Industry:
The Indian IT Industry has slowly become a global force to reckon with for its IT Prowess. The sales percentage on basis of geography is shown below with help of graph.

2% 13%

IT Sales

7%

US UK Asia Pacific

60% 18%
Continental Europe Rest of the World

Main market of Indian IT Industry

Since almost 60% of the income comes in foreign currency these firms feel a strong need to hedge them against the foreign exchange risk exposure. And in the current scenario when currency is so volatile, it is becoming difficult for IT Companies to sustain their growth momentum. The amount of foreign exchange risk exposure a company faces and the degree of hedging it should undertake depends on a number of factors: Firm Size: Large firms have economies of scale and hence their hedging cost get greatly reduced and they also have large risk apetite. Leverage: Firms which are highly leveraged have more incentive to leverage. Liquidity and profitability: High liquidity means lesser exposure. Sales growth: Firms having high sales should hedge freely since they do not have debt on their books.

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MAJOR PLAYER IN INDIAN IT SECTOR ARE:

TCS Infosys Wipro e.t.c.

TCS:
TCS gets over 90% of its total revenue from exports. Major exposure exists in the $/INR domains. Business Geographies for TCS is shown below with the help of pie chart.

4% 9%

TCS

4%

USD EUR GBP

16% 59%
AUD INR Others

8%

Business Geographies of TCS

TCS hedge both revenue and balance sheet, mainly receivables. It does not use any discretion in hedging receivables which protects 100% of its receivables. The table shows the volume of foreign exchange transactions at TCS in last few years.

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TCS
FY 2012-2013 Forward Contract
Foreign Currency No of contract s Notional Amount (Mn) Total Amount (Mn) No of contract s Notional Amount (Mn) Total Amount (Mn) No of contract s Notional Amount (Mn) Total Amount (Mn)

FY 2011-2012

FY 2010-2011

U.S. Dollar Sterling Pound Euro Australia n Dollar Option Contract U.S. Dollar Sterling Pound Euro Australia n Dollar Total

4 2 8

22.71 0.79 2.78

90.84 1.58 0 22.24

44 26

288.01 9.38

12672.4 4 243.88 0 490.16

52 38

207.82 27.7

10806.6 4 1052.6 0 180.5

44

11.14

19

9.5

56 12 15 -

1150 123 102 -

64400 1476 1530 0 67520.7

81 33 21 6

2185 217.5 210 30

176985 7177.5 4410 180 202159

58 9 21

349.38 54 149

20264.0 4 486 3129 0 35918.7

Outstanding currency Option and Forward contracts

Total Amount (Cr) PAT (Cr) Accounts Receivable % of A/R hedged Extended Hedge % Amount Net amount to be hedged

FY12-13 6752.07 13917.3 14076.6 47.97% 60% 8445.94 1693.87

FY11-12 20215.898 10413.49 11520.35 175.48% 60% 6912.21 -13303.69

FY10-11 3591.88 9068.04 8194.97 43.83% 60% 4916.98 1325.1

FY09-10 3685.47 7000.64 5855.41 62.94% 60% 3513.25 -172.23

FY08-09 2575.56 5256.42 6134.02 41.99% 60% 3680.41 1104.85

Hedging Scenario at TCS This is the hedging positions in last five years for TCS. In Yr. 2011-12, the invested highly which made the hedge investment almost 175% of its whole Trade Receivable for that Year. This is the summary of Account Receivable hedge. 60% of the Account Receivable should be hedged as a healthy hedge investment in the case of TCS, where it hedged 175% of its A/R in Yr. 2011-12 which resulted in heavy loss of Rs. 7488.2 Cr. The unhedged exposure for each year is calculated which is still under the currency risk exposure.
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TCS Currency Hedging

200000 180000 160000 140000 120000 100000 80000 60000 40000 20000 0 FY 2012-2013 FY 2011-2012 FY 2010-2011 Euro FY 2009-2010 Australian Dollar FY 2008-2009

U.S. Dollar

Sterling Pound

Derivative transactions for TCS

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INFOSYS:
Infosys gets over 98% of its total revenue from exports. And again its mazor part of revenue comes from UD Dollar. Business Geographies for Infosys is shown below with the help
of pie chart.

Infosys
6% 7%

7%
USD EUR

7%

GBP AUD INR

73%

Infosys hedge 100% of its receivables. It uses mainly Forward contracts for hedging the receivable. The table shows the volume of foreign exchange transactions at Infosys in last few years.

Infosys
FY 1213 Forward contract out standings FRA In USD FRA In EUR FRA In GBP FRA In AUD Options out standings Option In USD Total 4621 431 537 396 0 5985 FY 1112 3700 258 179 122 254 4513 FY 1011 2433 177 108 46 0 2764 FY 0910 1199 130 71 12 808 2220

In Rs. Cr FY 0809 1407 179 149 0 877 2612

Outstanding currency Option and Forward contracts

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Derivatives Maturity Not later than 1 month Later than 1 month less than 3 months Later than 3 months less than 12 months Later than 12 months less than 60 months Due after 5 years 988 1794 3203 0 0 344 146 84 790 0 0 3379 109 0 251 249 0 71 62 80 0 0 223 72

Derivatives Maturity Period

INFOSYS
FRA In USD 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 FY 12-13 FY 11-12 FY 10-11 FY 09-10 FY 08-09 FRA In EUR FRA In GBP FRA In AUD Option In USD

Derivative transactions for Infosys

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WIPRO:
Hedging for Wipro is a crucial strategy considering their diversified investment profile. Wipro has consistent hedging policy, designed to minimize the impact of volatility in foreign exchange fluctuation on the earnings. Business Geographies for Wipro is shown below with the help of pie chart.

6% 10%

Wipro

4%

USD EUR GBP

12% 59%

AUD INR Others

9%

They follow established risk management policies, including the use of derivatives like foreign exchange forward, option contracts to hedge forecasted cash flows denominated in foreign currency. The table shows the volume of foreign exchange transactions at Wipro in last few years.

Wipro

in Rs. Mln

FY 12- FY 11- FY 10- FY 0913 12 11 10 FY 08-09 Designated cash flow hedging derivatives instruments 777 1081 901 1518 1060 Sell USD 108 17 2 0 0 Euro 61 4 21 31 54 GBP 0 1474 3026 4578 6130 Yen 9 0 4 7 3 AUD 0 0 6 0 2 CHF 30 0 0 0 0 Interest Rate swaps USD Net investment hedge in foreign Operations 24511 24511 24511 26014 35016 Cross currency swaps YEN 257 262 262 262 267 USD 40 40 40 40 40 Euro 0 0 0 0 0 Others 34 | P a g e

Non designated derivative instrument 1241 Sell USD 73 GBP 47 EURO 60 AUD 767 Buy USD 1525 YEN 7000 Cross currency swaps YEN

841 58 44 31 555 1997 7000

526 40 48 13 617 0 7000

45 38 29 0 492 0 7000

612 53 39 0 438 23170 0

Outstanding currency contracts Wipro used to hedge 75-125% of its receivables, 5-75% of next 4 quarters net inflows and some long term contracts and debts.

Differences in Approaches of TCS, Infosys and Wipro: Particulars TCS Infosys Wipro

What do Companies 100% receivables Net receivables only 75-125% of receivables, 5and net revenues dont go over 100% 75% of next 4 quarters net Hedge? inflows, some long term contracts and debts management Risk management policy is Who decides the Risk management Risk committee committee presented to audit committee Hedging Policies? Usually 6 months 1-2 quarters Within a year, immediate Tenure of Hedges? quarter maximum hedged Forwards Predominantly forwards Forwards vs Options Largely options

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PHARMACEUTICALS INDUSTRY:
This industry is characterized by high payments for technology and high external debt financing because pharmaceutical companies like Cipla, Sun Pharmaceutical and Ranbaxy find raising debt in the countries of their vendors cheaper. As an example Ranbaxy hedge their currency risk by different derivatives contracts in different cross currencies. Derivative investments of Ranbaxy is shown below: Cross Currency Currency FY12-13
USD USD USD EUR ZAR GBP USD JPY USD USD JPY INR INR INR USD USD USD INR USD INR INR USD 137.3 8.34 20 4 0 0 120 0 430 100 0

Instruments
Forward Contract for Loans Forward Contract for Loans (ECB) Forward Contract Forward Contract Forward Contract Forward Contract Currency Swaps Currency Swaps for Loans Currency Options Currency cum interest rate swaps Interest Rate Swap(JPY LIBOR)

FY11-12
195 54 0 1 0 0 0 5900 654.5 0 2900

FY20-11
249 0 0 5 40.75 0 0 8150 846.5 0 7400

FY09-10
0 0 20 1.44 0 0 1038.5 10350 0 0 11800

FY08-09
0 0 218.4 35.3 0 0.17 0 0 1403 0 7.35

Outstanding currency contracts of Ranbaxy

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LIMITATION:
Only one type of risk is assumed i.e. the foreign exchange risk. Only very few firms were reviewed over just one time period so the conclusion is limited. There is lack of primary data so had to depend upon secondary data which I got from annual report of the companies. The time constraint was one of the major problem.

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CONCLUSION:
Currency Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporates can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. The limitation of this study is that only one type of risk is assumed i.e. the foreign exchange risk. Also applicability of conclusion is limited as only very few firms were reviewed over just one time period. However the results from this exploratory study are encouraging and interesting, leading us to conclude that there is scope for more rigorous study along these lines.

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REFERENCES:
Websites:

Giddy, Ian H and Dufey, Gunter, 1992, The Management of Foreign Exchange Risk, Available at: http://pages.stern.nyu.edu/~igiddy/fxrisk.htm. Amrit Judge and Ephraim Clark, How Firms Hedge Foreign Currency Exposure: Foreign Currency Derivatives versus Foreign Currency Debt, Available at http://www.efmaefm.org/efma2005/papers/126-judge_paper.pdf Neeraj Gambhir and Manoj Goel, Foreign Exchange Derivatives Market in India Status and Prospects, Available at http://kumarprasun.yolasite.com/resources/Foriegn%20exchange%20derivative s%20market%20in%20INDIA.pdf Asani Sarkar, 2006, Indian Derivative Markets from The Oxford Companion to Economics in India. Available at http://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.p df Muller and Verschoor, March, 2005, The Impact of Corporate Derivative Usage on Foreign Exchange Risk Exposure, Available at http://ssrn.com/abstract=676012 http://www.tcs.com/investors/financial_info/Pages/default.aspx http://www.infosys.com/investors/Pages/index.aspx http://www.wipro.com/investors/ http://www.ranbaxy.com/investor-relations/financial-information/annualreport/ www.forex.com www.bloomberg.com www.investopedia.com www.mcx-sx.com

Books: P.G. APTE

- International financial management

V. SHARAN - International financial management

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