Exchange Rate Risk Hedging By Indian CompaniesPresentation Transcript
EXCHANGE RATE RISK HEDGING BY INDIAN COMPANIES This is the risk which affects the business operations or the value of an investment-assets & liabilities, due to UNANTICIPATED change in the exchange rates. Also called Currency risk & can affect businesses and individuals who invest in international markets.
Variability of exchange rates gives rise to foreign exchange exposure and the foreign exchange risk. Three types of Foreign Exchange exposures: Transaction, Translation & operating or economic.
hedging techniques Broadly classified into internal & External Hedging techniques. The various internal hedging techniques are: - Exposure netting - Leading and Lagging - Hedging by choosing the currency of invoice, and - Hedging through sourcing.
Hedging tech contd.. The various External Hedging techniques are: - Forwards - Futures - Options, and - Money markets
Exotic options for External Hedging Barrier Option - It is like a plain vanilla option but with one exception: the presence of one or two trigger prices. It has two features: Knock out feature: If the trigger price is touched at any time before maturity it causes the option to immediately terminate. Knock in feature: If the trigger price is touched at any time before maturity, it causes an option with pre-determined characteristics to come into existence.
Exotic options for External Hedging Asian Option - Asian option is the one whose average value of the underlying asset is linked to its payoff. It is also known as the Average Option. It is further of two types: Average strike option: The strike price is set equal to the underlying price of the asset over life span of the option. Average rate/ price option: The strike price is fixed; payoff is based on the difference between average value of the underlying asset and the strike price.
Exotic options for External Hedging Basket option: A basket option is an option whose payoff is linked to a portfolio or "basket" of underlying asset’s value. The basket can be of any weighted sum of asset’s values so long as the weights are all positive. Contingent premium option: A contingency clause is attached during the life of the option, the premium of the option is paid as soon as it is exercised, also as soon as the underlying asset is greater than or equal to the strike price, the contingency clause requires the option to be exercised.
Exotic options for External Hedging Chooser option: Purchaser pays an upfront premium and has the choice of having it to be a call or put vanilla on a given underlying asset. It is also called as a path dependent option. Compound option: It is an option on option. There are two strike prices and two expiration days and two premiums, one each for compound option and one for the underlying asset. These options are extremely sensitive to volatility.
Exotic options for External Hedging Ratchet option: It is a series of consecutive forward start options. The first is active immediately, second becomes active when the first expires and so on. The effect of the entire instrument is of an option that periodically "locks in" profits in a manner somewhat analogues to a mechanical ratchet. Rainbow option: These are derivatives linked to two or more underlying assets. Basket options linked to multiple assets, but are generally not referred to as rainbows.
Where lies the problem?? Complexity – Exotic Derivatives are complex and specialized unlike the plain vanilla derivatives which are simple and commonly used. Little Understanding – Exotic derivatives are little understood by the players as well as the traders because of the hidden pricing and profit making mechanisms. So if not chosen wisely, these can prove to be risky themselves despite being the risk hedging instruments.
The RANBAXY Episode
What went wrong??
The Strategy used Bought “PUT” options from banks. Sold “CALL” options to banks. Dollar appreciated against Ranbaxy’s expectations. Banks exercised the “CALL” options. Loss from fair valuation of derivatives was alone Rs 784 crore.
Analysis of the Strategy used
When value of underlying declines!!
When value of underlying increases!!
Proposed Solution… Buy a “CALL” option When the rupee depreciates the call buyer will exercise the call option and buy the dollar at the strike price which is lower than the current market price. Also there will be income for the seller of a put in form of premium as the put buyer will not exercise the put option adding to the profits. Write a “PUT” option When the rupee appreciates the call option will result in the loss of premium as it will not be exercised and the put option will result in large loss as it will be exercised by the buyer
BIoCON Initially entered into fixed price forward cover Forward rate being 41 when the dollar was trading at 39.94 This was based on assumptions that Indian markets were buoyant and GDP growth is around 8%.
Contd… On the backdrop was financial crisis the rupee had depreciated Biocon suffered lost to the tune of 147 crore when the rupee breached 50 mark Biocon’s hedge was to only protect is against rupee appreciation
Biocon’s Financial Figures For FY 09 Mark to market losses at Rs 147 crore PAT impacted by MTM, declines to 93 crore Earnings per share at Rs 12 ( pre MTM ) Earnings per share at Rs. 4.65 ( post MTM )
Biocon’s strategy reworked It entered into contracts to protect it from both rupee appreciation and depreciation It has brought protection at Rs. 50 at the lower end with the right to participate in the upside
Banking sector RBI Report: Contingent Liability, Off – Balance Sheet Items increasing. 2007 – 2008: Contingent Liability rose by 88.44% (to Rs.144.3 trillion) 2006-2007: 80.2% growth Axis Bank March 20008: Structured 188 O/S Derivative transactions, where clients had MTM loss of $168m or Rs.674 crore. Details: 2 companies involved with Rs.72 Crore or $18mn, gone to court, Rajshree Sugars and Chemicals, Coimbatore
Banking sector (Contd...) PRIVATE PARTIES Last Q of F.Y. 2007 – 2008: Axis Bank, ICICI Bank, Yes Bank, HDFC Bank and Kotak Mahindra Bank Alleged mis–selling of exotic derivative instruments, leading to losses. Private Parties include: a. Karur–based Sabare International b. Chennai based Sundaram Multi Pap c. Ludhiana based Garg Arcylite d. Hyderabad based NCS Sugars.
HDFC bank (Euro / $) Himatsinghka, textile firm sued HDFC Bank Net Sales Rs.174.16 Crore MTM loss Rs.175 Crore (10.03.2008) MTM loss large: Large Exposure Euro moving against Dollar Longer tenure To fund, entered into another structure “Contingent Premium Paying Structure” – obligation to pay a premium if Euro touches a particular level of $ Here, paid Rs.4.53 crore each quarter Besides entering into Vanilla forward contracts, entered into foreign exchnage derivative contracts – adviced by HDFC
HDFC Bank vs hsl Measures to counter (for HDFC): Not advise clients to take such big exposure. Measures to counter (for HSL): a. Hedge its position using normal SWAPs or forward contracts using a hedge ratio of 4:7, to clear the losses
Icici bank (swiss franc / $) Swiss Franc & Japanese Yen – good cover for $ liabilities, trade strongly against $, ICICI persuaded clients to take position in Swiss Franc to cover losses from $, as Rupee registered biggest gain in 34 years. Client: Sundaram Multi Papers 2006 – 2007: Total Sales: Rs.84.81 Crores Net Profit: Rs. 4.44 Crore ICICI Bank asked Margin Rs.6 Crore to cover for losses. Sundaram no business in Switzerland Paid nothing to enter the contract (betting on Swiss Franc against $, Franc traded @ 1.17 to $)
Icici bank (swiss franc vs $) Franc more than 1.23 to dollar, sundaram would get $36,000 (within a month) If Franc below, Sundaram had to buy (Franc 1.095 to $, sundaram bought $6mn @ 1.23 Francs to $) Nov 20: Franc rose to 1.08 – concerns about US recession: 2nd Contract of potential profit of $22,000 turned to losses and Sundaram bought 1$7.5mn @ 1.23 ICICI could not see the movement Litigation meant ICICI needed to keep high amounts of contingent liabilities in b/s
Conclusion Hedging has a cost Wards off the state of uncertainty- brings one to a state where risk can be managed comfortably. Therefore, it’s prudent to go for hedging