Project report - Hedging strategies for garment exporter
PROJECT REPORTHEDGING STRATEGIES FOR GARMENT EXPORTERS SUBMITTED TO: PROFESSOR HARKIRAT SINGH SUBMITTED BY: BKC-MUMBAI GROUP Waris S Imam – Roll No. 47 Tanmay Shah – Roll No. 40 Nilesh Mashru – Roll No. 28 Kedar Marathe – Roll No. 21 Joshil A K – Roll No. 18 Anurag Nagaria – Roll No. 12 Anil Agrawal – Roll No. 09
INDEX1. OVERVIEW OF THE INDIAN TEXTILE INDUSTRY2. CURRENCY FLUCTUATIONS & RISKS ASSOCIATED3. RISK MANAGEMENT ALTERNATIVES4. CASE OF THE GARMENT EXPORTER5. HEDGING STRATEGIES – PROCESS, EVALUATION & IMPLEMENTATION6. IMPACT OF HEDGING STRATEGIES ON HIS BUSINESS7. CONCLUSION AND SUGGESTIONS
1] OVERVIEW OF THE INDIAN TEXTILE INDUSTRY1.1 Background:Indian textile industry is one of the leading textile industries in the world. The industry has gonethrough a robust transformation post the liberalization of the economy in 1991 which gave themuch needed thrust to this industry. Indian textile industry largely depends on themanufacturing and exports. Textile exports contribute a major portion of India’s exports.Some figures: Earns 27% to India’s total foreign exchange Contributes 14% to India’s total industrial production Contributes 3% to India’s GDP Largest employment generator for India – estimated to be approximately 35 million peopleSegments of Indian Textile Industry: Cotton Textiles Silk Textiles Woolen Textiles Readymade Garments Hand-crafted Textiles Jute & Coir
1.2 Current Scenario:1.3 Technical Textile Segment:This is a very critical contributor to the India textile industry. The working committee for the11th 5 year plan has estimated it’s market size to be US$ 10.6 Billion in 2011-12 without anyregulatory framework and US$ 15.16 Billion with regulatory framework. The scheme for growth& development of technical textiles aims to promote indigenous manufacture of technicaltextile to leverage global opportunities and cater to the domestic demand.Further the govt is set to launch US$ 44.21 Million mission for promotion of technical textileswhile the finance ministry has cleared up setting up of 4 new research centres for the industry,which include products like mosquito and fishing nets, shoe laces and medical gloves. Theglobal technical industry is estimated at US$ 127 billion and the same in India is pegged at US$11 Billion.
1.4 Major Players in the Indian textile Industry: Welspun India Ltd Vardhman Group Alok Industries Ltd Raymond Ltd Arvind Mills Ltd Bombay Dyeing & Manufacturing Company Ltd Garden Silk Mills Ltd Mafatlal Industries Ltd Aditya Birla Nuvo ITC Lifestyle Reliance Industries Ltd1.5 Government Initiatives & Regulatory Framework:The GOI has implemented various export promotion policies for the textile Industry in the unionbudget 2011-12 and the foreign trade policy 2009-14. This also includes various incentivesunder focus market scheme and focus product schemes.Below is a gist of various schemes by the GOI for promotion of this industry: FDI: 100% FDI allowed in textiles under the automatic route thereby promoting the development of the industry and capital inflow in the country. Welfare Schemes: 161.10 million weavers and ancillary workers offered health insurance & life insurance under the handloom weaver’s comprehensive welfare scheme and 7.33 lacs artisans provided health coverage under the Rajiv Gandhi Shilpi Swasthya Bima Yojna E-marketing: The central cottage industries corporation of India (CCIC) and the handicrafts &handlooms export council of India (HHEC) have developed various emarketing platforms to simplify marketing issues. Skill development: The integrated skill development scheme offers training assistance to the workers for enhancement of skills. All 3 sub sectors of the textile industry viz: Textiles & Apparels, Handicrafts and Jute & Sericulture. Credit linkages: As per the credit guarantee program, over 25000 artisan credit cards have been supplied to various artisans and 16.50 million additional applications for issuing up credit cards are under consideration. Financial package for waiver of overdues: The GOI has announced a package of US $ 604.56 Million to waive off overdue loans in the handloom sector. Other regulations: Government has also levied regulations to prohibit child labour. Also government has brought in regulations for better wages and compensation to workers who develop respiratory diseases due to paint pigments used for dying of the fabrics and yarns. Textile Parks: The GOI has approved 40 new textile parks to be set up and this would be executed over a period of 36 months. Thereby leveraging further employment in this industry. Recent developments: Along with the increasing export figures in the Indian apparel sector in the country, Bangladesh is planning to set up two special economic zones for attracting Indian companies in view of the duty free trade between the two countries. The 2 SEZs are
expected to come up on 100-acres plot of land in Kishoreganj & Chattak in Bangladesh. Italian luxury major Canali has entered into a 51:49 joint venture with Genesis luxury fashion which currently has distribution rights of Canali-branded products in India. The company will now sell Canali branded products in India exclusively.1.6 Policy & regulatory Framework:The ministry of textiles which is responsible for policy formulation, planning, development,export promotion and trade regulation in the textile sector. Various policies viz National TextilePolicy 2000, Technology mission on Cotton (TMC) 2000, National Jute policy 2005, Jutetechnology Mission (JTM) 2006, Mega cluster schemes laid its emphasis and focus on: Technological upgrades Enhancement of productivity Quality consciousness & Strengthening of raw material base Product diversification, Increase in exports and innovative marketing strategies Financing arrangements Increasing employment opportunities & Integrated human resource development1.7 Investments & Opportunities:Investments: The industry attracted FDI worth US $ 934.04 million between April 2000 andJanuary 2011. FDI in the textile industry stood at USD 129 Million in FY11.Opportunities: The potential size of the Indian textiles industry is expected to reach US $ 220billion by 2020.Private sector participation in Silk production, demand for technical textiles, growth in the retailsector, establishment of Centres of excellence for research & technical training etc haveboosted the opportunities in the textile industry. Typical Value Chain of the textile Industry
2] CURRENCY FLUCTUATIONS & RISKS ASSOCIATED2.1 Risk In GeneralRisk is defined as the potential that a chosen action or activity will lead to a loss or anundesirable outcome. To simplify, it is a potential loss or less than expected returns. It is thechance that an investment’s actual return will be different than expected or required. Differentversions of risk are usually measured calculating the standard deviation of the historical returnsor average returns of a specific investment. A high standard deviation indicates a high degree ofrisk.A fundamental idea in finance is the relationship between risk and return. The greater theamount of risk that an investor is willing to take on, the greater the potential return. The reasonfor this is that investors need to be compensated for taking on additional risk.This is why increasing number of companies are allocating large amount of time and money indeveloping risk management strategies to help manage risks associated with business andinvestment dealings.Risk management is a process of identification, analysis and either acceptance or mitigation ofuncertainty associated in decision making. Simply put, risk management is basically a 2 stepprocess – determination of risks associated with an investment or a decision and handling thoserisks in a way best suited to the investment or decision objectives.However, a broad framework with risk management is as given below:Risk and return go hand in hand. While the level of risk increases with increasing expectationsin the returns required, there are certain risks which are associated with current level ofbusiness and the concern is not necessarily about the increase in the return or a potential lossbut to safeguard or be sure of the current business situation.One such risk associated with the international business is the risk associated with the currencyfluctuations. Such risks usually affect the business in various ways and impact the costs/revenue/ expenditure and eventually performance of any company/ organization involved withinternational business.
2.2 Currency Fluctuations – Rupee vs USD/ Euro Source: Midmarket rates as per Xe.comAbove graphs are clear indications of the currency fluctuations in past 12 months which wouldhave its impact not only on the country’s BOP and trade performance but also oncompetitiveness and profitability of the firms/ companies involved in international business.USA and Europe being the major export markets for the Indian textile industry and the industryitself being a major contributor to the country’s exports, there is growing significance forcurrency risk management in this industry. While large size exporting companies havededicated risk management team, small exporters also have initiated the same to mitigate therisks associated with currency fluctuations.
2.3 Risks associated with Currency FluctuationsAlthough exchange rates cannot be forecasted with perfect accuracy, firms can at leastmeasure their exposure to exchange rate fluctuations. Technically speaking, there are 3 kinds ofrisks associated with currency fluctuations which can affect a firm’s value: Translation Exposure Transaction Exposure Operational Exposure Moment in time when exchange rate changes Translation Exposure Operating Exposure Changes in reported owner’s equity Changes in expected future cash in consolidated financial flows arising from an unexpected statements caused by a change in change in exchange rates exchange rates Transaction Exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time weeeExample:A Taiwanese company has the following USD exposures: 1. Owns a factory in Texas worth US$5 million. 2. Agreement to buy goods worth US$2 million. 3. Biggest competitor is a US company.What happens if the NT dollar appreciates? 1. NT$ value of US factory goes down (translation exposure). 2. NT$ cost of buying goods goes down (transaction exposure). 3. Global competitiveness of Taiwanese company decreases (operating exposure).
Translation Exposure: The exposure of an MNC’s consolidated financial statements to exchangerate fluctuations is known as translation exposure. In particular, subsidiary earnings translatedinto the reporting currency on the consolidated income statement are subject to changingexchange rates.From a cash flow perspective: The translation of financial statements for consolidated reportingpurposes does not by itself affect an MNC’s cash flows.However, a weak spot rate today may result in a weak exchange rate forecast (and hence aweak expected cash flow) for the point in the future when subsidiary earnings are to beremitted.From a stock price perspective: Since an MNC’s translation exposure affects its consolidatedearnings and many investors tend to use earnings when valuing firms, the MNC’s valuation maybe affected.An MNC’s degree of translation exposure is dependent on: The proportion of its business conducted by foreign subsidiaries, The locations of its foreign subsidiaries, and The accounting methods that it uses.Transaction exposure: The degree to which the value of future cash transactions can beaffected by exchange rate fluctuations is referred to as transaction exposure. Transactionexposure measures changes in the value of outstanding financial obligations incurred prior to achange in exchange rates but not due to be settled until after the exchange rates change. Thus,this type of exposure deals with changes in cash flows that result from existing contractualobligations.Transaction exposure arises from: Purchasing or selling on credit goods or services whose prices are stated in foreign currencies. Borrowing or lending funds when repayment is to be made in a foreign currency. Being a party to an unperformed foreign exchange forward contract. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.Transaction exposure is usually measured by estimating the net cash inflows or outflows ineach currency, and then the potential impact of the exposure to those currencies. Variousmethods like the standard deviation, correlation coefficients or the value-at-risk methods areused for assessing the transaction exposure.Operational Exposure: Operating exposure, also called economic exposure, competitiveexposure, and even strategic exposure on occasion, measures any change in the present valueof a firm resulting from changes in future operating cash flows caused by an unexpected changein exchange rates.Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’sfuture individual transaction exposures together with the future exposures of all the firm’scompetitors and potential competitors worldwide. Operating exposure is far more importantfor the long-run health of a business than changes caused by transaction or accountingexposure. Operating exposure is inevitably subjective, because it depends on estimates offuture cash flow changes over an arbitrary time horizon. Planning for operating exposure is a
total management responsibility because it depends on the interaction of strategies in finance,marketing, purchasing, and production.An expected change in foreign exchange rates is not included in the definition of operatingexposure, because both management and investors should have factored this information intotheir evaluation of anticipated operating results and market value.From an investor’s perspective, if the foreign exchange market is efficient, information aboutexpected changes in exchange rates should be reflected in a firm’s market value.Only unexpected changes in exchange rates, or an inefficient foreign exchange market, shouldcause market value to change.Operating exposure is usually measured using audit/ scenarios analysis or statistical approachand is managed through various means like pass through the costs to customers, use ofmarketing strategies and use of production management. Financial hedging techniques mayalso be used.Day to day currency risk management is mostly related to the transaction exposure or riskinvolved on account of currency fluctuation.An effective tool of currency risk management to mitigate/ manage the transaction exposure isHEDGING.
3] RISK MANAGEMENT ALTERNATIVES – HEDGING3.1 Risk managementThere are various kinds of risks which a company has to encounter. We must remember thatforeign currency risk management is only a small part of the company’s overall riskmanagement process.Below figure illustrates various risks as a part of a corporate risk management process:Risk management has to be taken seriously and a modern risk management program issustained over a period of time with these objectives: Raising the awareness level of key risks in the business (risk exposure reporting) Proactively mitigating significant risks so as not to exceed senior management’s defined worst case (risk tolerance level) Incorporating risk management into capital allocation decisions (risk-adjusted returns) Strong controls and meaningful reporting to senior management (governance) Hedging should stabilize earnings and modify the risk profile of a company.Given below figures to illustrate the above:
Objectives Of Risk Management Hedging to stabilize cash flowsThe major aim of currency risk management via Hedging tools is to determine the appropriatemismatch or imbalance between maturing foreign assets and liabilities given certain basicinformation such as current & expected exchange rates, interest rates (both locally & abroad)and the risk return profile acceptable to a company’s management.
3.2 HedgingHedging is the taking of a position, either acquiring a cash flow or an asset or a contract(including a forward contract) that will rise (fall) in value to offset a fall (rise) in value of anexisting position.Hedging, therefore, protects the owner of the existing asset from loss (but it also eliminates anygain resulting from changes in exchange rates on the value of the exposure).Hedging is an effective tool for currency risk management and helps reduce the variability ofexpected cash flows about the mean of the distribution. This reduction of distribution varianceis a reduction of risk.Whether this reduction of variability in cash flows then sufficient reason for currency riskmanagement is a continuing debate in financial management and corporate finance and thereare several schools of thought to the same.Opponents of currency hedging commonly make the following arguments: Stockholders are much more capable of diversifying currency risk than the management of the firm. Currency risk management does not add value to the firm and it incurs costs. Hedging might benefit corporate management more than shareholders.Proponents of currency hedging cite: Reduction in risk in future cash flows improves the planning capability of the firm. Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress). Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Individuals and corporations do not have same access to hedging instruments or same cost.
Hedging of currency in itself is a process and undergoes a step by step approach in its successfulimplementation. A typical hedging process can be illustrated in the figure below.As mentioned earlier, day to day currency risk management is mostly related to the transactionexposure or risk involved on account of currency fluctuation.Transaction exposure can be managed by contractual, operating and financial hedges: Contractual Hedges include - Forward, Future, Options and Money Market hedges Operating and Financial Hedges include - Risk-Sharing Agreements, Leads and Lags in Payment Terms, Swaps and Other StrategiesContractual hedges:Forward contracts: A forward contract is an agreement between a firm and a commercial bankto exchange a specified amount of a currency at a specified exchange rate (called the forwardrate) on a specified date in the future.There are two types of forward contracts: Deliverable and non-deliverable forwards (NDF). Aderivable forward will be exchanged into the spot currency at the expiry of the forward. An NDFis handy when you need to hedge currency exposures from countries that have foreignexchange control where access to the local forward markets are restricted to domesticcompanies only. A NDF, unlike the deliverable contracts, only settles the difference betweenthe onshore official fixing and the NDF rates at contract maturity date. Customer either pays tothe Bank or receives from the Bank the difference depending on the onshore official fixing at
contract maturity. The customer could then buy/sell the same currency in the onshore marketto fulfill the physical currency requirement. Effectively, the customer is buying/selling theonshore currency at the offshore NDF contract rate.Future contracts: Currency futures contracts specify a standard volume of a particular currencyto be exchanged on a specific settlement date.They are used by MNCs to hedge their currency positions, and by speculators who hope tocapitalize on their expectations of exchange rate movements.The contracts can be traded by firms or individuals through brokers on the trading floor of anexchange (e.g. Chicago Mercantile Exchange), automated trading systems (e.g. GLOBEX), or theover-the-counter market.Brokers who fulfill orders to buy or sell futures contracts typically charge a commission.Enforced by potential arbitrage activities, the prices of currency futures are closely related totheir corresponding forward rates and spot rates.Currency futures contracts are guaranteed by the exchange clearinghouse, which in turnminimizes its own credit risk by imposing margin requirements on those market participantswho take a position.MNCs may purchase currency futures to hedge their foreign currency payables, or sell currencyfutures to hedge their receivables.Currency Options: Currency options provide the right to purchase or sell currencies at specifiedprices. They are classified as calls or puts. Standardized options are traded on exchangesthrough brokers. Customized options offered by brokerage firms and commercial banks aretraded in the over-the-counter market.A currency call option grants the holder the right to buy a specific currency at a specific price(called the exercise or strike price) within a specific period of time.A call option is in the money if exchange rate > strike price, at the money if exchange rate = strike price, out of the money if exchange rate < strike price.Firms may purchase currency call options to hedge payables, project bidding, or target bidding.A currency put option grants the holder the right to sell a specific currency at a specific price(the strike price) within a specific period of time.A put option is in the money if exchange rate < strike price, at the money if exchange rate = strike price, out of the money if exchange rate > strike price.Options are handy to Hedge against adverse exchange rates movement but you do not want to miss the potential gain if the future currency movement is in your favor. Have the right to deal but not the obligation to deal. Options are combined into structures that give specific payoff profiles and exposures.
Contingency Graphs for Currency Options For Buyer of £ Put Option For Seller of £ Put Option Strike price = $1.50 Strike price = $1.50 Premium = $ .03 Premium = $ .03 Net Profit Net Profit per Unit per Unit +$.04 +$.04 Future +$.02 Spot +$.02 Rate 0 0 $1.46 $1.50 $1.54 $1.46 $1.50 $1.54 – $.02 – $.02 Future Spot – $.04 – $.04 RateMoney Market hedge: This is taking a money market position to hedge future receivables/payables. This usually is done in following steps: borrow foreign currency to be received convert to domestic currency invest for future useOperational hedges: Risk shifting & risk sharing Leading & Lagging Leading (accelerate timing of depreciating currency) Lagging (delay timing of appreciating currency) Exposure Netting Cross-Hedging Currency Diversification Use of marketing strategies Use of product management Transferring the risk to the buyers
4] CASE OF THE GARMENT EXPORT – M/S MAHALAXMI TEXTILES (INDIA)About the company: Mahalaxmi Textiles is a textile manufacturer established in 1985 &exporter based out of Worli, Mumbai. The company is into the export of all kinds of garmentsmajorly to USA and Europe markets and has a turnover of INR 100 crores.Their vision: To become world leaders in innovation & consolidation with a potential toproduce and market quality oriented customer products.Their mission: To endure our brands with integrity and solidity by consistently manufacturing &supplying our branded consumer products through well organized business channel across theglobe.Core products: Men’s & Women’s fashion wearCore competencies: Developing new items as per specifications of overseas buyers Use of latest technology and manufacturing techniques Strong focus on quality and 20 years of experience in exports market OEM suppliers to international brandsThis company has been into exports for over 20 years and their major markets have been USAand Europe. Their typical sales include the merchandise meant for fashion industry and thevalue chain cycle time from production to consumption is approximately 8 to 12 months. Hencein June 2012 they would manufacture merchandise meant for the expected fashion trend &demand for Winter 2013. An illustrative interpretation of the cycle time in the typical valuechain shared earlier could be as below:8 to 12months cycle
5] HEDGING STRATEGIES – PROCESS, EVALUATION & IMPLEMENTATION5.1 Current Hedging strategyMahalaxmi group have been into the exports business for the past 20 years and are workingwith their bankers (Citibank) for as many years. This has enabled them to enjoy high bargainingpower over their bankers with respect to interest rates/ exchange rates and other services.The company follows a typical 4 step hedging process as illustrated below: Identifying exposures: With the growing currency fluctuations in US dollars and Euro, and the company being 100% export oriented, the complete business revenue of the company is exposed to currency fluctuations risk. While the rupee has been stable against Euro, it has been volatile against the US dollar although recent trends have seen rupee depreciating against the same. Formulate hedging strategy: Mahalaxmi group works on a cost plus model and all its procurement and manufacturing costs are in INR. At the time of executing a contract in foreign currency i.e. an export, the costs in INR are converted to the denomination of foreign currency to arrive at expected costs of that contract in foreign currency and includes finance cost for 6 months considering the payment cycle. Margin is then added over this cost in foreign currency to arrive at selling price. To cover the risks hence Mahalaxmi group signs a forward contract with their bank and the future rate available to them is Rs. 1.20 higher than the spot rate on the date of executing such a contract for a period of 12 months. Hence if the spot rate is Rs. 53 against 1 US $, the forward rate would be Rs. 54.20 thereby improving the price realization of the exporter at the time of maturity. Execute hedging strategy: Mahalaxmi group regularly signs forward contracts with their bankers for a period of 12 months.
Monitor performance & adjust: Mahalaxmi group regularly keeps pace with overseas market. However since they use forward contracts only to hedge against the currency risks, there is little need for adjustments in the hedging strategies.5.2 Impact of hedging strategies on businessMahalaxmi group uses hedging strategies with an objective of risk managing and not with theprofit objective. A forward contract thus impacts their business as per the following illustration: Forward USD/INR as on Fx P/L for unhedged Fx P/L for hedged Contract delivery date Exporter exporter 1$ = Rs 53.00 1 $ = Rs 56.00 + Rs 3.00 Nil 1 $ = Rs 50.00 - (Rs 3.00) NilAs seen above, a hedged exporter will not earn any profit or incur any loss on account of a forexfluctuation. However, there could be gain (on account of a forward contract) in the pricerealization since the company follows a cost plus model with current INR costs as the base costto arrive at selling price for a particular contract. This is however a notional gain. Considering an export order for 1000 shirts @ USD 10 each and spot rate assumed at 53. Payment terms are 90 days Particulars US $ INR Qty 100 100 Selling price per piece $10 Total selling price $1,000 (a) Cost price per piece 424 Total cost price 42,400 (b) Total cost price $ $800 (c = b/53) Expected gross margin $ $200 (d = a-c) Keeping the cost price constant at INR 42400, and selling price at 54.20 on date of maturity Price realization in INR 54,200 (e = a * 54.2) Costs in INR (being constant) 42,400 (b) Actual Gross Margin in INR 11,800 (f = e-b) Actual Gross Margin $ $218 (g = f/54.2) Change in gross margin $ $18 (h = g-d) Change in gross margin % 8.9% (I = h/d%)
6] CONCLUSIONS & SUGGESTIONS6.1 Conclusions: A forward Contract booked by an Exporter seeks to protect his profitabilityfrom his business operations (Export of Shirts in the present example)As long as the Forward Contract is not cancelled, and the contracted export takes place as perthe agreed timeline, the Exporter does not make any gains/losses on account of thefluctuations in the foreign currency versus INR (if exports invoiced in foreign currency)If a Forward Contract (Exports) is cancelled, there could be a gain for the Exporter, if the foreigncurrency (vs INR) price depreciates as on date of cancellation as compared to the spot rate ondate of booking the contract.If a Forward Contract (Exports) is cancelled, there could a loss to the Exporter, if the foreigncurrency (vs INR) price appreciates as on date of cancellation as compared to the spot rate ondate of booking the contract.
6.2 Suggestions – Final word of advice: 1. Financial hedging: In the light of the current trend in currency fluctuations, the exporter can use put option in combination with forward contracts to increase profitability in the event that rupee depreciates beyond the forward contract rate of 1.20 premium over spot rate (as per their current contract with the bankers). However if rupee appreciates then the exporter could incur loss arising out of insufficient cover under a forward contract (as partial amounts will be hedged using a put option). 2. Dealing with bankers: Due to Mahalaxmi’s long relationship with the Citibank on one hand its stands benefitted but at the same time risks complacency an thereby risk of getting exploited by Citibank. So before Mahalaxmi hedges its funds it is advisable that they survey the market at least intermittently if not regularly. 3. Money market hedge: The exporter may also get into money market hedge and borrow foreign currency to be received, convert to domestic currency and invest for future use. This would however invite risks in case if rupee appreciates. 4. Operation hedging: Considering the current trend of fluctuations and steep appreciation of rupee against US dollar (relatively higher compared to its valuation against EURO), the company can get into risk shifting and increase proportion of exports to USA compared to Europe. Also risks related to eurozone should support this move if adequate business is available in US markets and if the company has a competitive advantage.It is however imperative for Mahalaxmi textiles to stay updated with the fluctuation trends,market exposure and internal factors to implement an overall risk management process.