Foreign Exchange Hedging Tools

FOREIGN CURRENCY HEDGING TOOLS
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Contents……...
Meaning of Hedging
Currency Hedging
Generic Hedging Decision Tree
Types of Currency Exposure
What is Exposure and Risk?
Hedging Tools
Examples of Hedging in Indian Companies
Case Study

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What is the meaning
of Hedging?
An important tool in the global
financial markets, hedging is used in
every asset class to mitigate losses.
This can be utilised by anyone,
whether it is an individual or
corporates, to overcome the negative
impact of price volatility.
For the corporates in which the
business activity is dependent on
import and export of commodities,
there is an automatic exposure to
foreign exchange and, hence, the
need for hedging is higher. In the
current context, since the world
markets are interlinked, they
eventually affect and impact the
movement of currencies.
Hedging, in any asset class, is
ultimately a strategy to decrease or
transfer risk in order to protect one's
portfolio or business from
uncertainty in prices. In case of
hedging in the foreign exchange
market, a participant who is entering
a trade with the intention of
protecting the existing position from
an unexpected currency move, is said
to have created a forex hedge.
The strategy to create a hedge
would depend on the following
parameters:
(a) risk component
(b) risk tolerance and
(c) to plan and execute the strategy.
Why the need for hedging ?
Hedging is a preventive strategy used by individual investors or companies
to protect their portfolio from adverse currency, interest rate, or price
movements and is aimed specifically at reducing any uncertainty in the
market. The hedge ratio is explained as the percentage of the position in an
asset that is hedged using derivatives. Some see hedgers as risk averse
individuals. However, we see hedgers as risk neutral individuals as they
choose their hedging strategy based on the expected value (return) of any given
strategy. To better justify ourview of hedgers being risk neutral individuals

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Currency or Forex
Hedging?
Currency movement hedge is used by
international companies or investors
that hold an international portfolio. A
currency movement hedge allows
hedgers to manage and minimize
their exposure to any adverse
exchange rate movement. Note that
it is only the currency movement
hedge that will be the focus of this
thesis.
International businesses are naturally
exposed to currency risk. With the
rapid integration of the global
economy, many efforts have been
directed to study those risks
associated with exchange rate.
Transaction risk and translation risk
are the two most commonly
discussed currency risks for
international businesses. Transaction
risk can be defined as the impact of
unexpected changes in the exchange
rate on the cash flow arising from all
contractual relationships. On the
other hand, translation risk refers to
the risks which arise from the
translation of the value of an asset
from a foreign currency to the
domestic currency.
Authors, such as Mannino and Milani
(1992), Hollein (2002), and
Homaifar(2004, p.217), also defined
translation risk as the change in book
value of assets and liabilities,
excluding stockholders’ equity as
residuals, due to changes in the
foreign exchange rate. International
companies that trade and receive
revenue in foreign currencies
would incur translation risk. The most
common cases of companies
experiencing translation risk are
when overseas subsidiaries translate
the subsidiaries’ balance sheet and
income statements into the
functional currency of the parent
companies for consolidation and
reporting purposes as required by
legislations. During this translation
process, movement in the exchange
rate can produce accounting gains or
losses that are posted to the
stockholders’ equity
Transaction risk and Translation risk
are the two most commonly
discussed currency risks for
international businesses strategy.

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We believe the
common view of
hedging can be
summarized as
follows
(1) Hedging is one of the three most
fundamental reasons for the
existence of the financial market,
alongside speculative and arbitrage
activities
(2) The hedging industry is evolving
just like the rest of the business
world. Infact, there is no definite set
of tools or technique that can define
hedging. Asthe world changes, new
hedging mechanisms are derived; and
as time passes, these mechanisms are
refined and evolve into something
new that can be better applied to the
contemporary commercial
marketplace
(3) Hedging is not a way of making
money, but to assist management in
better managing corporate revenue
through reducing the corporate
exposure to volatility in the foreign
currency markets
(4) When used prudently, hedging
can be effective insurance as well as a
value-enhancing exercise for
corporations. Effective hedging
programs have been proven to allow
corporations to minimize or transfer
their foreign currency exposure. The
diminished exposure to foreign
currency fluctuations allows more
stable and predictable cash-flows,
notably in terms of revenue. As a
result, firms are then capable of
making more comprehensive
financial plans, including more
reliable estimations on tax, income
after tax and dividends payable to
shareholders. It is believed that a
dividend payout is often of significant
appeal to long-term, current or
prospective shareholders
The ideal result for a hedge
would be to cause a “seesaw effect”
where one effect will cancel out
another. Because of this “seesaw
effect”, hedging not only protects
companies from any losses that may
occur due to an adverse market, but
also restricts companies
from any gains if the market goes in
favor of the companies. The three
main questions surrounding
hedging: when, what and how to
hedge are explained further

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Generic Hedging Decision Tree
When to Hedge?
Under
Currency
Risk
Exposure
When to Hedge?
Hedge
No
Hedge
Hedge Ratio
• 10%
• 50%
• 100%
OR
• Any ratio
between
0.1% - 99%
Fully
participating
market
movements
How to Hedge?
?
Financial Tools
1. Forward
2. SWAP
3. Money
Market
4. Futures
5. Options
6. Leveraged
Spot
Non-Financial
Tools
1. Leading
2. Lagging

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Types of Currency Exposure
Currency Exposure
Long-Term
Operating
Exposure
Strategic
Exposure
Short-Term
Accounting
(Translation
Exposure)
Cash Flow
Anticipated
Changes
Unanticipated
Changes
(Transactions
exposure)

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What is Exposure,
Risk – are they same?
Each firm is “exposed” to
unforeseen changes in a number
of variables in its environment.
These variables are called Risk
Factors. E.g. Exchange rate
fluctuation is a risk factor.
EXPOSURE:It is the measure of the
sensitivity of a firm’s performance
to fluctuations in the relevant risk
factor i.e. whether or not a certain
risk factor affects a firms
performance.
RISK:It is the measure of the
extent of variability of the
performance attributable to the
risk factor i.e. how much does a
risk factor affect a firms
performance.
Different types of Exposure-
• Transaction exposure
• Translation exposure
• Operating exposure
Hedging tools could be chosen depending on the type of exposure.
For example, between April 1992 and July 1995 the exchange rate between
rupee and US dollar was rock steady. For an Indian firm involved in exports
and imports from US, this meant that it had significant exposure to this
exchange rate (because the exchange rate could have affected its
performance) but it did not perceive significant risk because the exchange
rate was stable.

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Translation exposure, also called Accounting
Exposure or Balance Sheet exposure, arises because
financial statements of Foreign subsidiaries – which
are stated in foreign currency – must be restated in
the parent’s reporting currency for the firm to
prepare consolidated financial statements.
Translation exposure is the potential for an increase
or decrease in the parent’s net worth and reported
net income caused by a change in exchange rates
since the last translation.
The accounting process of translation, involves
converting these foreign subsidiaries financial
statements into home currency-denominated
statements. It is the exposure on assets and
liabilities appearing in the balance sheet but
which are not going to be liquidated in the
foreseeable future. It has no direct impact on
cash flows of a firm.
An Example An Indian Company with a U.k. subsidiary
Particular
March 31, 2012
(£1=Rs85)
March 31, 2013
(£1=Rs70)
Value in £ Translated value Value in £ Translated value
Real Estate £1,000,000 Rs 85,000,000 £950,000 Rs 66,500,000
Inventories £200,000 Rs 17,000,000 £250,000 Rs 17,500,000
Cash £150,000 Rs 12,750,000 £160,000 Rs 11,200,000

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Total £1,350,000 Rs 102,000,000 £1,360,000 Rs 95,200,000
Transaction Exposure: The risk, faced by companies
involved in international trade, that currency
exchange rates will change after the companies have
already entered into financial obligations. It stems
from the possibility of incurring exchange gains or
losses on transactions already entered into and
denominated in a foreign currency. Transaction
exposure is short term in nature.
It has a direct impact on cash flows of a firm.
An Example
Thus, exposure is the chance of either a loss or a gain
Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for €1,800,000 payment to be
made in 60 days. (S0 = $0.90/€)
The U.S. seller expects to exchange the €1,800,000 for $1,620,000 when payment is received.
Transaction exposure arises because of the risk that the U.S. seller will receive something other than
$1,620,000.
If the euro weakens to $0.8500/€, then Trident will receive $1,530,000
If the euro strengthens to $0.9600/€, then Trident will receive $1,728,000

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Operating exposure, also called economic
exposure, competitive exposure, and even
strategic exposure on occasion, measures any
change in the present value of a firm resulting
from changes in future operating cash flows
caused by an unexpected change in exchange
rates.
Measuring the operating exposure of a firm
requires forecasting and analyzing all the firm’s
future individual transaction exposures together
with the future exposures of all the firm’s
competitors and potential competitors worldwide.
Operating exposure is far more important for the
long-run health of a business than changes caused
by transaction or translation exposure.

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Hedging Tools………
Forwards: A forward is a made-to-
measure agreement between two
parties to buy/sell a specified amount
of a currency at a specified rate on a
particular date in the future. The
depreciation of the receivable
currency is hedged against by selling
a currency forward. If the risk is that
of a currency appreciation (if the firm
has to buy that currency in future say
for import), it can hedge by buying
the currency forward.
Futures: A futures contract is similar
to the forward contract but is more
liquid because it is traded in an
organized exchange i.e. the futures
market. Depreciation of a currency
can be hedged by selling futures and
appreciation can be hedged by
buying futures. Advantages of futures
are that there is a central market for
futures which eliminates the problem
of double coincidence. Futures
require a small initial outlay (a
proportion of the value of the future)
with which significant amounts of
money can be gained or lost
with the actual forwards price
fluctuations. This provides a sort of
leverage.
Example: if RIL wants to buy crude oil in US dollars six months hence, it can
enter into a forward contract to pay INR and buy USD and lock in a fixed
exchange rate for INR-USD to be paid after 6 months regardless of the actual
INR-Dollar rate at the time. In this example the downside is an appreciation of
Dollar which is protected by a fixed forward contract. The main advantage of a
forward is that it can be tailored to the specific needs of the firm and an exact
hedge can be obtained. On the downside, these contracts are not marketable,
they can’t be sold to another party when they are no longer required and are
binding.
Example: The previous example for a forward contract for RIL applies here also
just that RIL will have to go to a USD futures exchange to purchase standardised
dollar futures equal to the amount to be hedged as the risk is that of
appreciation of the dollar. As mentioned earlier, the tailorability of the futures
contract is limited i.e. only standard denominations of money can be bought
instead of the exact amounts that are bought in forward contracts

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Options: A currency Option is a
contract giving the right, not the
obligation, to buy or sell a specific
quantity of one foreign currency in
exchange for another at a fixed price;
called the Exercise Price or Strike
Price. The fixed nature of the exercise
price reduces the uncertainty of
exchange rate changes and limits the
losses of open currency positions.
Options are particularly
suited as a hedging tool for
contingent cash flows, as is the case
in bidding processes. Call Options are
used if the risk is an upward trend in
price (of the currency), while Put
Options are used if the risk is a
downward trend
Swaps: A swap is a foreign currency
contract whereby the buyer and
seller exchange equal initial principal
amounts of two different currencies
at the spot rate. The buyer and seller
exchange fixed or floating rate
interest payments in their respective
swapped currencies over the term of
the contract. At maturity, the
principal amount is effectively re-
swapped at a predetermined
exchange rate so that the parties end
up with their original currencies. The
advantages of swaps are that firms
with limited appetite for exchange
rate risk may move to a partially or
completely hedged position through
the mechanism of foreign currency
swaps, while leaving the underlying
borrowing intact. Apart from covering
the exchange rate risk, swaps also
allow firms to hedge the floating
interest rate risk.
Example of RIL which needs to purchase crude oil in USD in 6 months, if RIL
buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to
buy a specified amount of dollars at a fixed rate on a specified date, there are
two scenarios. If the exchange rate movement is favourable i.e the dollar
depreciates, then RIL can buy them at the spot rate as they have become
cheaper. In the other case, if the dollar appreciates compared to today’s spot
rate, RIL can exercise the option to purchase it at the agreed strike price. In
either case RIL benefits by paying the lower price to purchase the dollar

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v
Money Market: The money market
and forward market are identical
because interest rate parity holds. So
hedging in the money market is like
hedging in the forward market. A
money market hedge also includes a
contract and a source of funds to
fulfill the contract. Those hedgers
who use money market hedges
borrow in one currency and convert
the borrowing into another currency.
We have included a discussion on the
mechanism of hedging using the
money market in
Leveraged Spot Market: The
leveraged spot contract is
fundamentally the same as a spot
contract. The only difference
between the leveraged spot contract
and a spot contract is the leverage
ratio available in all leveraged spot
contracts. The leverage ratio can
range from twenty (1:20) to two
hundred (1:200), and is specified by
the trading financial institutions. This
leverage ratio is a powerful feature of
the leveraged spot contracts. Indeed,
if the leverage ratio is twenty (1:20),
this means that the leveraged spot
contract trader will have access to a
credit line twenty times larger than
his/her initial collateral. It is obvious
that this distinct feature of the
leveraged spot contracts will allow
traders to trade at a significantly
lower capital requirement when
compared to the spot market.
.
Example: Consider an export oriented company that has entered into a swap for
a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company
pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on
1st January & 1st July, till 5 years. Such a company would have earnings in
Dollars and can use the same to pay interest for this kind of borrowing (in
dollars rather than in Rupee) thus hedging its exposures
Example: Indeed, the mechanism of trading a leveraged spot contract involves
borrowing a certain amount of money from a country, say, Japan, for a specific
period at a specific interest rate, then converting the amount of Japanese yen
into another currency, say, the Australian dollar, at the existing spot rate and
investing the Australian dollar in the Australian money market at the Australian
interest rate, and finally converting the Australian dollar back to Japanese yen
to repay the Japanese yen borrowing.

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Examples of Hedging by Indian Companies
SUN PHARMA (as on 31st
march 2014)
Type of contract Currency Buy/sell Cross currency Amt (in millions) Nature of
exposure
Forward contract USD Sell Rs USD 240 Exporter of
generic
drugs.
Forward contract USD Sell NIS USD 41
Forward contract USD Sell CAD USD 65.3
Cross currency
swaps
NIS Buy USD USD 9.1
Interest rate swaps
(floating to fixed)
USD Sell USD USD 7.8

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MARUTI SUZUKI (AS ON 31ST
MARCH 2015)
Type of contract Currency/commodity Buy/sell Cross
currency
Amt (Rs in millions) Nature of
exposure
Forward contract
against imports
USD Buy Rs Nil Borrowings in
JPY. Also,
metals that are
imported are
hedged.
Forward contract
against imports
JPY Buy USD 7575
Forward contract
against imports
Euro Buy USD 882
Forward contract
against exports
USD Sell Rs 2279
Forward contract
against commodities
Platinum - - 305
Forward contract
against commodities
Palladium - - 221
Forward contract
against commodities
Lead - - 153

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Case Studies
HCL TECH CASE STUDY - 2008
This case study provides in depth understanding of the situation in which HCL
Tech suffered huge foreign exchange losses and the measures taken by the
company to overcome from it. In addition to this, the case study provides the
views of stock broking houses and analysts on the decisions taken by HCL Tech.
INTRODUCTION
HCL Tech, a leading global IT player, had a presence in 18 countries at 60 locations
all over the world. It was the fifth largest Indian IT player as of 2008 with a 3%
contribution in the IT-ITES sector. It provided a wide range of IT-related products
and services to mid- and large size enterprises all over the world with the help of
more than 50,000 employees...
FOREX STRATEGY FOLLOWED BY HClTECH
As a major part of HCL Tech's revenue was generated from outside India, the cash
flows of the company were influenced by currency movements. The company
therefore used derivative financial instruments like foreign currency forwards to
hedge its currency risk for a certain forecasted period...
FLUCTUATIONS IN FX MARKET
The Indian Rupee (INR) recorded its strongest mark against the US Dollar (USD) in
November 2007 at Rs. 39, having strengthened by around 11% from Rs. 44 per
dollar at the beginning of the year 2007. The strengthening of the Indian Rupee
was mainly due to the depreciation in the USD. The depreciation was mainly due
to the slowdown in the US economy, high spending on wars, and the negative
balance of payment in the US. In the same year, foreign capital investment in
India increased...
IMPACT OF FX FLUCTUATIONS ON HCL TECH
HCL Tech took the forward hedge covers for the next coming 7 to 10 quarters,
depending upon the earnings visibility and forex market. As the rupee

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appreciated from Rs. 44.27 per dollar in January 2007 to Rs. 39.45 per dollar in
November 2007, HCL Tech reported a huge forex gain as it had already covered its
revenues at around Rs. 44 per dollar...
STEPS TAKEN BY HCL TECH
As the company reported on a mark-to-market basis, the gains or losses occurring
from the forward hedge covers of future quarter revenues caused huge
fluctuations in its reported profits. This also created a mismatch between the
reported revenues and the forex losses/gains...
FUTURE OUTLOOK
With the cancellation of currency hedges, industry analysts opined that the
company's move toward unhedged currency forwards reflected its expectations
that the rupee would depreciate against the dollar and sustain at Rs. 47 to Rs. 50
in the short to medium term. But they wondered what the company’s position
would be if the rupee appreciated above Rs.47 against the dollar...

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WOCKHARDT - CASE STUDY – 2008
Life after debt
(This article appeared in The Economic Times, India Edition dated 17th August 2010)
Last year, a trusted lieutenant of Habil Khorakiwala dialled a Singapore number to
contact a gentleman named Ponty Singh. Mr Singh, a former banker with Morgan
Stanley and Citi, owns the financial services firm Tricolor Capital. The conversation
that followed was the first of its kind by an official of an Indian company.
Wockhardt, the company that Mr Khorakiwala founded in 1967, was sitting on a
mountain of losses — nearly 1,500 crore — after a series of cross-currency
derivative deals with banks backfired. These are complex transactions that the
pharma firm had done to get a better exchange rate — so that its export earnings
generate more when converted into rupees — and possibly convert a slice of its
expensive local loans into cheaper foreign currency credit with a lower interest
rate.
All that was possible with the magic of derivatives — a wonderworld that many
small Indian companies had stepped into and later burnt their fingers when
currency markets moved against them.
But Wockhardt was not a textile outfit in the backyard of Tirupur. It was a
closelytracked company with solid brands, research centres and manufacturing
facilities in half a dozen countries. But fortunes reversed between February 2008
and the first quarter of 2009. And one day, Wockhardt looked like a basket case.
Debts had ballooned from Rs 1,000 crore to Rs 3,500 crore, bankers were asking
for money, analysts downgraded the stock and deal-makers were snooping
around for a possible buyout. While there was good cash flow from Wockhardt’s
regular businesses, which were growing, the money wasn’t enough to meet the
payouts that kept mounting. Indian companies and bankers had never
experienced something like this. Corporate America is full of stories of derivative
hits, with stuff like the $157-million loss of Procter & Gamble in the 90s now a
part of B-school textbooks. In May 2009, Wockhardt’s loss on derivatives was
double of that, at $300 million.

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Ponty Singh’s job was to evaluate the deals, assess how fair these transactions
were and how valid were the claims made by highstreet lenders, which included
banks like Calyon, Barclays, Deutsche, JP Morgan, ABN Amro, HSBC, Citi,
StanChart, DBS of Singapore and BNP. Another firm Numerics was roped in to
analyse the data. The findings by Tricolor formed the contours of a defence that
Wockhardt had put up in multiple court feuds in India and abroad. Some of these
were complex transactions: for instance Wockhardt EU had cut deals with
offshore banks against guarantees from Wockhardt Ltd, the Indian parent.
The guarantee was invoked abroad while a winding up petition was moved in the
Bombay High Court. Besides derivatives, other liabilities that troubled the
company were: $110-million foreign currency convertible bonds, which were not
converted into equity as the stock never touched the price that was fixed —
something Wockhardt had not expected and was being forced to pay back — and,
a large foreign currency loan to fund overseas acquisition.
Strangely, the debt hurdle looks less formidable today. Wockhardt’s bankers and
other creditors have been left frustrated, and almost driven to a point where they
are willing to accept any settlement terms. The company has sorted out the dues
with some of the derivative banks and is talking to creditors like Calyon, Barclays
and QVT — the offshore fund that invested in the convertible bonds.
Under the settlement, the derivative banks will get only 25% of what they
claimed, while QVT is being offered a deal that’s significantly better (for
Wockhardt) than what the fund had earlier proposed. Chances are QVT will go for
it. Though Syndicate Bank, one of the FCCB investors, is pushing Wockhardt to
clear its dues before it finalises the deal with QVT, bankers think the company
may be close to ending its debt woes.
What helped? Mr Khorakiwala and his team of advisors were quick to spot that
derivative outstandings, like FCCBs, were similar to personal loans or credit card
dues. They were unsecured and there was no recourse for banks but to move
courts. There was also another element. It lay in the complexity of derivatives.
Wockhardt argued that banks had missold complex products, never spoke about
the downsides and the contracts were wagers or pure bets that violated the laws

20
of the land. The cases dragged on in courts whose introduction to derivatives has
been recent.
And, local lenders, who have been Wockhardt’s bankers for years, tossed a
lifeline: led by ICICI and SBI, domestic banks came together to rejig the loans and
gave a priority loan of 500 crore to pay back some of the foreign derivative banks.
The combined hit for banks would be 1,000 crore. Meanwhile, the company’s
promoters chipped in 70 crore as part of the deal. Till the derivative and some of
the other liabilities are fully settled — something that could take a good part of
the year — the company’s bottomline will continue to bleed.
A few months ago, Wockhardt’s deal to sell its nutrition business, which owns
brands like Farex and Protienx, to Abbott Labs fell through. `The lenders opposed
it’ was the official explanation but many felt that Wockhardt was fishing for a
better price as things looked up. As the tide turns, the company will again look for
a buyer. The Wockhardt story, which captures the nasty surprises of the currency
market, the vulnerability of bankers, and ruthless negotiating skills of a company
close to the brink, will possibly go down as a case study for students in corporate
finance.
These days Wockhardt stays away from hedging. It shuns even deals like simple
forward contracts. Maybe, it demonstrates the firm’s aversion to step into an
unpredictable foreign exchange market. Or, perhaps it reflects banks reluctance
to deal with a party that has given much grief. But the company seems to have
picked up a few lessons. Some of the officials, who dealt with the derivative
banks, have been sacked. And visitors to Mr Khorakiwala’s office are occasionally
given a photocopy of the book ‘Traders, Guns & Money — Knowns & Unknowns
in the Dazzling World of Derivatives’.

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Sources:
Annual Report of Sun Pharma
Annual Report of Maruti
Various News Articles
Foreign Exchange Hedging and Profit Making Strategy using Leveraged Spot Contracts
CHING HSUEH LIU
Victoria Graduate School of Business
Faculty of Business and Law
Corporate Hedging for Foreign Exchange Risk in India
Submitted by:
Anuradha Sivakumar and Runa Sarkar
Industrial and Management Engineering Department
Indian Institute of Technology, Kanpur
SMBA Batch 34,
Prashant M
Shital P
Karunakar N
Rinki H
Shahzad S
Theresa T

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