Description
This is a presentation describes various sources of currency risks and ways to mitigate it.
CORPORATE CURRENCY RISK – AN OVERVIEW
Text Book Chapters
Rajwade : Chapter 14 , 15, 17
Apte : 3, 12, 13 Sathe : 8 , 9
INDIAN CORPORATES
Sources of currency risk :
? ?
?
Exports Imports Financials
? Borrowings ? Investments
?
Competition
CORPORATE PERSPECTIVE
Even in this technology dominated scenario, banks would still need to keep abreast of the requirements & expectations of the biggest consumer class of their products & services viz. corporates
The reference to corporates would have to be restrictive
?
Small and sub-SME segment corporates may no longer be relevant from a risk angle as product & service deliveries get standardized. This class may still be important from a revenue angle.
CORPORATE CURRENCY RISK
Since the advent of the floating exchange rates, any time that a transaction — whether that transaction is in goods, services, people, capital, or technology — has crossed borders, it has been subject to the influence of changes in exchange rates. The basic problem posed by exchange rates on the cross-border firm is that money across borders has no fixed value. Consequently, neither does a transaction undertaken across borders. Risk posed by exchange rate changes to the cross-border firm is commonly referred to as currency risk
RISK & EXPOSURE
Core Business Risks and Macroeconomic Environmental Risks Risk Factors
? ? ? ?
Currency rates Inflation Interest Rates Commodity Prices
Firms are ? exposed ? to unanticipated changes in risk factors
RISK & EXPOSURE
Exposure is a measure of sensitivity of the value of a financial item ( asset, liability or cash flow ) to unanticipated changes in relevant risk factors Magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor An example : USD/INR rate in 1993 –95
An exposure
An exposure is defined as a contracted or a forecast future cash flow, a liability or an asset denominated in foreign currency which either for revenue account or balance sheet purpose will have to be converted or translated into another currency at a rate which is yet to be determined.
Exposures will therefore include
Foreign currency denominated items on the balance sheet actual, physical purchases and sales of goods and services which have been invoiced in foreign currency but are yet to be settled contracted purchases and sales such as long-term contracts to purchase capital equipments denominated in foreign currency uncontracted foreign currency denominated receipts and payments which will materialize if forecasted manufacturing activity is realized investments in subsidiaries abroad guarantees issued by the Group companies denominated in foreign currencies
TYPES OF EXPOSURES
A cross-border firm is affected by exchange rate changes in three different ways.
Transaction Exposures Translation Exposures Economic Exposures
TRANSACTION EXPOSURE
A transaction exposure arises whenever the firm commits (or is contractually obligated) to make or receive a payment at a future date denominated in a foreign currency. Transaction exposures can therefore arise from
?
?
operating and free cash flows, e.g., accounts receivable and payable arising from the conduct of business; commitments to buy or lease capital equipment or financing cash flows, e.g., debt or equity service obligations arising from the funding of the firm’s business.
TRANSLATION EXPOSURE
A cross-border firm must periodically remeasure all of its global operations into a single currency for reporting purposes. This requires that the balance sheets and income statements of all affiliate operations worldwide be translated and consolidated into the currency of the parent company. Imbalances resulting from translation represent a potential change in the firm’s reported consolidated income, reported capital base, or both.
ECONOMIC EXPOSURE
A firm’s present value—firm value—will change as the value of expected future cash flows (and costs of capital) changes as a result of unexpected exchange rate changes. More precisely, a firm is said to have economic exposure to exchange rates when unanticipated real exchange rate changes have a non-zero effect on its expected future cash flows. People also sometimes use the terms operating exposure, real exposure, and competitive exposure as synonyms for such economic exposure.
PASS-THROUGH EFFECT
Exchange Rate pass-through is defined as a firm’s ability to pass on the impact of exchange rate changes to its customers A firm having a pass-through of 1 is able to pass on to its customers the full impact arising out of exchange rate changes While a firm with a zero pass-through is unable to pass on such changes
CURRENCY RISK MANAGEMENT
Successful management of currency risk requires a well-designed and wellimplemented risk management program comprising :
?
Perception Measurement Strategy Implementation
?
?
?
CURRENCY RISK – CASES
Following slides contain caselets highlighting certain peculiar risks faced by various firms when there are changes in currency rates Objective is to identify and appreciate such risks and to portray a very broad risk profile
CASE 1
COMPANY IS INVOLVED IN MANUFACTURING OF MACHINE PARTS RM COSTS ARE 75 % OF PRODUCTION COST IMPORTED MATERIAL ACCOUNTS FOR 80% OF RM CONSUMED MORE THAN 90% OF SALES ARE TO GOVT. DEPTS. AGAINST TENDERS
Transaction Exposure
CASE 2
COMPANY IS INVOLVED IN DISTRIBUTING IMPORTED ITEMS CRITICAL FOR HEART OPERATIONS THERE IS NO DOMESTIC PRODUCER BILLING IS DONE BASED ON ACTUAL LANDED COST PLUS AN AGREED MARGIN
CASE 3 :
COMPANY IS INVOLVED IN IMPORTING RAW DIAMONDS, POLISHING AND EXPORTING THEM ALL INVOICING IS DONE IN USD IMPORT PRICES ARE DECIDED DURING AUCTIONS IN BELGIUM EXPORTS GO TO CUSTOMERS WHERE PRICES ARE INDIVIDUALLY NEGOTIATED
No exposure
CASE 4 :
COMPANY WISHES TO SUBMIT A TENDER TO ONGC IMPORTED RM INVOICED IN USD COMPRISES 60 % OF THE CoP RESULT OF THE TENDER WOULD BE KNOWN AFTER 8 WEEKS
Contingent Exposure
CASE 5 :
COMPANY IS INVOLVED IN PROCESSING & IS 100 % EOU IMPORTS RM FROM EUROPE INVOICED IN EURO PROCESSING IS DONE IN FACTORIES IN INDIA SALES ARE ALL EXPORTS TO US INVOICED IN US Euro/Dollar exchange rate impact If dollar appreciates then favorable
CASE 6 :
COMPANY HAS NO IMPORTS , EXPORTS OR FOREIGN CURRENCY LIABILITIES COMPANY HAS ONE MAJOR COMPETITOR THE COMPETITOR ALSO HAS NO IMPORTS OR EXPORTS, BUT HAS FINANCED ITS FUND REQUIREMENTS THROUGH A FOREIGN CURRENCY LOAN IN USD.
CASE 7
COMPANY IS AN EXPORTER OF GARMENTS CUSTOMERS ARE IN US & EUROPE FACES COMPETITION FROM CHINESE EXPORTERS INFLATION IN INDIA IS 10 % AND THAT IN CHINA IS 5 % IN THE LAST YEAR RUPEE HAS DEPRECIATED AGAINST US DOLLAR BUT APPRECIATED AGAINST EURO CHINESE YUAN HAS STRENGTHENED AGAINST US DOLLAR
CASE 8
COMPANY IS A LEADING EXPORTER OF ENGINEERING GOODS EXPORTS ARE INVOICED IN USD HAS A SIZEABLE ORDER BOOK TO BE EXECUTED OVER NEXT 12 TO 18 MONTHS PERCEIVES THAT RUPEE MAY CONTINUE TO APPRECIATE AGAINST USD ENJOYS WORKING CAPITAL AND TERM FACILITIES FROM BANKS IN INDIA IN INDIAN RUPEES
CASE 9
WHAT IF THE COMPANY IN EARLIER CASE IS A ZERO DEBT COMPANY !
EXPOSURE MANAGEMENT
A transaction exposure of the firm is a singular event, an individual foreign currencydenominated cash flow commitment which exposes the firm to a loss or gain upon settlement of the outstanding obligation.
Examples
?
?
?
Indian exporter Buyer’s credit by Indian importers Short term FCNR(B) loan funding
EXPOSURE MANAGEMENT
Translation exposure arises because financial statements of foreign affiliates must be restated in the parent’s currency in order to consolidate financial statements.
Eastman-Kodak reckoned that its pre-tax earnings were depressed by $ 3.5 bln between 1980 and 1985 because of rising dollar. The dollar’s subsequent fall revived its fortunes by adding 60 cents a share in 1986, but its market share abroad took some more time to recover. American pharma multinationals such as Merck have found that during periods of strong dollar, their cash flows denominated in dollars tend to shrink while bulk of their R & D expenditure being denominated in dollars get significantly impacted affecting long-term competitiveness.
HEDGING BASICS
Peter Drucker once noted that, “Not to hedge is to speculate. Exchange rates are a cost of production that financial executives must manage.” An exchange rate hedge is an asset or position whose value changes (?H) in the opposite direction to that of an exposure (?X) as a result of a change in the exchange rate. A perfect hedge would be one whose value changes in an equal and opposite direction, resulting in a net change of zero in the value of the combined position: ?V = ?X + ?H
HEDGING BASICS
Hedging protects the owner of the existing asset from loss. It is, however, important to note that while a hedge protects the firm against an exchange rate loss (relative to being unhedged), it can also eliminate any gains from an exchange rate change that is favorable. Hedging reduces variance in future cash flows thereby 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 the minimum required to make debt-service payments. Hedging can therefore reduce the likelihood of financial distress.
HEDGING BASICS
Exposures can be managed, or hedged, using either contractual solutions or operational solutions. Contractual solutions include forward contracts, foreign currency options, and foreign currency futures. These are financial derivatives, with their values changing over time as the asset underlying their value—in this case, a currency—changes. Contractual solutions enter the firm into derivative based positions which manage the individual exposure, at the end of which they are either liquidated or simply expire. Their cost ranges from zero out-of-pocket expense (forward contracts, although the bid-ask spreads represent an implicit transaction cost) to up-front payment (currency options).
HEDGING BASICS
Operational solutions include risk-sharing agreements and currency matching. Risk-sharing agreements are pricing agreements whereby the buyer and seller of goods or services agree on a formula-based ?sharing? of exchange rate changes. Currency matching is the ongoing process of matching cash inflows and outflows by currency per period of time. Operational solutions are inherently multiperiod
HEDGING BASICS
Choice of Solution
? ? ? ? ? ? ?
Views of the firm Risk taking ability of the firm Risk averseness Availability Access to specific solutions Cost-Benefit Analysis Awareness of the firms’ management
PERFORMANCE EVALUATION
Getting the ? best rate ? always is a noble but unrealistic objective
Many corporates benchmark to the ruling forward rate – logic being that a contractual hedge is available at that rate Financial gains and losses are different than accounting gains and losses.
RISK MANAGEMENT POLICY
Approval from the highest decision making authority I.e. board Must address exposure recognition & benchmarking issues Outline a comprehensive hedging policy including hedging instruments permitted Should ideally stipulate Open Position Limits, Portfolio Loss Tolerance and Take Profit Levels Clearly specify hierarchy & powers
CORPORATE PHILOSOPHY
RISK - REWARD RELATIONSHIP OBJECTIVES OF RISK MANAGEMENT RISK MANAGEMENT STRATEGIES LOW RISK - LOW REWARD HIGH RISK - LOW REWARD LOW RISK - REASONABLE REWARD HIGH RISK - HIGH REWARD
CORPORATE PHILOSOPHY
SELECTIVE HEDGING
SPECULATION
CONSERVATIVE
IGNORANT
Source : Int Finance, Forex & Risk Management by A V Rajwade
PWC SURVEY OF CORPORATES
• • 20% of companies had no formal treasury policy. Of the other 80% that did have a policy the real effectiveness of control over the policy was questionable, because • in many instances, the Treasurer was solely responsible for developing the policy and often without formal involvement of the Board. • in over 30% of all cases, the Board had not formally approved the treasury policy • for over 50% of respondents, the Board was not receiving regular management information on treasury activity • in almost 50% of companies, the treasury function was operating without adequate limit controls over its risk management activities. Some 10% of respondents confirmed that exposures were not being hedged at all.
•
REQUIREMENTS & EXPECTATIONS
A corporate would approach a bank for a product/s in line with its risk management objectives In most of the cases the objective is to hedge and not to ? speculate? Having taken a hedge the corporate would then prefer to benchmark the contract rate to its own internal comfort rate rather than calculating the ? opportunity ? gains or losses visà-vis the market rates If a bank dealer respects this background, it is so much easier for him/her to serve the corporate customer better
REQUIREMENTS & EXPECTATIONS
Undoubtedly ? price ? remains the key consideration However, some other factors also significantly contribute to a corporate preferring a particular bank
?
Efficiency of Execution
Ability to handle large transactions without letting the market know too much
?
?
Relationship
Expectations could go up dramatically in future requiring banks to structure innovative packaged solutions - An example follows
CORPORATES IN INDIA
OVER REGULATED ? LESS CONSCIOUS OF THE RISKS INVOLVED ? LIMITED PRODUCTS AVAILABLE ? ONLY A FEW PLAYERS ? HERD MENTALITY ? PRONE TO PANICKING ? UNAWARE OF CAPABILITIES OF SOPHISTICATED PRODUCTS & STRUCTURES ? COMPLACENT ? CAN MEET CHALLENGES OF GLOBALIZATION ?
Our exposure to market risk arises principally from exchange rate risk. Even though our functional currency is Indian rupees, we transact a major portion of our business in foreign currencies, particularly the USD, GBP and Euro. The exchange rate between the rupee and the dollar has changed substantially in recent years and may fluctuate substantially in future. Consequently, the results of our operations are adversely affected as the rupee appreciates against dollar.For fiscal 2006 & 2007, US dollar denominated revenues represented 77.4 & 72.9 % of total revenues. We have sought to reduce the effect of exchange rate fluctuations on our operating results by purchasing derivative instruments such as foreign exchange forward contracts and option contracts to cover a portion of outstanding accounts receivables. As of March, 07 we had outstanding forward contracts in the amount of $ 170 mio. As on the same date, we also held range barrier options of $ 207 mio, Euro Accelerator options for euro 24 mio and Target Redemption Structure Options for GBP 16 mio. These contracts typically mature within one to twelve months, must be settled on the day of maturity and may be cancelled subject to the payment of any gains or losses in the difference between the contract rate and the market rate prevailing on cancellation date.
Source : Infosys Annual Report for 2006-07
We use these derivative instruments only as a hedge mechanism and not for speculative purposes. The risks that we perceive in this context are : a. we may not purchase adequate instruments to insulate ourselves from foreign exchange risks b. the policies of the RBI may change from time to time which may limit our ability to hedge the foreign exchange risk c. any such instrument may not perform adequately as a hedging mechanism
Source : Infosys Annual Report for 2006-07
?For the first time in as many years, an appreciating rupee had a 3.5 per cent direct fallout on our operating margins. While a 13-15 per cent increase in offshore wages and 5-6 per cent hike in onsite salaries had an impact of 2.5 per cent, higher visa costs contributed another 1 per cent to the overall operational impact,? Infosys CFO V Balakrishnan said. He stated that Infosys was successful in neutralising the negative impact of a strong rupee by hedging against the US dollar (1.5 per cent), increasing the utilisation rate (3 per cent) and securing better pricing (1 per cent) to the extent of 4 per cent.
?As a result, the impact was brought down to 3 per cent on the operating margin. We had hedged $925 million to take forward cover at the conversion rate of Rs 40.58 per dollar. We will increase the forward cover if required by hedging more. The rupee had also appreciated against the euro by 4.9 per cent, pound by 5.5 per cent and other currencies during the quarter,? Balakrishnan pointed out. Business Standard 12th July ,07
Transaction Appropriateness
The case was written to detail the multitude of issues involved in what is frequently cited as the most prominent derivatives debacle in U.S. financial history. Although finance students are routinely schooled in the construction and valuation of various financial derivatives, including foreign exchange and interest rate swaps, they rarely see how these specific instruments fit within the corporate frameworks of financial policy and procedure. The failure of Bankers Trust to divulge all of the valuation details behind the transaction sold to Procter & Gamble in 1993-94, and the failure of P&G's treasury staff to pursue their own valuation and mark-to-market due diligence on the transactions entered into, combine to create a situation in which disaster was an eventuality. Topics include the understanding and valuation of leveraged interest rate swap transactions, a bank's possible fiduciary duties in regards to corporate customers, and corporate philosophy on differentiating hedging from speculation.
TRANSACTION APPROPRIATENESS
• AWARE CUSTOMER OR AN UNAWARE CUSTOMER ?
• PRODUCT APPROPRIATE OR INAPPROPRIATE ?
• DOES THE PORTFOLIO RISK INCREASE OR DECREASE BY USING THE DERIVATIVE ?
Transaction Appropriateness
TRANSACTION APPROPRIATE AWARE CUSTOMER UNAWARE CUSTOMER TRANSACTION INAPPROPRIATE
Transaction Appropriateness
It’s Nov. 2, 1993, and two employees of Bankers Trust are discussing a leveraged derivative deal the bank had recently sold to Procter & Gamble Co. “They would never know. They would never be able to know how much money was taken out of that,” says one employee, referring to the huge profits the bank stood to make on the transaction. “Never, no way, no way,” replies her colleague. “That’s the beauty of Bankers Trust.” That dialogue was automatically picked up by a Bankers Trust recording system—similar to those at other financial institutions—that routinely tapes conversations involving transactions, mainly to settle disputes over trades. It is part of a mountain of evidence that forms the basis of a major legal assault by P&G against the bank. P&G contends that the 1993 conversation is just one of many showing that Bankers Trust deliberately misled and deceived P&G, keeping the company in the dark about key aspects of the derivatives the bank was selling.
“The Bankers Trust Tapes,” BusinessWeek, October 16, 1995, p. 105.
M I S Related issues
• Exposure recognition process
• MIS template
• • •
Committed and forecast exposures Time horizon Receivables
• • • • •
• • • •
•
Payables
Export receipts Planned drawals of f.c. loans EEFC account balances Return on overseas investments Other receipts
Import payments Servicing of F C loans Overseas investments Other payments
•
Travel, custom duty
M I S Related issues
•
Benchmarking
• What rate to use • Completed and open transactions
•
Portfolio approach
• Long and Short • And square
RISK MANAGEMENT POLICY
Source : Master Circular on Risk Management & Interbank Dealings dated 1st July, 07
RISK MANAGEMENT POLICY
Source : Master Circular on Risk Management & Interbank Dealings dated 1st July, 07
doc_354651688.ppt
This is a presentation describes various sources of currency risks and ways to mitigate it.
CORPORATE CURRENCY RISK – AN OVERVIEW
Text Book Chapters
Rajwade : Chapter 14 , 15, 17
Apte : 3, 12, 13 Sathe : 8 , 9
INDIAN CORPORATES
Sources of currency risk :
? ?
?
Exports Imports Financials
? Borrowings ? Investments
?
Competition
CORPORATE PERSPECTIVE
Even in this technology dominated scenario, banks would still need to keep abreast of the requirements & expectations of the biggest consumer class of their products & services viz. corporates
The reference to corporates would have to be restrictive
?
Small and sub-SME segment corporates may no longer be relevant from a risk angle as product & service deliveries get standardized. This class may still be important from a revenue angle.
CORPORATE CURRENCY RISK
Since the advent of the floating exchange rates, any time that a transaction — whether that transaction is in goods, services, people, capital, or technology — has crossed borders, it has been subject to the influence of changes in exchange rates. The basic problem posed by exchange rates on the cross-border firm is that money across borders has no fixed value. Consequently, neither does a transaction undertaken across borders. Risk posed by exchange rate changes to the cross-border firm is commonly referred to as currency risk
RISK & EXPOSURE
Core Business Risks and Macroeconomic Environmental Risks Risk Factors
? ? ? ?
Currency rates Inflation Interest Rates Commodity Prices
Firms are ? exposed ? to unanticipated changes in risk factors
RISK & EXPOSURE
Exposure is a measure of sensitivity of the value of a financial item ( asset, liability or cash flow ) to unanticipated changes in relevant risk factors Magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor An example : USD/INR rate in 1993 –95
An exposure
An exposure is defined as a contracted or a forecast future cash flow, a liability or an asset denominated in foreign currency which either for revenue account or balance sheet purpose will have to be converted or translated into another currency at a rate which is yet to be determined.
Exposures will therefore include
Foreign currency denominated items on the balance sheet actual, physical purchases and sales of goods and services which have been invoiced in foreign currency but are yet to be settled contracted purchases and sales such as long-term contracts to purchase capital equipments denominated in foreign currency uncontracted foreign currency denominated receipts and payments which will materialize if forecasted manufacturing activity is realized investments in subsidiaries abroad guarantees issued by the Group companies denominated in foreign currencies
TYPES OF EXPOSURES
A cross-border firm is affected by exchange rate changes in three different ways.
Transaction Exposures Translation Exposures Economic Exposures
TRANSACTION EXPOSURE
A transaction exposure arises whenever the firm commits (or is contractually obligated) to make or receive a payment at a future date denominated in a foreign currency. Transaction exposures can therefore arise from
?
?
operating and free cash flows, e.g., accounts receivable and payable arising from the conduct of business; commitments to buy or lease capital equipment or financing cash flows, e.g., debt or equity service obligations arising from the funding of the firm’s business.
TRANSLATION EXPOSURE
A cross-border firm must periodically remeasure all of its global operations into a single currency for reporting purposes. This requires that the balance sheets and income statements of all affiliate operations worldwide be translated and consolidated into the currency of the parent company. Imbalances resulting from translation represent a potential change in the firm’s reported consolidated income, reported capital base, or both.
ECONOMIC EXPOSURE
A firm’s present value—firm value—will change as the value of expected future cash flows (and costs of capital) changes as a result of unexpected exchange rate changes. More precisely, a firm is said to have economic exposure to exchange rates when unanticipated real exchange rate changes have a non-zero effect on its expected future cash flows. People also sometimes use the terms operating exposure, real exposure, and competitive exposure as synonyms for such economic exposure.
PASS-THROUGH EFFECT
Exchange Rate pass-through is defined as a firm’s ability to pass on the impact of exchange rate changes to its customers A firm having a pass-through of 1 is able to pass on to its customers the full impact arising out of exchange rate changes While a firm with a zero pass-through is unable to pass on such changes
CURRENCY RISK MANAGEMENT
Successful management of currency risk requires a well-designed and wellimplemented risk management program comprising :
?
Perception Measurement Strategy Implementation
?
?
?
CURRENCY RISK – CASES
Following slides contain caselets highlighting certain peculiar risks faced by various firms when there are changes in currency rates Objective is to identify and appreciate such risks and to portray a very broad risk profile
CASE 1
COMPANY IS INVOLVED IN MANUFACTURING OF MACHINE PARTS RM COSTS ARE 75 % OF PRODUCTION COST IMPORTED MATERIAL ACCOUNTS FOR 80% OF RM CONSUMED MORE THAN 90% OF SALES ARE TO GOVT. DEPTS. AGAINST TENDERS
Transaction Exposure
CASE 2
COMPANY IS INVOLVED IN DISTRIBUTING IMPORTED ITEMS CRITICAL FOR HEART OPERATIONS THERE IS NO DOMESTIC PRODUCER BILLING IS DONE BASED ON ACTUAL LANDED COST PLUS AN AGREED MARGIN
CASE 3 :
COMPANY IS INVOLVED IN IMPORTING RAW DIAMONDS, POLISHING AND EXPORTING THEM ALL INVOICING IS DONE IN USD IMPORT PRICES ARE DECIDED DURING AUCTIONS IN BELGIUM EXPORTS GO TO CUSTOMERS WHERE PRICES ARE INDIVIDUALLY NEGOTIATED
No exposure
CASE 4 :
COMPANY WISHES TO SUBMIT A TENDER TO ONGC IMPORTED RM INVOICED IN USD COMPRISES 60 % OF THE CoP RESULT OF THE TENDER WOULD BE KNOWN AFTER 8 WEEKS
Contingent Exposure
CASE 5 :
COMPANY IS INVOLVED IN PROCESSING & IS 100 % EOU IMPORTS RM FROM EUROPE INVOICED IN EURO PROCESSING IS DONE IN FACTORIES IN INDIA SALES ARE ALL EXPORTS TO US INVOICED IN US Euro/Dollar exchange rate impact If dollar appreciates then favorable
CASE 6 :
COMPANY HAS NO IMPORTS , EXPORTS OR FOREIGN CURRENCY LIABILITIES COMPANY HAS ONE MAJOR COMPETITOR THE COMPETITOR ALSO HAS NO IMPORTS OR EXPORTS, BUT HAS FINANCED ITS FUND REQUIREMENTS THROUGH A FOREIGN CURRENCY LOAN IN USD.
CASE 7
COMPANY IS AN EXPORTER OF GARMENTS CUSTOMERS ARE IN US & EUROPE FACES COMPETITION FROM CHINESE EXPORTERS INFLATION IN INDIA IS 10 % AND THAT IN CHINA IS 5 % IN THE LAST YEAR RUPEE HAS DEPRECIATED AGAINST US DOLLAR BUT APPRECIATED AGAINST EURO CHINESE YUAN HAS STRENGTHENED AGAINST US DOLLAR
CASE 8
COMPANY IS A LEADING EXPORTER OF ENGINEERING GOODS EXPORTS ARE INVOICED IN USD HAS A SIZEABLE ORDER BOOK TO BE EXECUTED OVER NEXT 12 TO 18 MONTHS PERCEIVES THAT RUPEE MAY CONTINUE TO APPRECIATE AGAINST USD ENJOYS WORKING CAPITAL AND TERM FACILITIES FROM BANKS IN INDIA IN INDIAN RUPEES
CASE 9
WHAT IF THE COMPANY IN EARLIER CASE IS A ZERO DEBT COMPANY !
EXPOSURE MANAGEMENT
A transaction exposure of the firm is a singular event, an individual foreign currencydenominated cash flow commitment which exposes the firm to a loss or gain upon settlement of the outstanding obligation.
Examples
?
?
?
Indian exporter Buyer’s credit by Indian importers Short term FCNR(B) loan funding
EXPOSURE MANAGEMENT
Translation exposure arises because financial statements of foreign affiliates must be restated in the parent’s currency in order to consolidate financial statements.
Eastman-Kodak reckoned that its pre-tax earnings were depressed by $ 3.5 bln between 1980 and 1985 because of rising dollar. The dollar’s subsequent fall revived its fortunes by adding 60 cents a share in 1986, but its market share abroad took some more time to recover. American pharma multinationals such as Merck have found that during periods of strong dollar, their cash flows denominated in dollars tend to shrink while bulk of their R & D expenditure being denominated in dollars get significantly impacted affecting long-term competitiveness.
HEDGING BASICS
Peter Drucker once noted that, “Not to hedge is to speculate. Exchange rates are a cost of production that financial executives must manage.” An exchange rate hedge is an asset or position whose value changes (?H) in the opposite direction to that of an exposure (?X) as a result of a change in the exchange rate. A perfect hedge would be one whose value changes in an equal and opposite direction, resulting in a net change of zero in the value of the combined position: ?V = ?X + ?H
HEDGING BASICS
Hedging protects the owner of the existing asset from loss. It is, however, important to note that while a hedge protects the firm against an exchange rate loss (relative to being unhedged), it can also eliminate any gains from an exchange rate change that is favorable. Hedging reduces variance in future cash flows thereby 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 the minimum required to make debt-service payments. Hedging can therefore reduce the likelihood of financial distress.
HEDGING BASICS
Exposures can be managed, or hedged, using either contractual solutions or operational solutions. Contractual solutions include forward contracts, foreign currency options, and foreign currency futures. These are financial derivatives, with their values changing over time as the asset underlying their value—in this case, a currency—changes. Contractual solutions enter the firm into derivative based positions which manage the individual exposure, at the end of which they are either liquidated or simply expire. Their cost ranges from zero out-of-pocket expense (forward contracts, although the bid-ask spreads represent an implicit transaction cost) to up-front payment (currency options).
HEDGING BASICS
Operational solutions include risk-sharing agreements and currency matching. Risk-sharing agreements are pricing agreements whereby the buyer and seller of goods or services agree on a formula-based ?sharing? of exchange rate changes. Currency matching is the ongoing process of matching cash inflows and outflows by currency per period of time. Operational solutions are inherently multiperiod
HEDGING BASICS
Choice of Solution
? ? ? ? ? ? ?
Views of the firm Risk taking ability of the firm Risk averseness Availability Access to specific solutions Cost-Benefit Analysis Awareness of the firms’ management
PERFORMANCE EVALUATION
Getting the ? best rate ? always is a noble but unrealistic objective
Many corporates benchmark to the ruling forward rate – logic being that a contractual hedge is available at that rate Financial gains and losses are different than accounting gains and losses.
RISK MANAGEMENT POLICY
Approval from the highest decision making authority I.e. board Must address exposure recognition & benchmarking issues Outline a comprehensive hedging policy including hedging instruments permitted Should ideally stipulate Open Position Limits, Portfolio Loss Tolerance and Take Profit Levels Clearly specify hierarchy & powers
CORPORATE PHILOSOPHY
RISK - REWARD RELATIONSHIP OBJECTIVES OF RISK MANAGEMENT RISK MANAGEMENT STRATEGIES LOW RISK - LOW REWARD HIGH RISK - LOW REWARD LOW RISK - REASONABLE REWARD HIGH RISK - HIGH REWARD
CORPORATE PHILOSOPHY
SELECTIVE HEDGING
SPECULATION
CONSERVATIVE
IGNORANT
Source : Int Finance, Forex & Risk Management by A V Rajwade
PWC SURVEY OF CORPORATES
• • 20% of companies had no formal treasury policy. Of the other 80% that did have a policy the real effectiveness of control over the policy was questionable, because • in many instances, the Treasurer was solely responsible for developing the policy and often without formal involvement of the Board. • in over 30% of all cases, the Board had not formally approved the treasury policy • for over 50% of respondents, the Board was not receiving regular management information on treasury activity • in almost 50% of companies, the treasury function was operating without adequate limit controls over its risk management activities. Some 10% of respondents confirmed that exposures were not being hedged at all.
•
REQUIREMENTS & EXPECTATIONS
A corporate would approach a bank for a product/s in line with its risk management objectives In most of the cases the objective is to hedge and not to ? speculate? Having taken a hedge the corporate would then prefer to benchmark the contract rate to its own internal comfort rate rather than calculating the ? opportunity ? gains or losses visà-vis the market rates If a bank dealer respects this background, it is so much easier for him/her to serve the corporate customer better
REQUIREMENTS & EXPECTATIONS
Undoubtedly ? price ? remains the key consideration However, some other factors also significantly contribute to a corporate preferring a particular bank
?
Efficiency of Execution
Ability to handle large transactions without letting the market know too much
?
?
Relationship
Expectations could go up dramatically in future requiring banks to structure innovative packaged solutions - An example follows
CORPORATES IN INDIA
OVER REGULATED ? LESS CONSCIOUS OF THE RISKS INVOLVED ? LIMITED PRODUCTS AVAILABLE ? ONLY A FEW PLAYERS ? HERD MENTALITY ? PRONE TO PANICKING ? UNAWARE OF CAPABILITIES OF SOPHISTICATED PRODUCTS & STRUCTURES ? COMPLACENT ? CAN MEET CHALLENGES OF GLOBALIZATION ?
Our exposure to market risk arises principally from exchange rate risk. Even though our functional currency is Indian rupees, we transact a major portion of our business in foreign currencies, particularly the USD, GBP and Euro. The exchange rate between the rupee and the dollar has changed substantially in recent years and may fluctuate substantially in future. Consequently, the results of our operations are adversely affected as the rupee appreciates against dollar.For fiscal 2006 & 2007, US dollar denominated revenues represented 77.4 & 72.9 % of total revenues. We have sought to reduce the effect of exchange rate fluctuations on our operating results by purchasing derivative instruments such as foreign exchange forward contracts and option contracts to cover a portion of outstanding accounts receivables. As of March, 07 we had outstanding forward contracts in the amount of $ 170 mio. As on the same date, we also held range barrier options of $ 207 mio, Euro Accelerator options for euro 24 mio and Target Redemption Structure Options for GBP 16 mio. These contracts typically mature within one to twelve months, must be settled on the day of maturity and may be cancelled subject to the payment of any gains or losses in the difference between the contract rate and the market rate prevailing on cancellation date.
Source : Infosys Annual Report for 2006-07
We use these derivative instruments only as a hedge mechanism and not for speculative purposes. The risks that we perceive in this context are : a. we may not purchase adequate instruments to insulate ourselves from foreign exchange risks b. the policies of the RBI may change from time to time which may limit our ability to hedge the foreign exchange risk c. any such instrument may not perform adequately as a hedging mechanism
Source : Infosys Annual Report for 2006-07
?For the first time in as many years, an appreciating rupee had a 3.5 per cent direct fallout on our operating margins. While a 13-15 per cent increase in offshore wages and 5-6 per cent hike in onsite salaries had an impact of 2.5 per cent, higher visa costs contributed another 1 per cent to the overall operational impact,? Infosys CFO V Balakrishnan said. He stated that Infosys was successful in neutralising the negative impact of a strong rupee by hedging against the US dollar (1.5 per cent), increasing the utilisation rate (3 per cent) and securing better pricing (1 per cent) to the extent of 4 per cent.
?As a result, the impact was brought down to 3 per cent on the operating margin. We had hedged $925 million to take forward cover at the conversion rate of Rs 40.58 per dollar. We will increase the forward cover if required by hedging more. The rupee had also appreciated against the euro by 4.9 per cent, pound by 5.5 per cent and other currencies during the quarter,? Balakrishnan pointed out. Business Standard 12th July ,07
Transaction Appropriateness
The case was written to detail the multitude of issues involved in what is frequently cited as the most prominent derivatives debacle in U.S. financial history. Although finance students are routinely schooled in the construction and valuation of various financial derivatives, including foreign exchange and interest rate swaps, they rarely see how these specific instruments fit within the corporate frameworks of financial policy and procedure. The failure of Bankers Trust to divulge all of the valuation details behind the transaction sold to Procter & Gamble in 1993-94, and the failure of P&G's treasury staff to pursue their own valuation and mark-to-market due diligence on the transactions entered into, combine to create a situation in which disaster was an eventuality. Topics include the understanding and valuation of leveraged interest rate swap transactions, a bank's possible fiduciary duties in regards to corporate customers, and corporate philosophy on differentiating hedging from speculation.
TRANSACTION APPROPRIATENESS
• AWARE CUSTOMER OR AN UNAWARE CUSTOMER ?
• PRODUCT APPROPRIATE OR INAPPROPRIATE ?
• DOES THE PORTFOLIO RISK INCREASE OR DECREASE BY USING THE DERIVATIVE ?
Transaction Appropriateness
TRANSACTION APPROPRIATE AWARE CUSTOMER UNAWARE CUSTOMER TRANSACTION INAPPROPRIATE
Transaction Appropriateness
It’s Nov. 2, 1993, and two employees of Bankers Trust are discussing a leveraged derivative deal the bank had recently sold to Procter & Gamble Co. “They would never know. They would never be able to know how much money was taken out of that,” says one employee, referring to the huge profits the bank stood to make on the transaction. “Never, no way, no way,” replies her colleague. “That’s the beauty of Bankers Trust.” That dialogue was automatically picked up by a Bankers Trust recording system—similar to those at other financial institutions—that routinely tapes conversations involving transactions, mainly to settle disputes over trades. It is part of a mountain of evidence that forms the basis of a major legal assault by P&G against the bank. P&G contends that the 1993 conversation is just one of many showing that Bankers Trust deliberately misled and deceived P&G, keeping the company in the dark about key aspects of the derivatives the bank was selling.
“The Bankers Trust Tapes,” BusinessWeek, October 16, 1995, p. 105.
M I S Related issues
• Exposure recognition process
• MIS template
• • •
Committed and forecast exposures Time horizon Receivables
• • • • •
• • • •
•
Payables
Export receipts Planned drawals of f.c. loans EEFC account balances Return on overseas investments Other receipts
Import payments Servicing of F C loans Overseas investments Other payments
•
Travel, custom duty
M I S Related issues
•
Benchmarking
• What rate to use • Completed and open transactions
•
Portfolio approach
• Long and Short • And square
RISK MANAGEMENT POLICY
Source : Master Circular on Risk Management & Interbank Dealings dated 1st July, 07
RISK MANAGEMENT POLICY
Source : Master Circular on Risk Management & Interbank Dealings dated 1st July, 07
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