Comparative Analysis of Foreign Exchange Risk Management Practices Among Non Banking Companies in...

8/12/2019 Comparative Analysis of Foreign Exchange Risk Management Practices Among Non Banking Companies in India by Anupam Mitra-Libre

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AFRICA DEVELOPMENT AND RESOURCES RESEARCH INSTITUTE (ADRRI) JOURNAL

ADRRI JOURNAL (www.adrri.org)

pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 attention to the traditional types of exchange rate risk (transaction, translation, and economic), and the advantages

and disadvantages of various exchange rate risk management approaches (tactical vs. strategic, passive vs. active). It

has also tried to outline a set of widely accepted best practices in currency risk management, and review the use of

some of the widely used hedging instruments in the OTC and exchange traded markets.

Keywords: Foreign Exchange Risk, Non-banking Companies, India

INTRODUCTION

"You cannot discover new oceans unless you have the courage to lose sight of the shore"

The etymology of the word “Risk” can be traced to the Latin word “Rescum”, meaning Risk at

Sea or that which cuts. Risk is associated with uncertainty and reflected by way of charge on thefundamental/basic. Risk may also be defined as the probability of incurring a loss or damage. In

other words risk can be defined as the chance that the actual outcome from an activity will differ

from the expected outcome. This means that, more variable the possible outcomes that can occur(i.e. broader the range of possible outcomes), the greater the risk.

Risk management means a course of action planned to reduce the risk of an event occurring, and

minimizing or containing the consequential effects should that event occur. It is one of thoseideas, the sense that a logical, consistent and disciplined approach to the future uncertainties will

allow us to live with them prudently and productively, avoiding unnecessary waste of resources.

It goes beyond faith and luck, the twin pillars of managing the future before we began learning

how to measure probability. As Peter Bernstein wrote, “If everything is a matter of luck, riskmanagement is a meaningless exercise. Invoking luck obscures truth, because it separates an

event from its cause.”

Risk management does not aim at risk elimination, but enables the organization to bring theirrisks to manageable proportions while not severely affecting their income. This balancing act

between the risk levels and profits needs to be well-planned. Apart from bringing the risks to

manageable proportions, they should also ensure that one risk does not get transformed into any

other undesirable risk. This transformation takes place due to the inter-linkage present among thevarious risks. The focal point in managing any risk will be to understand the nature of the

transaction in a way to unbundle the risks it is exposed to.

In todays volatile global economy, amidst swift and sudden shifts in currency trends,

corporations worldwide increasingly regard foreign exchange exposure management as a criticalcomponent of their overall strategy to cut costs, manage risk and maximize corporate value.

Foreign Exchange risk has been always an important subject of research. Traditionally, this

research focused on the macroeconomic consequences of an exchange rate adjustment. Morerecently, the focal point of research has shifted to investigate the impact of exchange rate risk on

corporate performance.

The need for currency risk management started to arise after the breakdown of the Bretton

Woods system and the end of the US dollar peg to gold in 1973. Exchange rate risk managementis an integral part of every firm's decisions about foreign currency exposure. Currency risk

hedging strategies entail eliminating or reducing this risk, and require understanding of both the

ways that the exchange rate risk could affect the operations of economic agents and techniques to





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 deal with the consequent risk implications. Selecting the appropriate hedging strategy is often a

daunting task due to the complexities involved in measuring accurately current risk exposure and

deciding on the appropriate degree of risk exposure that ought to be covered.As Indian businesses become more global in their approach, evolution of a broad based, active

and liquid Forex (Foreign Exchange) derivatives markets is required to provide them with aspectrum of hedging products for effectively managing their foreign exchange exposures. Rise involatility of exchange rates and interest rates have lead to a plethora of financial innovation,

exemplified by the proliferation of derivative instruments and their increasing use by companies.

While derivatives can be quite efficient hedging instruments for corporate risk management, theycan be quite complex as well, with strong leverage effects. Consequently, the use of these

instruments carries with it high risks, both for the unsophisticated user, as well as for managers

tempted by an urge for gambling with their shareholders‟ money. In contrast, when properly

used for hedging, derivatives or various other financial transactions can reduce those risks of

companies. Since the term „hedging‟ is widely misused in practice, a clear conceptual

foundation is a key to management action consistent with the objective of firm value

maximization.

LITERATURE REVIEW

Logue (1995) and Chowdhry and Howe (1999) argue that operating exposure cannot be

effectively managed using financial hedges. Instead, they suggest that long-term strategyadjustments (i.e., operational hedges) are the most effective way of managing long-run operating

exposure.

According to Copeland and Joshi (1996), foreign exchange risk management programs may

cause more harm than good. Their study of nearly two hundred large companies has yieldedenough evidence to cast serious doubt about the economic benefits of foreign exchange hedging

programs. Given scarce management time and the substantial amount of capital currentlydevoted to hedging, it is clear that many programs diminish value instead of creating it. Hedgingtheories assume a static world in which all factors apart from foreign exchange rates stay exactly

the same. In addition, the relationships between these factors are shifting constantly. Hard

enough to understand in hindsight, they are virtually impossible to predict in advance.Fok et al. (1997) have reported that although the primary purpose of hedging is to reduce

earnings volatility, it may also increase firm value. Their study shows that hedging reduces the

probability of financial distress, the agency costs of debt, and the costs of equity. In addition,they suggested that corporate ownership structure might affect the desirability of hedging. They

also found that large firms had a stronger tendency to hedge, firms with a larger percentage of

value derived from growth opportunities were more likely to hedge, and convertible debt served

as a substitute for corporate hedging.The Foreign Exchange exposure of 171 Japanese multinationals was examined by He and Ng

(1998). They documented that 25 percent of the firms’ experienced significant Foreign Exchangeexposure. The extent to which a firm was exposed to Foreign Exchange risk was linked to the

firms export ratio. He and Ng also examined the relationship between Foreign ExchangeExposure and variables that were assumed to reflect derivatives usage. The results showed that

firms that were predicted to hedge had lower Foreign Exchange exposure, on average, than

comparable sample firms.





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 Ammon (1998) discussed two competing approaches to corporate hedging: equity value

maximizing strategies and strategies determined by managerial risk aversion. The first category

suggested that the managers acted in the best interest of shareholders. The second categoryconsidered that managers maximized their personal utility rather than the market value of equity.

He concluded that the total benefits of hedging were not the sum total across the various motives.Therefore, a manager has to concentrate on a primary motive to implement an effective riskmanagement program.

Bodnar and Gebhardt (1998) carried out a comparative study of the responses to the survey of

derivative usage between the US and German nonfinancial firms. Their study shows that Germanfirms are more likely to use derivatives than US firms. Apart from this higher overall usage, the

general pattern of usage across industry and size groupings is comparable across the two

countries. In both countries, foreign currency derivative usage is most common, followed closely

by interest rate derivatives, with commodity derivatives a distant third. In contrast to thesimilarities, firms in the two countries differ notably on issues such as the primary goal of

hedging, their choice of instruments, and the influence of their market view when taking

derivative positions. These differences appear to be driven by the greater importance of financialaccounting statements in Germany than the US and stricter German corporate policies of controlover derivative activities within the firm.

Nydahl (1999) investigated 47 Swedish firms‟ Foreign Exchange exposures. The evidence

showed that exposure increased with the fraction of sales classified as foreign. Further, using

survey evidence on firms‟ hedging of foreign assets, Nydahl examined the association between

translation exposure hedging and Foreign Exchange exposure. The results indicate that

translation hedging reduced the sample firms‟ Foreign Exchange exposure.

Marshall (2000) empirically shows, furthermore, that contrary to the general view found in the

literature derivatives use doesn’t always decrease the variability of the firms value and that the

degree of usage of certain techniques is even associated with an increase in the variability of

certain financial measures.Wong (2000) investigated the Foreign Exchange exposure of manufacturing firms in the U.S. to

test for an association between Foreign Exchange exposure and derivative disclosures required.

He documented weak associations between derivative disclosures and Foreign Exchangeexposure and suggested that this can be due to inability in controlling for firms inherent

exposures and shortcomings of the accounting disclosures.

The survey study of Yadav and Jain (2000) based on 44 corporate firms in India has shown thatthe Indian companies involved in international operations are conscious of the unique risks that

arise as a result of doing business abroad. They report that companies are taking steps to manage

political risk, exchange rate risk and interest rate risk. They observe that companies are covering

a good part of their exchange rate risk and as many as 30 per cent of companies hedge their

exposures in totality.Loderer and Pichler (2000) have observed that firms believe that their exposure is trivial and

they fail to understand the importance of assessing their risk profiles.

Joseph (2000) has studied the relationship between the use of hedging techniques and thecharacteristics of UK multinational enterprises. The study indicates that firms are not very

receptive to the newer and more complex types of derivatives.

Oosterhof (2001) has suggested that corporate risk management and hedging are importantactivities within financial as well as non-financial corporations. The study concluded that the





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 Abor (2005) suggested that foreign exchange risk can be managed by adjusting prices to reflect

changes in import prices resulting from currency fluctuation, and also by buying and saving

foreign currency in advance. The main problems that firms face are the frequent appreciation offoreign currencies against the local currency and the difficulty in retaining local customers

because of the high prices of imported inputs, which tend to affect the prices of their finalproducts sold locally.Yazid and Muda (2006) studied the usage pattern of foreign exchange management strategies in

multinational corporations. They found that multinationals are involved in foreign exchange risk

management primarily because they sought to minimize operational overall cash flows, whichare affected by currency volatility. Also, the majority of multinationals centralizes their risk

management activities and at the same time imposes greater control by frequent reporting on

derivative activities. This level of caution could perhaps be because of huge financial losses

related to derivative trading in the past.

Sathya Swaroop Debasish in his 2008 paper “Foreign Exchange Risk Management Practices – A

Study in Indian Scenario” conducted an industry wide cross-sectional research on the techniques

used by non-banking Indian based firms for foreign exchange risk management. The sampling ofthe study involved 501 non-banking Indian companies. The study identifies that the prime reasonfor hedging is the volatility and reduction in cash flows. The paper identifies and discusses the

various foreign exchange risk management techniques in detail. The study finds out that forward

contracts are the most commonly used techniques by Indian firms and it is then followed byswaps and cross-currency options. He has also mentioned that the currency risk management in

India is growing at very slow pace and there should be urgency shown in using better-suited

hedging instruments appropriate for the firms while considering the impact of the foreign

exchange.Sivakumar and Sarkar (2008) in their paper “Corporate Hedging for Foreign Exchange Risk in

India” evaluate the various alternatives available for Indian companies to hedge the foreign

exchange risks. The paper studies various companies from various sectors and concludes thatcurrency forwards and currency options are the most highly preferred hedging techniques used

by Indian companies for short term hedging while swaps are preferred for long term hedging.

They also discuss the various factors that influence the decision of the companies to hedge. Theirresearch concluded that software companies in India have short term planning horizons when

compared with high capital-intensive organizations. In general Indian firms choose short-term

measures for hedging. The paper concluded that there is a need for rupee futures.

Dash et al (2008), compared the performance of different FOREX risk management strategies forshort-term foreign exchange cash flows. Their results indicated that, for outflows, the currency

options strategy yielded the highest mean returns in all periods, irrespective of the movement in

the exchange rate; while for inflows, the forwards strategy yielded the highest mean returns

whenever there was a decreasing trend in the exchange rate, and the cross-currency strategyyielded the highest mean returns whenever there was a cyclic fluctuation in the exchange rate,

however, when there was an increasing trend in the exchange rate, there was no single strategy

yielding the highest mean returns.

Objectives of the study

To explain different approaches taken by non-banking companies in India towardsforeign exchange risk management.





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 final respondents and the same was found to be fairly representative without any bias towards

any particular industry or size.

Total responses received Intended Sample Size

IT / IT Services 7 23

Pharmaceuticals 4 13

FMCG 4 12

Consumer durables 2 8

Infrastructure 3 12

Telecommunication 2 6

Others 4 16

26 90

Responses and analysis of data

Q-1) What is the primary source of foreign

exchange exposure for your company :

Q-2) If both exports and imports are a

source of foreign exchange exposure for

your company, which one is a moredominant source





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 Q-19) Does your company have a documented foreign exchange risk management policy :

CONCLUSION AND RECOMMENDATION

The study throws up some very interesting insights and break quite a myth related to the level of

awareness that corporate in India have on the complex subject of exchange rate derivatives. Both

imports and exports are a source of exchange exposure for Indian companies. The fact that the

respondents did not include any oil refiner, and had a healthy representation of companies who

generate a substantial part of their revenue through exports may have lead to a slightly tilted

outcome in favour of exporters. Most of the respondents consider the exchange risk involved

while entering into a foreign contract. An overwhelming majority of those who consider such

risk involved, hedge their exposure. Majority of the respondents used external techniques to

hedge their foreign exchange exposure. Since the study excluded the non-indian MNCs, it is

possible that for the corporate covered in the study, the ability to employ internal techniques to

hedge their exchange exposure is limited. Forward contracts appear to be most commonly used

techniques by Indian firms although the majority of the respondents use a combination of

forward contracts, swaps and option to hedge. For respondents who stated that they do not hedge

their exchange exposure, the majority chose not to do so as they felt that their exposures are not

large enough as well as either they do not understand the derivatives too well or find them too

pricey/risky. On their view on the continuing volatility in the forex markets, majority were

uncertain on the future of the current volatility. However most of them believed that Rupee will

depreciate even further. Minimizing the volatility in their cash flows was the single largest

reason cited by the respondents to be the key objective of their risk management strategy. This





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 was substantiated by an identical proportion of respondents treating the Transaction risk as the

primary focus of their risk management strategy. Difficulty in quantifying the exposure was the

single largest concern cited by the respondents. An overwhelming majority of respondents

consider their treasury function as a cost centre Most interestingly the largest proportion of

respondents see little benefit in hedging. This is particularly surprising given that for majority of

the respondents had a well evolved hedging program. Majority of the respondents were satisfied

with the effectiveness of their present exchange risk management program. On RBI‟s level of

intervention to the ongoing currency turmoil, majority believed that RBI is doing enough or at

least doing something, though it could do more. An overwhelming proportion was quite positive

on the long term outlook for rupee.

REFERENCE

Anuradha Sivakumar and Runa Sarkar “Corporate Hedging for Foreign Exchange Risk in India”,

Industrial and Management Engineering Department, Indian Institute of Technology,

Kanpur

Belk, P.A. 2002. The organization of foreign exchange risk management: A three-country

Study, Managerial Finance

Bengt Pramborg - Foreign Exchange Risk Management by Swedish and Korean Non-Financial

Firms: A Comparative Survey - Department of Corporate Finance, School of Business,

Stockholm University, Sweden

Bodnar, G.M. and Gebhardt, G. 1998. Derivatives usage in risk management by U.S. and

German non-financial firms: A comparative survey. Working Paper Number 6705.

National

Bureau of Economic Research

Bodnar, G.M., Jong, A. and Macrae, V. 2003. The impact of institutional differences onderivatives usage: A comparative study of US and Dutch firms. European Financial

Management

Debasish, Sathya Swaroop “Foreign exchange risk management practices-a study in Indian

scenario“, BRAC University Journal , Volume 5, Number 2, 2008





pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 Thomas E. Copeland and Yash Joshi Why derivatives don‟t reduce FX risk, The Mckinsey

Quarterly 1996 Number 1

Yazid, A.S. and Muda, M.S. 2006. The Role of Foreign Exchange Risk Management in

Malaysia. Irish Journal of Management, Dublin.

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