Foreign Currency and Interest Rate Risk Management at...
68
UNIVERSITY OF NOTTINGHAM Foreign Currency and Interest Rate Risk Management at Forex and Treasury Division of Essar Group Parixit Mehta MBA FINANCE 2008 A Dissertation presented in part consideration for the degree of MBA in Financial Studies.
Transcript of Foreign Currency and Interest Rate Risk Management at...
UNIVERSITY OF NOTTINGHAM
Foreign Currency and Interest Rate Risk
Management at Forex and Treasury
Division of Essar Group
Parixit Mehta
MBA FINANCE
2008
A Dissertation presented in part consideration for the degree of MBA in Financial Studies.
1
Acknowledgement
An internship is a stepping stone towards a successful career in the corporate world and I
would like to acknowledge the contributions of individuals and organizations in successful
accomplishment of the project.
In my tenure at Essar Group, I gained invaluable experience and skills in the foreign
exchange markets which will aid me in my future endeavours. I am grateful to Forex and
Treasury Division, Essar Group and its management for providing me with this opportunity.
I express my sincere gratitude to Mr N. S. Paramasivam (Head, Forex and Treasury
Division) of Essar Group and Prof. David Newton (Faculty Guide) for giving their valuable
time and guidance.
I would like to give a special word of thanks to all my colleagues Mr.M.V.Subraminiam,
Ms.Perpetina Corda, Mr.Appireddy Gattikonda, Mr.Venkatesh Hegde, Mr.Aroubind
Kaningo, Mr.N.Sarma, Mr.Nayan Doshi, Mr.Edwin D‘souza, Mr.Manish Joshi for their
valuable inputs, information and guidance.
Parixit Mehta
2
Abstract
This report gives an insight into the operations and working of Forex and Treasury Division
of Essar Group focusing on managing foreign currency and interest rate risks. The strategies
used by the treasury divisions of a global conglomerate have been highlighted by studying the
activities carried out at the Essar Group.
The report includes how forex exposures are managed to maximize the receivables and
minimize the interest costs and discusses the use of financial instruments such as Forwards,
Options and Swaps to hedge against adverse movements of exchange rates.
Based on the economic slowdown triggered by the sub-prime crisis and crude oil shocks, we
discuss how an organization such as Essar Group can get drastically affected due to the micro
economic and macro economic factors influencing international business. Finally we touch
upon the proactive decisions taken by the management to achieve the goals add value to the
organization.
3
Table Of Contents
Essar Global: A Profile ............................................................................................................ 4
Forex and Treasury Division: Essar Group ............................................................................ 10
Objectives of forex risk management at Essar group ........................................................................ 10
Division structure .............................................................................................................................. 11
Foreign Exchange risk management ...................................................................................... 12
Management of foreign exchange exposures .................................................................................... 12
Performance measurement ................................................................................................................ 14
An introduction to the forex market ....................................................................................... 16
Factors influencing the foreign exchange markets ............................................................................ 16
Participants in Foreign Exchange markets ........................................................................................ 17
Types of transactions ........................................................................................................................ 18
The dealing room .............................................................................................................................. 18
Fundamental analysis ........................................................................................................................ 20
Technical Analysis ............................................................................................................................ 32
Tools available to Essar Group in the forex markets ........................................................................ 38
Interest rate risk management ............................................................................................... 40
Interest Rate Risk management: Key areas of supervision ............................................................... 43
Hedging tools used by ESSAR Group for IRR reduction ................................................................. 47
Interest cost forecast on Forex borrowings ....................................................................................... 48
Strategies of Interest Cost reduction: Essar Group ........................................................................... 50
Interest Cost Reduction Exercise: Forex and Treasury Division ...................................................... 51
Interest Cost Savings / Value addition, 2006: Forex and Treasury division, Essar Group ............... 53
Interest Cost on Guaranteed Borrowings: Lenders‘ Perspective ...................................................... 53
The Road Ahead .................................................................................................................... 56
World Economy ................................................................................................................................ 56
Indian Economy ................................................................................................................................ 57
Forex and Treasury Division ............................................................................................................. 60
References: ............................................................................................................................ 63
Appendix 1: Financial Exposures of Essar Steel Ltd. .............................................................. 65
Appendix 2: Global Economic Indicators ............................................................................... 66
Appendix 3: Forex Reserves ................................................................................................... 67
Source: Essarnet 4
Essar Global: A Profile
Essar Global Limited (EGL) is a diversified business corporation with a balanced portfolio
of assets straddling the manufacturing and services sectors of Steel, Energy, Power,
Communications, Shipping Ports & Logistics, Construction and Mining & Minerals. EGL
has a firm value of approximately USD 50 billion (INR 200,000 crore) and employs more
than 40,000 people across offices in Asia, Africa, Europe and the Americas.
With a firm foothold in India, the Essar Group has been focusing on global expansion with
projects/investments in Europe, North America, the Caribbean, Africa, the Middle East and
South East Asia. Privately owned and professionally managed, the Group is judiciously
invested in the commodity, annuity and services businesses. Forward and backward
integration, as well as the use of state-of-the-art technology and in-house research and
innovation have made Essar Global a leading player in each of its businesses. EGL‘s abiding
philosophy is to be a low cost, high quality, technology driven group with innovative
customer offerings.
STEEL
Essar Steel is a global producer of steel with a footprint covering India, Canada, USA, the
Middle East and Asia. It is a fully integrated flat carbon steel manufacturer—from iron ore to
ready-to-market products. Essar Steel has a current capacity of 9 million tonnes per annum
(MTPA). With its aggressive expansion plans in India as well as Asia and the Americas, its
capacity will go up to 20 to 25 MTPA by 2012. Its products find wide acceptance in highly
discerning consumer sectors, such as automotive, white goods, construction, engineering and
shipbuilding.
In 2007, ESHL acquired Algoma Steel in Canada, which has a capacity of 4 MTPA, and
Minnesota Steel, which owns iron ore reserves of over 1.5 billion tonnes. The company is
building a 6MTPA pellet plan in Minnesota. In Indonesia, it operates a 400,000 TPA cold
rolling complex with a galvanising line of 150,000 TPA, making it the largest private steel
company in that country. Additionally, Essar is setting up a 2 MTPA hot strip mill in
Vietnam and a 2.5 MTPA integrated steel plant in Trinidad & Tobago.
Source: Essarnet 5
Essar Steel is the largest steel producer in western India, with a current capacity of 4.6 MTPA
at Hazira, Gujarat, and plans to increase this to 9 MTPA. The Indian operations also include
an 8 MTPA beneficiation plant at Bailadilla, Chattisgarh, and an 8 MTPA pellet complex at
Visakhapatnam. Additionally, Essar is setting up a 6 MTPA integrated steel plant in Paradip,
Orissa.
The Essar Steel complex at Hazira in Gujarat, India, houses the world‘s largest gas-based
single location sponge iron plant, with a capacity of 5.5 MTPA. The complex also houses the
steel plant and the 1.4 MTPA cold rolling mill. The steel complex has a complete
infrastructure setup, including a captive port, lime plant and oxygen plant.
Essar Steel produces highly customised products catering to a variety of product segments
and is India‘s largest exporter of flat products to the highly demanding US and European
markets, and to the growing markets of South East Asia and the Middle East. It has invested
in downstream capabilities to evolve from being a product based company to becoming a
value added service provider. It has a global network of retail steel outlets, called Steel
Hypermarts, and offers services, like cutting, slitting and blanking of steel sheets, through
specialised Steel Service Centres worldwide.
ENERGY
Essar Oil Ltd (EOL, NSE: ESSAROIL) operates a fully integrated oil company. Its assets
include developmental rights in proven exploration blocks, a 12 MTPA refinery in the west
coast of India and over 1,000 oil retail stations across India. Plans are under way to increase
its exploration acreage in various parts of the globe, expand its refinery capacity to 34 MTPA
and open 5,000 retail outlets.
The Exploration and Production (E&P) business of the company has participating interests in
several hydrocarbon blocks for exploration and production of Oil & Gas. This includes the
Ratna and R-Series blocks on Bombay High and an E&P block in Mehsana, Gujarat, which
has currently started commercial production. It has also been awarded a Coal Bed Methane
(CBM) block at Raniganj in West Bengal, and two more E&P blocks in Assam, India. The
overseas E&P assets include three onshore oil & gas blocks in Madagascar-Africa, and one
offshore block each in Vietnam and Nigeria.
EOL‘s 10.5 MTPA refinery at Vadinar in Gujarat started commercial production on May 1,
2008. It has been built with state-of-the-art technology and has the capability to produce
Source: Essarnet 6
petrol and diesel suitable for use in India as well as advanced international markets. It will
also produce LPG, Naphtha, light diesel oil, aviation turbine fuel (ATF) and kerosene. The
refinery has been designed to handle a diverse range of crude—from sweet to sour and light
to heavy. It is supported by an end-to-end infrastructure setup including SBM (Single Buoy
Mooring), crude oil tankage, water intake facilities, a captive power plant (currently 125
MW, being expanded to 1,200 MW), product jetty and dispatch facilities by both rail and
road. The refinery is strategically located in Vadinar, a natural all-weather, deep-draft port
that can accommodate very large crude carriers (VLCCs). Vadinar also receives almost 70
percent of India‘s crude imports. Post its expansion to 34 MTPA, the refinery will run at a
Nelson Complexity of 12.8. This means it will be able to refine all varieties of crude,
producing Euro 5 grade fuels. It will also be among the largest single location refineries in
the world thus leveraging on economies of scale.
EOL supplies to bulk consumers and has already opened more than 1,000 retail outlets. The
first private Indian company to enter petro retailing, EOL has product offtake and
infrastructure sharing agreements with oil PSUs, namely Bharat Petroleum Corporation Ltd
(BPCL) and Hindustan Petroleum Corporation Ltd (HPCL). It has also received the
Certificate of Type Approval, a prerequisite to supplying ATF to the Indian Armed Forces.
POWER
Essar Power operates five power plants with a combined capacity of 1,200 MW in three
locations across India. This includes two gas-based plants, of 500 MW and 515 MW
capacities, and one liquid fuel based 32 MW power plant in Hazira, a 120 MW co-generation
plant in Vadinar and a 25 MW coal-based plant in Visakhapatnam.
Work is currently under way to increase generation capacity to 6,000 MW. The company will
set up three coal-based plants of 1,200 MW each in Gujarat, Madhya Pradesh and Jharkhand,
aggregating 3,600 MW. An additional 1,200 MW (co-generation plant of equivalent capacity)
is also under development in Vadinar to supply power and steam to the expanded refinery.
With a license to enter the transmission, distribution and power trading segments, Essar
Power is now a fully integrated, end-to-end player in the Power sector. By using the latest
technology and equipment, Essar Power can generate and supply power at very competitive
price points. The company also has the capability to execute power projects for other
companies.
Source: Essarnet 7
Essar Power is exploring opportunities for new projects based on thermal, wind and hydro
energy. It is also committed to reducing emissions from its plants and earning carbon credits.
The 500 MW combined cycle power plant at Hazira is eligible for Certified Emission
Reductions (CERs) under the Kyoto Protocol‘s Clean Development Mechanism (CDM).
COMMUNICATIONS
Essar Communications operates in four business segments: Telecom, telecom retail,
telecom infrastructure and Aegis Services.
Vodafone-Essar is a joint venture of Essar Communication Holdings Ltd and the UK-
based Vodafone Group. It is one of India‘s largest cellular service companies, with a
subscriber base of over 50 million.
Essar operates integrated IT enabled services through the Aegis brand name, with a
presence in interaction services, back office services and value-added services. Aegis
has a global delivery model with 20 centers across USA and India. It employs over
20,000 employees in India and the U.S who have expertise in the Telecom, Insurance,
Banking and Healthcare domains.
Essar has launched India's first national chain of multi-brand and multi-service outlets
in the telecom retail space. The MobileStore Ltd currently runs over 1,000 ―The
MobileStore‖ outlets. Over 2,500 stores outlets are expected across 650 cities.
Essar Telecom Infrastructure is one of the largest independent telecom infrastructure
service provisioning companies in the country. It builds telecom tower infrastructure
and shares it with several telecom operators in India. It has already set up over 3,500
towers in India, with plans to build 20,000 towers.
SHIPPING & LOGISTICS
Essar Shipping Ports & Logistics Ltd (NSE: ESSARSHIP) is an end-to-end logistics
provider with sea and surface transportation services, oilfield drilling services, dry and liquid
terminals, tankage and associated pipelines. It provides complete supply chain management
services to clients in oil & gas, steel and power generation industries.
Source: Essarnet 8
The Sea Transportation business provides transportation management services for
crude oil and petroleum products, and dry bulk cargo to the global energy, steel and
power industries. With an experience of more than 220 ship years, it owns a diverse
fleet of 26 vessels, which is being expanded to 38 vessels.
The Ports & Terminals business is among India‘s largest owners and operators of
ports and terminal facilities. The operations include an oil terminal in Vadinar and
bulk terminals in Hazira and Salaya, all in the state of Gujarat. Vadinar, which is an
all-weather, deep-draft port, serves major oil refineries and independent cargo traders
in the region. The terminal has crude receiving capacity of 32 MTPA and sea-based
product dispatch capacity of 14 MTPA. The port at Hazira has a capacity to handle 8
MTPA of bulk cargo. This will be enhanced to 25 MTPA through building a shipping
channel that can berth larger vessels. The enhanced capacity will not only serve the
expansion in the Hazira steel plant, but also cater to the needs of the upcoming Essar
SEZ units. The business is also building a port, of about 20 MTPA capacity, at Salaya
comprising a bulk and liquid terminal with container handling facilities.
The Logistics business provides end-to-end logistics services – from ships to ports,
lighterage services, intra-plant logistics and dispatch of finished products. It owns
trans-shipment assets to provide lighterage support services, and onshore & offshore
logistics services. It also operates a fleet of 4,200 trucks (of which 38 are owned) to
provide inland transportation of steel and petroleum products.
Essar Oilfields Services offers onshore and offshore contract drilling, and offshore
construction services. It has invested USD 400 million in purchasing drilling
equipment and owns 12 onshore rigs, and an offshore semi-submersible rig.
CONSTRUCTION
Essar Projects is a 4,000 people strong global engineering procurement and construction
company headquartered in Dubai. It has offices in India, China and Czechoslovakia. It
provides complete construction solutions under one roof. It operates through five main
businesses:
Essar Constructions: This division has over four decades of experience in executing
projects involving industrial plants, civil & irrigation projects, laying of pipelines
Source: Essarnet 9
(both offshore and onshore), and highways and expressways. With a pipeline division
certified at ISO 9001, it has developed capabilities to undertake turnkey projects.
Essar Offshore Subsea: The marine construction expertise within Essar Oil, Essar
Shipping, Essar Projects and Essar Construction has now demerged into a single
entity namely Essar Offshore Subsea Ltd (EOSSL). The business provides
Engineering, Procurement, Construction & Installation (EPCI) services in this sector
in domestic as well as overseas markets. In the high-growth oil & gas sector, EOSSL
provides EPC services for offshore logistics support and marine construction projects.
Global Supplies: The Global Supplies team specialises in procurement, with a
presence in India, China, the Middle East and Europe. It has excellent relationships
with vendors across the globe, giving it the ability to procure materials in a timely
manner and at competitive prices.
Heavy Engineering Services: Has modern facilities for manufacturing pressure
vessels, reactors, vacuum vessels, cranes etc. This is strategically located on the
waterfront at Hazira on the west coast of India.
Project Management Consultants: An independent team of Project Management
Consultants ensures compliance to processes in project execution. The team is also
pitching for third-party projects.
The Projects business also leverages on the capabilities of Essar‘s Engineering Centres that
specialise in detailed engineering and design required for executing large projects. With a
presence in Chennai, Kolkata, Hazira and Mumbai, the centres have specialised technical
staff of over 1,000 people, focused on the steel, power and hydrocarbon sectors.
Essar Projects also owns a vast bank of sophisticated construction equipment used in large
projects.
MINING & MINERALS
Essar Mineral Resources owns iron ore and coal mines in India and overseas. It has
acquired the US based Minnesota Steel that has iron ore reserves of approximately 1.5 billion
tonnes.
10
Forex and Treasury Division: Essar Group
The Forex and Treasury Division proactively manages the currency and interest rate risks on
its foreign currency exposures on the revenue and balance sheet side through an independent
team of professionals reporting to the board.
The company‘s primary objective of risk management is to:
Reduce the effective interest cost on loans, optimise the realization on export
receivables and try to lower the cost of imports so that it could gain more on the
overall basis
The company periodically evaluates the risk on unhedged foreign exchange exposures
in order to decide upon the appropriate hedging strategies which have to be adopted
through which the company can maximise its receivables in the coming time
Objectives of forex risk management at Essar group
The primary objective of foreign exchange risk management of the company is the protection
of the underlying business from foreign exchange risks. The foremost task in determining the
most suitable system for managing the foreign exchange exposures is to clearly define the
corporate objectives in this area at the very outset.
The following objectives form the basis for strategies and technical models to manage forex
risk:
Maintain the core cover to the total exposure ratio, as per the forecasts of the market
conditions
Evaluation of the unhedged exposures on a periodical basis
Market intelligence and identification of seasonal factors
Diversification of currency mix in order to reduce the interest cost on foreign
currency borrowings
Identifying the profitable market opportunities and operate accordingly to derive
invisible gains / benefits
11
Adopting appropriate hedging strategies so as to achieve lower interest rate costs on
the foreign currency loans
Trading on non-dollar exposures to minimize the cross currency risk and try to
achieve better core rate.
Being the largest hot rolled coil exporter of the country (Essar Steel), it has a significant
percentage of its sales denominated in foreign currencies primarily in USD. Since a major
portion of company‘s forex liabilities are also dollar denominated (Essar Oil), the company
benefits from the natural hedge available to it.
Division structure
The Forex and treasury division consists of the following desks:
Currency exchange: This desk analyses the forex market and deals in foreign currency
transactions based on the limit of exposures of the trades crystallized by the group
companies
Derivatives: This desk analyses the forex market for strategizing based on derivatives
such as swaps for interest rate management and currency forwards and options for
forex risk management
Trade finance: This desk communicates with the banks to provide best deals available
for buyer‘s credit and supplier‘s credit
Commodity: This desk analyses the commodity markets and deals in commodities
such as natural gas, zinc steel etc to minimize commodity risks. Crude Oil however is
dealt by a separate team and is not a part of the forex and treasury division
Back Office: This desk handles the back office transactions supporting the other desks
The daily transactions in forex markets amount to more than $100 million. The annual
turnover for the year was $47 billion.
12
Foreign Exchange risk management
Management of foreign exchange exposures
The important features of the methodology of management of forex exposures followed by
the Essar group are:
Centralised foreign exchange operations
The centralised Foreign Exchange and Treasury Division manages the exchange and
the interest rate risks on the foreign currency and assets of various operating
companies in the group.
The fully fledged centralised Forex and Treasury division is equipped with state of the
art systems such as Bloomberg and Reuters screens and is managed by experienced
dealers under the guidance of top management to carry out the foreign exchange
operations of the various companies under the Essar Group.
Well defined foreign exchange risk management policies
The organization has well defined risk management policies and the following policy
guidelines have been set for effective risk management:
Objectives of foreign exchange exposure management
Hedging strategies to be followed for managing the currency risk
Application of various hedging tools for managing currency risk
Monitoring of Exposure
The currency-wise exposures are segregated into short, medium and long term maturities
under the capital and revenue categories and magnitude of risk is established by evaluation of
exposures periodically.
13
Classification of Forex exposures
Payables Receivables
Capital Exposures
Loan Repayment
Import of Capital Goods
Technical know-how fees
Foreign Equity Participation
External Commercial Borrowings
Convertible Bonds
Revenue Exposures
Interest payments on foreign
currency loans
Import of Raw materials
Export Bills and L/Cs
Rupee advance against exports
Evaluation of exposures
The evaluation exercise is carried out on a fortnightly basis, by comparing the benchmark
rates for various exposures with the prevailing market rates. The generated selective hedging
report is being reviewed periodically to assess the trade-off between cost of covering and
potential loss on unhedged exposures
Analysis of currencies and interest rates
An analysis of currencies and interest ratesis carried out to determine what directions they
will move in. Cyclical and other factors which affect currency and interest rate movements
are identified
The forex risk manager keeps abreast with the latest developments internationally both on
economic and political fronts. The continuous analysis of currencies will facilitate in
understanding how much risk an exposure in any particular currency can bring about. This
will help in planning in advance deciding whether to invoice in a particular currency. A
14
detailed analysis on interest rate movements will help in deciding whether to go in for a
floating rate or a fixed rate.
Exposure Management - Key areas of supervision
The top management of the company needs to review the following areas to supervise and
control the operation of the department:
1. To review the consolidated position of forex liabilities and assets and fix a core cover
to total exposures ratio, as per forecast of market conditions. This core cover to total
exposure ratio is being altered from time to time, in line with the market scenario and
perception of the market.
2. To review the benchmark rates of the forex exposures in relation to the market rates
and advice suitable risk management strategies.
3. To decide/advise adoption of selective hedging strategies relating to exposure
currencies in terms of volatility and maturity (short, medium and long term) of the
underlying exposures.
4. To review the performance and evaluate the results on the techniques employed and
to suggest alternate options for achieving better results.
5. Periodical review of interest rate exposures to suggest options for reducing the
effective interest cost on the foreign currency borrowings.
6. Periodical review of the conditions in the local and overseas markets.
Performance measurement
Benchmark rate:
Whenever a forex exposure is taken up or has arisen in the course of business, it has to be
allocated a limit for the adverse exchange rate fluctuation which it can sustain. The worst
case scenario limit acceptable to the corporate is called the benchmark rate for that exposure.
Targetted rate:
15
Target rate is the hedge adjusted benchmark rate. The target rate will be tougher if the hedge
rates are worse than the benchmark rates and easier if the hedge rates are better than the
benchmark rates.
It is very important to gauge the performance of an exposure related action. Here the
exposure budgeted rate and the exposure retirement rate is compared after recognizing profit /
loss on market operations completed during the exposure. The net result of all such
performance measurements guides the management to be aware of the potential profit / loss
on the exposures and to assess the market risk.
16
An introduction to the forex market
Factors influencing the foreign exchange markets
Balance of Payments
It is a definite indicator of the demand and supply of foreign exchange. If a country is having
favourable balance of payments position, it implies that there is more supply of foreign
currency and therefore foreign currencies will tend to be cheaper vis-à-vis domestic currency.
However, if the balance is unfavourable, it indicates a higher demand for foreign currency
and the foreign currency will firm up
Strength of the economy
The relative strength of the economy also has an effect on the demand and supply of foreign
currencies. If an economy is growing at a faster rate, it is generally in the long run expected
to have a better performance on balance of trade. In the short run, increasing economic
activity in the country may necessitate higher imports and exports may take some time to
increase.
Fiscal Policy
If the government follows an expansionary policy by having lower interest rates, it will fuel
the engine of economic growth and will result in better trade performance. However, if the
government is following an expansionary policy by resorting to high budget deficit financing
and monetizing the deficit, this will lead to high inflation in the country.
Interest rate
High interest rates make speculative capital move between countries and this affects
exchange rates. The capital is attracted provided there are no controls towards currencies
yielding high interest rates. If interest rates of domestic currency are raised this will result in
more demand for domestic currency and cause it to firm up.
Monetary Policy
It is a very effective tool for controlling money supply and is used particularly for keeping a
tab on the inflationary pressures in the economy. Its main objective is to maintain money
17
supply in the economy. If money supply is more, it will lead to inflation and the central bank,
will raise interest rates, sell government securities through open market operations raise cash
reserve requirements thud giving a signal foir a tight money supply policy.
Political Stability
Expected changes in Government due to elections or changes in incumbency in the govt may
affect exchange rates. However, whether the currency of the country concerned will become
stronger or weaker will depend on the expected policies to be pursued by the new
government
Exchange control regime
Exchange control is generally aimed at disallowing free movement of capital flows and
therefore effects exchange rates. This is done by keeping the price of the currency at an
artificial level. If a country wants to boost its exports, it will keep the value of its currency
vis-à-vis a foreign currency. This will help the exporters in realizing more units of local
currency for the same units of foreign currency and vice versa if the government decides to
follow liberal import policy
Central bank intervention
Buying or selling of foreign currency in the market by the central bank with a view to
increase the demand or supply is known as intervention. If the central bank is of the opinion
that local currency is becoming stronger thereby effecting the exports, it buys foreign
currency which increases the demand for foreign currency and will cause it to go up.
Participants in Foreign Exchange markets
Traditionally, the following participants significantly influence the volatility in Forex markets
Traders: Exporters and Importers have a requirement to make payment in currency other
than home currency. Earlier, these payments constituted 8-10% of the market but as the
markets have become prone to more fluctuations and liquid, other players have risen
significantly.
Commercial Banks: Banking Institutions have international exposure on behalf of their
clients and on their own accounts. These banks also hedge their total risk levels and form
18
major players in the market. Today, inter-bank transactions account for over 70% of all
volumes traded in forex daily.
Brokers: These are people who facilitate market hedging by forming a platform for the
meeting of various players in the market. They also enhance liquidity and efficiency of the
markets by facilitating extremely short term arbitrage
Speculators: An overlapping set of people who are willing to undertake exchange rate risk to
gain rewards. This set of people includes all the above mentioned participants and constitutes
a significant portion of the volumes (80%) in the foreign exchange market
Central Banks: These are regulatory authorities that manage the exchange rates of their
home currency and attempt to make it adhere to desirable levels. They are not regular players
but have a profound influence on the functioning of the markets.
Types of transactions
Hedging: Elimination of exchange risks to profit from the intrinsic value of the trade itself.
Inter-bank trading: It involves very short term positions normally lasting less than 5 minutes
where the objective is to profit from minimal movements in the market where the dealer
looks for a margin of 1-2 basis points. The decision making process has more to do with
simple trading (buy-sell) than with the national economies of the currency traded.
Speculation: It takes into account all the fundamentals and technical aspects of an
investment in a currency. These trades may be for a longer duration than all the other
categories of transactions
Intervention: These are regulatory transactions by the central bank of a country to defend
what they believe is the currency‘s true value. These are not regular transactions of the
market and while they exert a high degree of influence on the market, they do not account for
major volumes.
The dealing room
The deals in currencies take place through banks which amounts to transaction costs to be
paid to the bank. The bank charges this cost by an adjustment in the spot rate called the
margin. While quoting the rates to the company, the margin is pre-decided, however, given
the fluctuations in the exchange rates, these quotes change in a matter of seconds. The
19
quoted rate consists of one more adjustment termed as cash/spot which can be explained
using the figure below.
The transaction on the same day is termed CASH while for settlement in one day is
Tomorrow. The spot rate indicates the transaction that settles in 2 days. This is because when
the transaction is carried out on the spot rate, the actual settlement by payments take 2
working days to complete ie the amount is delivered on T+2 day. This amounts to an interest
of 2 days that the intermediary bank gains. The client has to be compensated for this loss of
interest of 2 days which amounts to the cash/spot adjustment while quoting the exchange rate.
A spot rate transaction in INR/USD can be illustrated using the following example:
If Essar Group has to make a payment of $1 million to XYZ Inc after 2 days, and the current
spot rate is 44.45 INR/USD, the bank,s quote can be calculated as follows
Spot: 44.45
Cash/Spot: - 0.016
Margin: +0.0025
44.4365
Since the INR/USD rates are quoted in multiples of quarter paise, the quote will be rounded
off the the next higher multiple ie 44.4375
Similarly, if Essar Group has to receive a payment from $1 million to XYZ Inc after 2 days,
and the current spot rate is 44.45 INR/USD, the bank‘s quote can be calculated as follows
CASH Tomorrow SPOT 1 month 2 month 12 month
Forwards
20
Spot: 44.45
Cash/Spot: - 0.016
Margin: -0.0025
44.4315
Since the INR/USD rates are quoted in multiples of quarter paise, the quote will be rounded
off the the next lower multiple ie 44.4300.
Since cash/spot is a reflection of the interest earned by the bank during the settlement period,
it may vary if the settlement period is longer than 2 days due to weekend or bank holiday.
This results in a cash/spot that is different for many days of the year. Therefore dealers refer
to a customised calendar that mentions the cash/spot for each day so that the future deals can
be planned.
Fundamental analysis
The forex and treasury division deals mainly in the following currencies
USD
INR
EUR
GBP
JPY
CHF
We will look into the fundamentals of these currencies
The Unites States Dollar (USD)
The United States Dollar is a part of each of the world‘s most actively traded currency pairs.
According to Bank of International Settlements, USD forms a part of 89% of daily turnover
of the forex markets. It is the world‘s primary reserve currency accounting for over 63% of
the worlds currency reserves. Also many private businesses and individuals outside the
United States hold US dollars for trade reasons. Many major commodities such as oil, gold
and silver are priced in US dollars making access to USD essential for anyone in the world
21
who wants to purchase these products. These are the major factors for considering USD as
the king currency in the forex markets. (Waring D 2008)
Many have argued that while USD is still king of the currency world, the tides are changing
and USD is in danger of losing this status. Whether or not his happens, to what extent it
happens, and if it does happen how quickly or slowly it happens, is of huge importance to
currency traders. About $4.7 trillion is held as reserves by central banks around the world.
This is an enormous amount of dollars being held by central banks outside of the United
States, so forex traders watch closely anything that could show a decrease in the appetite of
central banks for US dollars. (Waring D 2008)
US has run large current account deficit for years. The government has also run large budget
deficits. This makes the debt of United States less attractive and has the potential to decrease
other countries‘ willingness to fund these activities by holding US dollar denominated debt as
reserves. Federal Reserve‘s increase of money supply to hold the interest low has been the
major factor in dollar‘s decline of over 35% in the last several years.
As the value of currency falls, countries around the world that hold that currency see wealth
evaporate due to falling value of their reserves. This potentially means a reduced appetite for
US dollars and a decrease in demand from central banks and a decrease in value of the
currency, all else being equal. Another factor which is considered as reason why US dollar
may lose its status as king of currency world is because of the rise in prominence of EURO
and its relative strength in comparison to the US dollar. While EURO still comes nowhere
close to the US dollar‘s dominance as the world‘s reserve currency, it is slowly gaining
ground on the dollar, an important point traders will be watching.
Economic indicators that influence the USD are listed as follows:
Non Farm Payrolls
FOMC Releases
Retail Sales
ISM Manufacturing
Inflation
Producer Price Index
The Trade Balance
Existing Home Sales
22
Foreign Purchases of US Treasuries (TIC Data)
Source: Fxwords
Great Britain Pound (GBP)
Although the United Kingdom is a member of the European Union, it has not yet adopted the
Euro as its currency, so it is not part of the European Monetary Union. There are a number of
reasons for this, but perhaps most famous is the country's forced withdrawal from the
Exchange Rate Mechanism, the precursor to the Euro. After initially trying to adhere to the
qualifications set forth for participation in the European Monetary Union, the value of the
pound dropped below the lower band, forcing the country out of what would become the
European Monetary Union. Many feel that the UK will eventually adopt the Euro, and
therefore any such talk can have an affect on the pound.
The former Prime Minister of the United Kingdom laid out 5 broad economic tests that must
be passed, before the UK would consider adopting the Euro in addition to requirements of
Maastricht treaty
1. Are business cycles and economic structures compatible so that the UK and others could
live comfortable with Euro interst rates on a permanent basis?
2. If problems emerge is there sufficient flexibility to deal with them?
3. Would joining the EMU create better conditions for firms making long-term decisions to
invest in britain.
4. What impact would entry into the EMU have on the competitive position of the UK's
financial services industry, particularly the city's wholesale markets?
5. In summary, will joining the EU promote higher growth, stability, and a lasting increase in
jobs?
While the GBP/USD is a very active currency, the Pound is also very active in the crosses,
and as the EU is their largest trading partner, traders pay particular attention to movements in
the EUR/GBP for fundamental ques on the currency.
Trading indicators for GBP include:
British Current Account
23
British Trade Balance
Non EU Trade Balance UK
British Visible Trade Balance
British Gross Domestic Product (GDP)
NIESR GDP Estimate – UK
Consumer Price Index (CPI) – UK
BOE Rate Decision
Minutes of BOE Meeting
Source: Fxwords
EURO (EUR)
The Euro is now the official currency of 15 of the 27 member states in the European Union
(EU), which makes it the currency used by over 320 Million people.
With the Maastricht treaty, member countries moved from a simple economic cooperation, to
the much grander ambition of political integration between member nations. It was here that
plans for a single currency to be used among member nations was introduced, and therefore
here that the basic fundamentals of the Euro were laid out.
There were three steps outlined in the Maastricht treaty that had to be completed before the
currency could be released which were:
1. Free circulation of capital among member countries.
2. The second, and most important step for traders to understand, was the coordination
of economic policies. Once the Euro was introduced, each of the member countries
would be bound by the monetary policy as set by the European Central Bank. With
this in mind, you could not have countries with extremely different levels of inflation
and interest rates, replace their currency with the Euro, without undermining the
credibility and fundamentals of the currency. To make the currency credible, and to
make its introduction as smooth as possible, member countries were required to keep
inflation, interest rates, and debt below certain levels. Lastly, they were also required
to maintain an exchange rate that was basically a banded peg, allowing their currency
to fluctuate only within a narrow band.
24
3. In 1999 the European Central Bank was established and eleven countries began to use
the Euro in electronic format only. The countries were Spain, Portugal, Italy,
Belgium, the Netherlands, Luxembourg, France, Germany, Austria, Ireland and
Finland.
These countries formed what is known as the European Monetary Union, which is comprised
of countries who are members of the European Union, and use the Euro as their currency.
Greece, the United Kingdom, Sweden, and Denmark (the other members of the European
Union at the time) remained outside the European monetary Union for different reasons.
The launch of the Euro was the largest monetary changeover ever, and was not guaranteed
success since getting a dozen countries, which varied widely in their economic and political
clout, to give up control over their own monetary policy and switch to a more centralized
monetary system, was no easy task. (Waring D 2008)
As the EMU nations are still primarily independent from a fiscal policy standpoint, they do
still have this in their toolbox. The issue here however, is that one of the ongoing
requirements established in the Maastricht treaty for countries which join the EMU, is that
member country's budget deficits must be less than 3% of GDP. So here again member
nations are somewhat limited in what they can do to help their own economies, should it
falter. From a fundamental standpoint, this is the most important thing to understand as it is
here that a true test of the Euro, will eventually come. (Waring D 2008)
Since the original 12 countries replaced their currencies with the Euro as their paper currency
in January of 2002, 3 more EU member nations have joined the EMU, and 5 other countries
outside the EU have adopted the Euro as their official currency. As a result of its success and
the large combined economies that the currency represent, many feel that the Euro will one
day replace the US Dollar as the premiere currency of the world. (Waring D 2008)
Trade indicators
There are literally thousands of economic numbers released in the Eurozone however, those
that affect the current account (trade flows) or interest rates (capital flows) are going to have
the greatest potential to move the currency
Euro-zone Trade Balance
German Current Account
25
German Trade Balance
French Current Account
Euro-zone Gross Domestic Product
ZEW Survey
Euro-zone Consumer Price Index (CPI) and Core
Euro-zone Retail Trade (Sales)
German Consumer Price Index (CPI) & Core
German Six States CPI
French Consumer Price Index (CPI)
ECB Rate Announcement and Press Conference
ECB President Speaks
ECB Council Member Speaks
ECB Chief Economist Speaks
EU Finance Ministers Meet
Source: Fxwords
The Japanese Yen (JPY)
The Japanese yen is the third most traded currency in the foreign exchange market after USD
and Euro. Introduced in 1872, the Yen lost most of its value during and after World War II.
After a period of instability, in 1949 the value of Yen was fixed at ¥360 per 1$ through a
United States plan, which was part of Bretton Woods system, to stabilise prices in the Japan
economy. That exchange rate was maintained until 1971 when the United States abandoned
the gold standard and imposed 10% surcharge on imports, setting in motion changes that
eventually led to floating exchange rates in 1973. (Waring D 2008)
Japanese Govenrnment Intervention
Japan, unlike the United States, has very few natural resources and the Japanese economy
relies heavily on exports. In the 1970s, Japanese government and business people were very
concerned that a rise in the value of the yen would hurt the export growth by making the
Japanese products less competitive in the international markets and would damage the
industrial base. The government therefore continued to intervene heavily in the foreign
exchange markets even after the decision to float the Yen in 1973. Despite intervention, Yen
continued to climb to a peak of 271¥ per 1$ before the impact of oil crisis was felt.
26
The Rise of Yen
In 1985, Finance officials from major nations signed the Plaza Accord, affirming the dollar
was overvalued. This agreement led to a rapid rise in the value of Yen from its average of
¥239 per dollar to a peak of ¥128 per dollar in 1988. In the decades following World War II,
Japanese population had one of the highest saving rates in the world. This led to rise in
investment in the property markets leading to a bubble that led to one of the most famous
asset price bubble burst derailing the Japanese economy in the 1990s. The effects of this
catastrophe on the Yen are still being felt today.
The economic downturn
In 1989, Bank of Japan began to raise interest rates hoping to control the astronomically high
stock and real estate prices, the markets reacted drastically resulting in a crash. This fall
triggered a chain reaction which caused the financial position of the banks to deteriorate
rapidly. Large Japanese institutions such as banks cooperate with one another and hence hold
large amounts of each others stocks. As the stocks tumbled, so did the banks capital position
putting further pressure on the stability of the banking system. A slowdown in the economy
and real estate bubble burst resulted in severe deterioration in quality of loans and hence the
financial system.
The Yen today
The reforms aimed at returning the stability of the Japanese financial system are still ongoing
today and these financial and structural reforms are closely watched by traders while
determining the fundamental direction of the Japanese economy. The losses incurred by
consumers have resulted in lowered consumer spending leading to deflation in the economy.
Bank of Japan had to resort to interest rate cuts all the way from over 8% to 0% in 1999 and
is still by far the lowest rate of any major economies in the world. (Waring D 2008)
To keep the Yen from rising to the point where it would hurt the Japanese economy, the Bank
of Japan is notorious for intervening in the foreign exchange market which can send the value
of Yen plummeting.
The history of intervention shows intervention taking place near the levels of 100¥ per dollar.
As Bank of Japan has been very effective with intervention, it has reached a point where now
all they need to do is talk of intervention to trigger downslide of the Yen. (Waring D 2008)
27
Econimic indicators of Yen include the following:
Japanese Trade Balance
Merchandise Trade Balance Monthly
Japanese Gross Domestic Product (GDP)
Japanese Tankan Survey - Report also covers Capex, Manufacturer and Non-
Manufacturer Conditions and Outlook
Tertiary Industry Index
Leading Economic Index
National Consumer Price Index (CPI)
Domestic Corporate Goods Price Index (DCGI)
Japanese Monthy Retail Trade
BoJ Monetary Policy Meeting and Announcement
BOJ Monetary Policy Meeting Minutes
BoJ Monetary Policy Monthly Report
Japanese Employment Situation - Jobless Rate, Job-to-Application Ratio, Workers
Spending, Household Spending and Personal Income
Source: Fxwords
Swiss Franc (CHF)
Switzerland is one of the richest countries in the world, and while its economic policies and
practices largely conform with EU standards, the country's population rejected accession
negotiations with the EU in March of 2001. So, at least for the foreseeable future, the Swiss
Franc is expected to remain one of the world's most actively traded currencies, with two
dominating features that are important to us as forex traders. (Waring D 2008)
Although this status has started to wane somewhat in recent years, the Swiss Franc has
historically been considered one of the world's primary safe haven currencies, which means
that money flows into the Swiss Franc during times of economic or geopolitical uncertainty.
The primary reasons why this is the case are:
28
1. The country's ability to remain out of Global Conflicts, a reputation it solidified by
remaining neutral during both World Wars.
2. Its economic stability and relatively low inflation rates.
3. The fact that up until recently the currency was 40% backed by gold.
4. Its reputation for high quality financial institutions and banking secrecy.
As you can see from this chart, traders who anticipated the Swiss Franc would strengthen
as a result of its safe haven status could have participated in the 1251 pip move lower in
USD/CHF, in the 10 days following the September 11th 2001 attacks.
As another example of the Swiss Franc displaying its safe haven tendencies, traders who
anticipated that the Swiss Franc would strengthen as a result of the US Invasion of Iraq, could
have participated in another 1200+ pip move in the USD/CHF in the 2 months following the
invasion.
29
In 2005 the Swiss government sold the nations vast gold inventory, and as a result the
currency is no longer backed by gold. Some argue that because of this the Swiss Franc has
lost much of its safe haven status, something that there will surely be more tests of in the
years to come.
The second thing that it is important about the Swiss Franc, is its strong correlation with the
Euro. As the Swiss Franc is quoted on the opposing side of the Dollar when compared to the
Euro, this means that the USD/CHF currency pair has a strong negative correlation with the
EUR/USD currency pair, as you can see from this chart:
30
As you can see here a chart of the two currency pairs shows the strong negative correlation of
over 90% between the two currency pairs, resulting from the strong economic ties between
Switzerland and the European Union.
The first reason that it is important for traders to understand this strong negative correlation,
is so that they can take it into account when considering trades in both currency pairs. As the
two currency pairs have such a high negative correlation, there is a very good possibility that
a trader's technical analysis will show a buy signal in the EUR/USD, while at the same time
showing a sell signal USD/CHF, or vice versa.(Waring D 2008)
As the Swiss Franc is no where near as liquid as the Euro, on an intraday basis it is important
to be aware that this negative correlation can breakdown some what. Lastly, should the Swiss
political and/or economic environment (especially monetary policy) start to substantially
diverge from that of the Eurozone, you could see a breakdown of this negative correlation on
the longer timeframes as well. (Waring D 2008)
Major trading indicators for Swiss Franc include the following:
Trade Balance
Gross Domestic Product
UBS consumption indicator
Consumer Price Index (CPI) – Switzerland
Adjusted Retail Sales- Switzerland
SNB Three-Month Target Libor Rate
SNB Quarterly Monetary Policy Assessment
SNB Chief Economist Speaks
Source: Fxwords
Indian Rupee (INR)
Background
Officially, the Indian rupee has a market determined exchange rate. However, the RBI trades
actively in the USD/INR currency market to impact effective exchange rates. Thus, the
currency regime in place for the Indian rupee with respect to the US dollar is a de facto
controlled exchange rate.
31
The exchange rate has varied in the past one year from a high of 1USD = 39 INR to the
recent lows of 1USD = 47 INR
Other rates such as the EUR/INR and INR/JPY have volatilities that are typical of floating
exchange rates. It should be noted, however, that unlike China, successive administrations
(through RBI, the central bank) have not followed a policy of pegging the INR to a specific
foreign currency at a particular exchange rate. RBI intervention in currency markets is solely
to deliver low volatility in the exchange rates, and not to take a view on the rate or direction
of the Indian rupee in relation to other currencies.
RBI also exercises a system of capital controls in addition to the intervention (through active
trading) in the currency markets. On the current account, there are no currency conversion
restrictions hindering buying or selling foreign exchange (though trade barriers do exist). On
the capital account, foreign institutional investors have convertibility to bring money in and
out of the country and buy securities (subject to certain quantitative restrictions). Local firms
are able to take capital out of the country in order to expand globally. But local households
are restricted in their ability to do global diversification. However, owing to an enormous
expansion of the current account and the capital account, India is increasingly moving
towards de facto full convertibility.
Key Economic Indicators
Consumer Price Index: The CPI is used to measure inflation by computing changes in
prices of products consumed by households. In India, prices are susceptible to rapid
increases. Consumers are not immune to these price hikes, as wholesalers have a strong
ability to pass the raise in price along. (Hegde et al 2008)
32
Gross Domestic Product: The Central Statistical Office of India recently started using data
reporting standards of the International Monetary Fund (IMF), reporting the GDP in early
quarters of the late 1990s. The GDP measures the total production and consumption of goods
and services in India. It is necessary to look at changes in real GDP growth in India's primary
industries, which include agriculture, manufacturing, trade, hotels, transport and
communication. (Hegde et al 2008)
Industrial Production: The index of Industrial Production (IIP) is a monthly composite of
the value of industrial production in various sectors of industrial sectors of the economy. The
current IIP includes the mining, manufacturing and electricity industries, each with different
weights. The mining and utility industries in India are especially worth watching. (Hegde et
al 2008)
Technical Analysis
33
It is a method of evaluating securities by analyzing statistics generated by market activity,
such as past prices and volume. Technical analysts do not attempt to measure a security's
intrinsic value, but instead use charts and other tools to identify patterns that can suggest
future activity. Technical analysts believe that the historical performance of stocks and
markets are indications of future performance. (Janssen et al 2008)
Most technical analysts rely on chart patterns and some combination of technical indicators
and oscillators. Technical analysis is based on three assumptions
1. The market discounts itself
2. Price move in trends
3. History tends to repeat itself
1. The Market Discounts Everything
A major criticism of technical analysis is that it only considers price movement, ignoring the
fundamental factors of the company. Technical analysts believe that the company's
fundamentals, along with broader economic factors and market psychology, are all priced
into the stock, removing the need to actually consider these factors separately. This only
leaves the analysis of price movement, which technical theory views as a product of the
supply and demand for a particular stock in the market. (Janssen et al 2008)
2. Price Moves in Trends
In technical analysis, price movements are believed to follow trends. This means that after a
trend has been established, the future price movement is more likely to be in the same
direction as the trend than to be against it. Most technical trading strategies are based on this
assumption. (Janssen et al 2008)
3. History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself, mainly in
terms of price movement. The repetitive nature of price movements is attributed to market
psychology; in other words, market participants tend to provide a consistent reaction to
similar market stimuli over time. (Janssen et al 2008)
Although many of the charts for technical analysis have been used for more than 100 years,
they are still believed to be relevant because they illustrate patterns in price movements that
34
often repeat themselves. Since the price movements are based on demand and supply,
technical analysis from patterns and charts can be used for price fluctuations of any security
such as currency rates, stocks, commodities etc.
Technical analysis is essentially used to determine the levels from which the prices are
estimated to go up ie the support levels and the levels from which prices are estimated to fall
ie the resistance levels . Since technical analysis is a vast subject, I would like to highlight
some of the most important and commonly used chart types and patterns at the ESSAR group
in dealing with foreign currency risks.
1. Trend: It is a general direction in which a security or market is headed ie uptrend
downtrend or sideways. Trends are classified as short term medium term and long
term as shown in the figure below
2. Fibonacci retracements: The Fibonacci series and the golden ratio have been
observed in various aspects of nature. The support and resistance levels are also
predicted based on the golden ratio and the recent top and bottom levels of the
security as prices are believed to follow these levels as shown in the figure below
35
Fibonacci retracement is a very popular tool used by many technical traders to help
identify strategic places for transactions to be placed, target prices or stop losses. The
notion of retracement is used in many indicators such as Tirone levels, Gartley
patterns, Elliott Wave theory and more.
3. Head and Shoulder pattern: A technical analysis term used to describe a chart
formation in which a stock's price:
a. Rises to a peak and subsequently declines.
b. Then, the price rises above the former peak and again declines.
c. And finally, rises again, but not to the second peak, and declines once more.
Head and shoulder patterns indicate a reversal of upward trend of the prices and hence
form an important part of market movements and bearish or bullish sentiments
36
4. Relative Strength Index(RSI): It technical momentum indicator that compares the
magnitude of recent gains to recent losses in an attempt to determine overbought and
oversold conditions of an asset. It is calculated using the following formula:
RSI = 100 -
100
______
1 + RS
RS = Average of x days' up closes / Average of x days' down closes
The chart below shows the movement of GBP and the RSI levels. As you can see, the RSI
ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70
level, meaning that it may be getting overvalued and is a good candidate for a pullback.
Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold
and therefore likely to become undervalued. (Janssen et al 2008)
37
Source: Bloomberg
Criticism
Much of the criticism of technical analysis has its roots in academic theory - specifically the
efficient market hypothesis (EMH). This theory says that the market's price is always the
correct one - any past trading information is already reflected in the price of the stock and,
therefore, any analysis to find undervalued securities is useless.(Investopedia)
Although technical analysis proves to be effective in determining the support and resistance
levels based on supply and demand, it cannot be flawless. This is because the support and
resistance levels predicted could be self-fulfilling prophecies. When the price of the security
reaches the support level estimated from technical analysis, traders would tend to buy at this
point. An increase in demand would automatically raise the price from the support level
thereby rendering the estimations true. Similarly, prices near estimated resistance levels
would encourage selling thereby fulfilling the prediction. It is however next to impossible to
know whether the support and resistance levels turn out to be correct due to its nature or due
to its self fulfilling mechanism.
38
Tools available to Essar Group in the forex markets
Derivatives such as forwards and options are used for hedging of risks due to currency
fluctuations. While forwards are relatively simple instruments to deal with, using options can
involve lot of parameters to be considered and high level of expertise and understanding to
deal with complexities.
An Example:
Essar group buys an out of money call option on USD against INR to hedge an amount to be
paid in USD in 3 months. At the same time it sells an out of the money put option to reduce
the premium costs. The pay-off diagram is as shown below:
Thus the company benefits from the hedge if USD appreciates thereby compensating for the
loss in payment. Owing to the spread, the company does not lose on the hedge position for
depreciation on the USD upto the strike price of the put option while it gains from the
movement in the payment to be made in 3 months. If USD depreciates and is believed to go
below the strike price of put, the company can cancel the hedge by taking the opposite
position.
However there are parameters other than the exchange rate that may affect the returns as the
price of the options depend on them as well. (Hull J 2002) These are:
Delta: It is the change in price of an option with respect to the change in exchange rate. This
can vary and hence needs to be hedged by buying or selling the currency.
39
Vega: This is the change in option price with respect to change in volatility. Options trade on
premiums or discounts leading to a different volatility than the one calculated by black
scholes. This is known as implied volatility
Gamma: This can be considered as second derivative of delta. It is the change in option price
with respect to a change in delta.
Theta: It is a measure of time decay of an option and is calculated as the change in option
price with respect to time.
Rho: It measures the theoretical option price changes due to interest rate shifts
Options therefore require an in depth understanding and constant monitoring to avoid
unexpected losses from the hedged position.
Other tools such as interest rate swaps have been discussed in the next section.
40
Interest rate risk management
Interest Rate Risk is the risk which is attached to the relative value of an interest bearing asset
which may go fluctuate negatively due to the rise in the interest rates. It is the adverse change
in the earnings of an asset or investment. The main causes of interest rate risk are the
difference in credit spreads between assets and liabilities, difference between the maturity
periods of assets and liabilities, inflation etc. It is a kind of systematic risk which needs to be
managed by the organization.
Measuring the Interest Rate risk
Interest rate risk analysis is almost always based on simulating movements in one or more
yield curves. There are a number of standard calculations for measuring the impact of
changing interest rates on a portfolio consisting of various assets and liabilities. The most
common techniques include:
Mark to market, calculating the net market value of the assets and liabilities,
sometimes called the "market value of portfolio equity"
Calculating the Value at Risk of the portfolio.
Calculating the multi period cash flow or financial accrual income and expense for N
periods
Measuring the probability distribution of cash flows and financial accrual income
over time.
Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by
classifying each asset and liability by the timing of interest rate reset or maturity,
whichever comes first.
Meaning: Interest Rate Risk Management
One of the most important functions of the modern day corporates is to reduce and control
various financial exposures related to the underlying assets of the firm with the application of
effective risk management techniques.
The Forex and Treasury division of Essar group has been successfully implementing the risk
management techniques to minimise different financial exposures attached to the holding
companies of the group.
41
The group follows strict plans and procedures to manage interest rate exposures of its
companies. Here we can focus on the general risk management methodology in order to
understand the it‘s relation with interest rate risk management undertaken by the Forex and
Treasury division of Essar Group:
Meaning of the term Risk Management:
Risk management is a structured approach to managing uncertainty related to a threat,
through a sequence of human activities including: risk assessment, strategies development to
manage it, and mitigation of risk using managerial resources.
The strategies include transferring the risk to another party, avoiding the risk, reducing the
negative effect of the risk, and accepting some or all of the consequences of a particular risk.
Steps in the risk management process:
Step 1: Establish the context:
Establishing the context involves
1. Identification of risk in a selected domain of interest
2. Planning the remainder of the process.
3. Mapping out the following:
The social scope of risk management
The identity and objectives of stakeholders
The basis upon which risks will be evaluated, constraints.
4. Defining a framework for the activity and an agenda for identification.
5. Developing an analysis of risks involved in the process.
6. Mitigation of risks using available technological, human and organizational resources.
Step 2: Create a risk management plan:
42
Selection of appropriate controls or counter measures to measure each risk is very important
in risk management process. Risk mitigation needs to be approved by the appropriate level of
management. At this level, risk management plan is formulated.
Step 3: Implementation:
Following all of the planned methods by risk management team identified by the appropriate
level of management for mitigating the effect of the risks.
Step 4: Review and evaluation of the plan:
Initial risk management plans will never be perfect. Practice, experience, and actual loss
results will necessitate changes in the plan and contribute information to allow possible
different decisions to be made in dealing with the risks being faced.
Risk analysis results and management plans should be updated periodically. There are two
primary reasons for this:
1. To evaluate whether the previously selected security controls are still applicable and
effective, and
2. To evaluate the possible risk level changes in the business environment. For example,
information risks are a good example of rapidly changing business environment.
Risk Management Matrix
Source: TBC
43
Interest Rate Risk management: Key areas of supervision
The following are the key areas of supervision and control of the Forex department:
Consolidated review of forex liabilities and assets and fix a cover to total exposures
ratio, as per the forecast of market conditions. This core cover and total exposure ratio
is being altered from time to time, in line with the market scenario and perception of
the market.
To review the reference rates of the forex exposures in relation to the market interest
rates and advice suitable interest rate hedging strategies.
To decide / advise adoption of selective hedging strategies relating to exposure
currencies in terms of volatility and maturity (short term, medium term and long term)
of underlying exposures.
To review the performance and evaluate the results on the techniques employed and
to suggest alternate options for achieving better results.
To reduce cost on rupee liabilities by using derivative products and by way of
refinancing / substation of loans / currency diversifications.
Periodical review of conditions in the local and overseas markets.
To invest temporary surplus funds of operating companies and holding companies.
Availing buyers‘ credit and suppliers‘ credit to reduce the financing cost of imports
both on the capital expenditures and operating expenditures.
Availing foreign currency export financing for both pre-shipment and post-shipment
to reduce the financing cost.
To reduce non interest expenses wherever possible.
To translate the potential market opportunities into gains.
A systematic approach to Interest Rate Risk Management: Essar Group
Forex and Treasury department has a systematic approach to tackle the interest rate risk. It
classifies the risk in the following manner:
A] Interest rate risk management on long term foreign currency liabilities (borrowings):
44
The department constantly monitors the interest rate movements of major currencies in the
overseas markets to suggest appropriate hedging tools for the purpose of liability
management.
The currency mix in the portfolio is periodically reviewed and the potential profitability
opportunities are looked into.
Diversification of currencies through currency swap route is done where necessary
The department is in constant touch with the banks and financial institutions on behalf of the
group companies to about the forex limits to take necessary derivative transactions.
B] Interest rate risk management on short term foreign currency liabilities (borrowings):
Arrangement for buyers‘ credit / suppliers‘ credit for import of capital goods at
competitive prices (interest rates) with offshore branches of Indian banks.
Availing short term foreign currency loans to reduce the interest cost on working
capital / long term liabilities.
Structuring arbitrage transactions to reduce cost of credit (interest cost) on imports.
C] Interest rate risk management on investments:
To follow an investment policy that ensures deployement of surplus funds of the
operating companies / holding companies of the group.
Maintaining high yeild on investment (interest income).
Ensuring risk free status of the deployed of funds.
Placement of long term debts in the market.
Maintaining market intelligence and identifying new investor banks and favourable
prices through negotiation.
Interest Rate Risk Management for domestic borrowings
The Forex And Treasury department gives valuable adviec to the group companies of
Essar Group on the domestic money market trends and guide them to fix floating
interest rate deals for short term tenors. Clear and effective analysis on the interest
rate scenario and its meaningful forecasting done by the department helps the group
companies to borrow domestic funds efficiently.
45
The interest rate risk forecasting done by the forex group helps the group companies
to frame interest rate swaps against rupee debts of these companies to mitigate the
interest rate risk arising out of their asset-liability mismatches.
The Forex and treasury division is also responsible for maintaining and nurturing
better working relations with the identified external contacts of Essar Group.
Major Interest Rate Risk Management tools available for Forex and Treasury Division,
Essar Group
Derivatives as tools for Interest Rate Risk management
The company has been able to consistently reduce the interest costs on its forex exposures
and it has been successfully mitigating the interest rate risks by constantly monitoring interest
rate movements of major currencies in the overseas markets. It diversifies the currency mix
with the help of currency swap and enters into interest rate swaps against foreign currency
liabilities to contain and minimise interest rate risk.
Interest rate swaps
It is done by swapping only the interest rates on notional principals (cash flows) between the
parties in the same currency. The principal amount is notional because there is no need to
exchange actual amounts of principal in a single currency transaction: there is no foreign
exchange component to be taken account of. Equally, however, a notional amount of
principal is required in order to compute the actual cash amounts that will be periodically
exchanged.
Under the most common form of interest rate swap, a series of payments calculated by
applying a fixed rate of interest to a notional principal amount is exchanged for a stream of
payments similarly calculated but using a floating rate of interest. This is a fixed-for floating
interest rate swap. Alternatively, both series of cash flows to be exchanged could be
calculated using floating rates of interest but floating rates that are based upon different
underlying indices. Examples might be Libor and commercial paper or Treasury bills and
Libor and this form of interest rate swap is known as a basis or money market swap.
The interest rate swap is a very efficient instrument. It can be constructed at extremely low
cost and is probably less expensive than taking out a new fixed rate loan and using the
46
proceeds to buy an offsetting floating rate security paying LIBOR. Technically this would
accomplish the same thing but it would surely be much more costly and time consuming to
set up.
Users and Uses of Interest Rate Swaps
Interest rate swaps are used by a wide range of commercial banks, investment banks, non-
financial operating companies, insurance companies, mortgage companies, investment
vehicles and trusts, government agencies and sovereign states for one or more of the
following reasons:
1. To obtain lower cost funding
2. To hedge interest rate exposure.
3. To obtain higher yielding investment assets.
4. To create types of investment asset not otherwise obtainable.
5. To implement overall asset or liability management strategies.
6. To take speculative positions in relation to future movements in interest rates.
Currency Swaps:
It is a foreign exchange agreement between two parties to exchange a given amount of one
currency for another and, after a specified period of time, to give back the original amounts
swapped.(Hull J 2002)
Essar Group. undertakes various hedging tools to minimize its exposures to forex market.
One of these important tools is the CURRENCY SWAPS. It helps the company to minimize
its interest cost of borrowed funds. The importance of Currency Swaps can be understood by
the following example.
The USD /INR Currency Swap can be undertaken by Essar Steel Limited against the
underlying Rupee term loan. The USD / INR Currency Swap will be for a period of 7 years,
which would correspond to the cash flows on the Rupee term loan. The swap exchange rate
will be fixed on the date of the swap transaction. This rate will be the market rate. By
undertaking the currency swap the company assumes the foreign exchange risk equivalent to
a foreign currency risk. (Janssen et al 2008)
47
Settlement under the Currency Swap:
The company pays USD fixed for 7 years at 6.25 %, settlement quarterly,
corresponding to the loan interest payment terms
The company receives fixed rupee for 7 years at 14.75 %, settlement quarterly,
corresponding to the loan interest payments terms
Interest difference in favour of the company will be - (14.75 – 6.25) % = 8.50 %
Net interest cost to the company:
Interest cost on rupee term loan 1 6.00 % p.a.
Interest difference derived via currency swap 8.50 % p.a.
--------------------
Net interest cost 7.50 % p.a.
Swaptions:
These are options to buy or sell a swap that will become operative at the expiry of the
options. Thus swaption is an option on forward swap. Rather then having calls and puts, the
swaptions market has receiver‘s swaptions and payer‘s swaptions. A receiver‘s swaption is an
option to receive fixed and pay floating. A payer‘s swaption is an option to pay fixed and
receive floating. (Hull J 2002)
Hedging tools used by ESSAR Group for IRR reduction
Corporates who have interest rate risk use instruments such as interest rate caps, collars,
floors for hedging the risk. These are also used by some fund managers to fund their medium
term projects with short term as they can hedge their exposure and thus gain confidence that
even substantial volatility in the interest rates will have no effect on the profitability of their
company.
48
Interest rate caps
Generally, ESSAR undertakes an agreement with the bank for floating rate whereby the bank
in return for premium undertakes to bear the extra cost on account of interest rate going up
beyond the agreed rate during the agreed period. This instrument therefore caps the interest
rate of ESSAR as the rise above the cap will be borne by the bank that has sold the cap.
Interest rate floors
Interest rate floor is an agreement under which a bank and ESSAR agree on a floating basis
that the bank for a premium will set floor on the interest rate earned by the company. Suppose
ESSAR is funding its 9% assets by borrowing on floating basis. The assets become a loss
making proposition if the floating rate goes beyond 9%. In order to avoid this, the company
can buy a floor by paying a premium which will ensure a return of 9% on the assets. If the
interest rises above 9%, ESSAR will enjoy the extra interest.
Interest rate collars
If the company takes a view that the interest rates will remain in a range, it can combine a cap
and a floor to reduce the premium as well as cover the risk of interest rates going high. If
ESSAR is of the view that the interest rates will remain between 7% and 9%, it can buy a cap
at 9% and sell a floor at 7%. The company could lose the benefit if interest rate falls below
7% but foregoing this, it the net premium is very low. Thus it actually protects the upside risk
at a very low cost.
Interest cost forecast on Forex borrowings
Taking into consideration the present domestic interest rates, the effective interest cost on
foreign currency borrowings (inclusive of nominal interest cost, transaction cost and
translation losses at the end of each financial year) would still be lower than the comparable
cost of rupee debt. This assumption will hold well as long as domestic long term interest rates
remain at or slightly below the existing levels. The possibility of a sharp drop in the long term
interest rates can be ruled out in the next 2 to 3 years period, in view of high fiscal deficit and
current rising inflation in the economy.
49
Suggested strategies for conversion of Rupee debts into long term Forex borrowings:
High interest cost on existing rupee debts of the company calls for conversion of these into
long term forex borrowings. A shift in the maturity period can facilitate this conversion. Debt
with institutions with near end maturity profile can be swapped into 7 year bullet loan or a
balloon loan payment. It will reduce the interest cost substantially. The pre-payment premium
payable to the concerned institution / s arising out of swapping of debts with them can be
conveniently included in the foreign currency loan amount to avoid any immediate cash
outflows.
An example to understand the concept of interest cost reduction:
Targetted interest cost on rupee loans vs. Estimated cost on proposed us dollar loans:
Targeted interest cost on current loan portfolio 8.25 to 8.75 %
Estimated interest cost on the proposed US Dollar loans
(Average maturity period of 5 years) % per annum
US Dollar LIBOR (Average) 4.00
Credit spread 2.50
Arrangement & other fees 1.00
Withholding Tax 0.75
The cost of raising dollar loans would be very high; the best option available for the
company is to swap the INR liabilities into Dollar liabilities by using the medium of
USD / INR currency swap for a tenor not exceeding 2 years.
The US Dollar liabilities of the company (including the currency swap liabilities) are
insulated from the USD / INR currency risk as the net revenue receivables provides
the natural hedge. Variations in domestic steel prices to a large extent track the
domestic currency movements. The Time Lag effect (GAP period) can be effectively
managed by hedging such risks in the market.
50
Strategies of Interest Cost reduction: Essar Group
Long term Rupee and Foreign currency loans:
The Forex and Treasury department follows the following policies and procedures to reduce
the Interest cost on long term rupee and foreign Currency loans.
1) Following pre-decided policies in selection of derivative transactions.
Short term tenor to avoid Tenor risk.
Low risk / High reward profile with conservative approach
Product segmentation to spread product risk.
Sensitivity analysis to measure the potential risk attached with derivative transactions.
Aggregate of derivative transactions outstanding at any point of time not to exceed
initially @ 25 % of the outstanding loans.
Leveraged transactions always multiply the risk component and must be avoided.
Currency swap transactions must be protected wherever possible with the option
embedded structures.
2) Potential exposure and risk quantification.
Carry out sensitivity analysis.
Potential exposure must not be exceed 25 % of company‘s interest liabilities in one
financial year.
Constantly monitoring the market for any adverse movements.
Benefits derived / potential upside under one type of transactions can be used to
neutralise any downside risks under other type of transactions.
3) Sensitivity analysis and application.
Sensitivity analysis is to be carried out to suggest the timing of the derivative
transactions and to measure / quantify the risks at the pre-transaction stage.
Whenever possible the derivative transactions are to be structured with the respective
term loan lenders to provide sufficient flexibility to restructure the terms of the loan in
adverse situations.
Types of derivative transactions to be undertaken are principal only swaps, cross
currency swaps, interest rate swaps with caps, floors and knock out options, coupon
only swaps and foreign currency options.
51
Foreign currency and rupee options are to be used to maximise export realisation on
dollar and non dollar receivables.
Currency and interest rate swaps to be used to interest rate cost of the company.
A. Short term Rupee and Foreign currency loans:
The company is undertaking short term / long term interest rate swaps on a selective
basis to reduce the fixed interest rate cost on the loans to the extent possible.
The exposures of foreign currency working capital are fully hedged to crystallise the
interest cost on the short term loans.
The net receivables on the revenue side are hedged. The extent of hedge is dependent
on the currency view / fore cast from time to time.
As regards working capital foreign currency exposures, these loans have been granted
by Working Capital Banks at an interest rate of LIBOR + 1 % p.a. in substitution of
Rupee Working Capital Demand loans (WCDL). WCDL carries an interest rate of
around 16 % p.a. (average). The terms of sanction of banks, require these loans to be
fully hedged. Being of short term nature, suitable cover is available in the market.
Even after providing for hedging cost, the company saves interest of nearly 5 % to 6
% p.a. by converting the rupee based working capital loans into foreign currency
loans.
Interest Cost Reduction Exercise: Forex and Treasury Division
Working
Capital Loans
Index Options for interest cost
reduction
FUND-BASED
1. Cash Credit
2. Bills Discounting
NON FUNDBASED
Prime Lending rate
(floating rate) minus 250
bps as per RBI norms)
1. Try for possible reduction
in Credit Spread
2. Conversion into short term
FCNR (B) USD loan on fully
hedged basis
3. Issue of CPs – Rating
Constraints
52
1. Import L/Cs
2. Export Bills
3. Negotiation / Discount
Purchase
4. Obtain a comfort letter
from the consortium lender/s
and draw a short term
MIBOR based loan to reduce
the Interest Cost.
5. Interest rate swaps etc.
6. Argue for interest rate
relief in relation to business
cycles.
Long term Loans /
Borrowings
Index Available options for
interest cost reduction
FUND-BASED
1. Term Loans
2. NCDs
3.Securitisation of receivables
NON FUNDBASED
1. Guarantees-performance &
financial
2. DPG
3. Comfort Letters
1. Fixed rates for term loans
2. Coupons for NCDs (Non
convertible Debentures)
1. Examine the prepayment
clause in NCDs and try for
substitution of debt.
2. Undertake interest rate
swap with the lender for
reduction of overall interest
cost based on short term
money market view.
3. Convert the high cost
rupee loans into short term
foreign currency loans (on
fully hedged basis)
4. Argue for interest rate
reduction on term loans
justified by present interest
rate scenario.
5. Try to avoid incremental
interest cost (1.05 % p.a.) on
account of non creation of
security by seeking for a
waiver, based on the follow
53
up action made by us from
time to time.
NON FUND BASED
EXPOSURES
Transaction Based There is scope for reduction
in bank charges / fees /
commission etc. as the
discretion available to banks
is to be exploited for our
benefit.
Interest Cost Savings / Value addition, 2006: Forex and Treasury division, Essar Group
Incremental yield on investment 0.5 % p.a
Interest Cost Reduction on Export financing.
1 to 1.5 % p.a
Interest Cost Reduction on Import Financing
(Buyers’ Credit and Suppliers’ Credit)
Over 2 % p.a.
Interest Cost Reduction on short term and long
term currency loans
0.75 % to 1.25 % p.a.
Higher Export realisation for Euro-denominated
export receivables
80 to 90 paisa per Euro
Higher Export realisation for USD export
receivables
40 to 50 paisa per USD
Interest Cost on Guaranteed Borrowings: Lenders’ Perspective
The corporate giants borrow US dollars or Rupee Loans from the overseas Banks and other
financial Institutions against the AAA rated Guarantee / SB Letter of Credit. These banks will
be charging these corporates the relevant credit spread on the basis of:
a. Reserve requirements – CRR / SLR requirements
b. Capital Adequacy Ratio – presently 9 % w.e.f. 31.03.2000
54
c. Administrative costs and overhead expenses
d. Allocation of interbank money / credit lines for sourcing of funds
The interest cost to the corporates will be the credit spread over the reference rate (USD
LIBOR / NSE MIBOR). The lenders adopt different approaches for FCNR (B) USD Loans
and MIBOR linked RUPEE Loans. The following discussion makes it clear about the interest
cost that is to be bourn by the corporates on these loans.
A. FCNR (B) USD LOANS:
There is no CRR requirement on these loans.
The SLR requirement is fixed at 25 % on the liability‘s side.
The cost of lenders on reserve requirements is zero.
The exposure risk is nil for the lenders as the loans are forwarded on guarantee / SB
L/C.
The cost of administrative and overhead expenses is charged at 25 basis points on
loan accounts. (0.25 % p.a.).
If the lenders choose to lend FCNR (B) USD loan from their own FCNR (B) deposits
funds then the margin between interest rate on deposits and LIBOR reference rate will
be the incremental spread over and above the credit spread charged to the borrower /
corporates.
On the other hand, if the lending organization chooses to source funds from interbank
market then it may charge a spread over 50 basis points over the reference rate. This
is because the lender serves the borrower by blocking its interbank credit lines in the
interbank credit market.
B. NSE MIBOR LINKED RUPEE BORROWINGS:
The reserve requirements are zero as there are no SLR / CRR on interbank
borrowings.
The risk exposure is zero as the lenders / banks are lending the rupee funds against
AAA Guarantee papers.
The floating interest rate risk is transferred to the borrower.
The lenders face liquidity risks. As the liquidity risk assumes great significance, the
lenders will charge 50 basis points minimum from the corporate borrowers.
55
Moreover, the use of interbank credit lines to serve the borrower and sacrificing any
arbitrage gain there of will induce the lenders to levy 75 basis points over and above
the reference rate on the borrowers.
The financial exposures of Essar Steel Ltd are given in Appendix 1
56
The Road Ahead
ESSAR group will be affected by macro-economic factors such as world economy and Indian
economy, Government regulations etc as well as micro-economic factors such as oil
consumption at ESSAR Oil, steel demand etc. Hence we shall discuss how these future
economic conditions could affect ESSAR group and its forex exposures.
World Economy
Considering the global economic slowdown and financial crisis one can safely state that the
aftermath of sub-prime crisis has not seen the bottom yet. With recession across the US, now
engulfing Europe, the cuts on the global economy will be deep and may take time to recover.
The US and Europe are facing historically high inflation of 5% and 4.1% respectively.
Around six emerging markets have joined the bandwagon of double digit inflation. IMF (July
2008) has revised its growth forecasts for the world economy and expects a significant
deceleration of activity in the H2 08 before a gradual recovery in 2009. No-doubt, advanced
economies are going to grow below their trend growth with worsening economic situation in
Euro area, UK, and Japan. Canadian economy is almost flat. Slowdown witnessed in Mexico
and Brazil. Other emerging markets including China, India and ASEAN are still keeping the
world growth buoyant. The global economic indicators are given in appendix 2
Lets discuss the major factors defining the current state of economy and whether and how
they can affect Essar Group.
Crude Oil
Crude Oil prices have been the highlight of the year in the global commodity markets.
Currently the crude oil prices are believed to be in a bear market with prices below 100$ per
barrel largely due to lower demand caused by the economic slowdown. Essar oil being the
importer of crude oil would be benefited from the downward trend. However, it should be
noted that Essar group gains per se only by lowering of crude oil due to lack of demand. As
seen recently, if crude oil prices are lowered due to stronger dollar, it nullifies the gain for the
company as the exchange rates move adversely. It calls for a careful watch on fundamentals
behind the movements in crude oil prices.
Financial Crisis
57
The bail out of Fannie and Freddie signaled an extreme of financial crisis but the shocks were
far from over. One wouldn‘t have imagined the end of large independent investment-banks
such as Lehman Brothers, Meryl Lynch, Morgan Stanley, Goldman Sachs within a couple of
weeks bringing forth to our minds the famous saying from Warren Buffet ‗Derivatives are
financial weapons of mass destruction‘. Such collapses are going to affect the derivatives
market and the derivative strategies of the company need to be reviewed and scrutinized
closely though Essar group uses derivatives for hedging purposes only. Other take-overs such
as the ones of Halifax Bank of Scotland by Lloyds TSB and collapse of AIG add to the crisis
woes.
The Bailout Plan
The Federal Reserve along with other major central banks of the world have entered into an
agreement to jointly revive the economies by working on a bailout plan for banks and other
institutions that have incurred fatal losses. It has brought about an air of hope across the
world but it is difficult to predict how effective this plan will be. Such actions have brought
about large volatility in the major currencies affecting the daily transactions of forex
management team.
Indian Economy
Turbulent Times Begun
After an extraordinary run for five successive years on super business cycle, Indian corporate
is suddenly grappled with macro economic turmoil. While the spread of US sub-prime crisis
has weakened the external demand prospects, the monetary tightening at home to rein in
inflation is threatening to derail the consumer-led growth story at home. Falling stock prices,
dwindling earnings growth, subdued foreign inflows, busting realty boom and a gloomy
business outlook have dented the corporate confidence. Manufacturing that was growing at
double digit in the recent past has slipped to mere 6% in the last six months. Is it a precursor
to bigger economic and business meltdown or just a blip? (Hegde et al 2008)
58
Entered into Slow Growth Phase
Industrial Slowdown Broad-based
The industry and manufacturing have shown very impressive growth during 2002-07 with the
pace doubled from 6% to 12%. Metals, machinery, textiles, beverages, chemicals & auto
segments led this. However growth of most of these industries may have reached a peak
either in FY07 or FY08. On use-based classification it is clearly visible consumer durable
segment was the first to develop cold feet. (Hegde et al 2008) And now it is spreading to
capital goods segment. This is a cause of concern for Essar Group companies. Most of the
recent surveys on industrial outlook and business expectations are depicting a gloomy
picture. (Hegde et al 2008)
59
Growth of Use Based Industries
Sales & Profitability on a Bumpy Road
Analyzing the quarterly performance (till March 2008) of the 50 Nifty companies that also
represents the Sensex, one witnesses a descending profit growth with sales showing a
fluctuating trend. Both operating profit & net profit growth declined from the peak of 2006.
In March 2008 operating profit grew by 20% vs. 31% a year ago. Growth in net profit also
tumbled down to the lowest level of 9.95% in the last eight quarters. No doubt these growth
rates are no less impressive, yet there is a clear sign of serious decline in many manufacturing
segments. (Hegde et al 2008)
60
Liquidity squeezing & interest rate hikes
When economic growth jumps from 6% to highs of 9% in a short span of time, inflationary
pressures are bound to occur. The RBI therefore resorted to demand contracting measures by
raising the cash reserves that banks have to hold with RBI by 400 bps between Dec'06 and
Jul'08, squeezing out Rs 1,35,000 crore from the banking system. Concomitantly RBI's
overnight lending rate to banks (repo) has been raised to 9% in Jul'08, leading to a hike in the
lending rates by a whopping 400-500 bps in the last 4 years.
These factors need to be taken into consideration to decide upon the policies and strategies
for interest rate and foreign exchange risk management in the long run.
Forex and Treasury Division
Arbitrage
The forex and treasury department of ESSAR group has plans to expand by setting up a desk
for arbitrage in commodity markets. This arbitrage would take place by a co-ordinated effort
of onshore desk with an off-shore desk of the group to take advantage of price differential
and a currency transaction to avoid losses due to currency exposure. The set of transactions
can be represented in a triangular form as shown below
61
The on-shore desk could buy at a lower cost while the off-shore desk sells at a higher cost
and the forex deal is locked simultaneously to settle the difference in currencies of on-shore
and off-shore desks
Currency Futures
Reserve Bank of India (RBI) approved the currency futures market for INR against USD.
This market is currently restricted to citizens of India only. Other restrictions include a cap of
either 5 million USD worth or 6% of market volume which ever higher, on positions held by
a trader. On 29th
August 2008, the National Stock Exchange (NSE) launched the market but
the market was illiquid due to strict guidelines and the total market volume on the first
trading day was about 9 million USD. Each lot in the currency futures market was of USD
1000.
For a corporate such as ESSAR group this is too small a market to deal in and hence it was
decided to wait until the market expands to adequate levels. RBI will soon be considering
opening the currency futures market to foreign investors. Also the market has seen a rise in
volumes so that 6% of the total volume of the market would exceed 5 million thereby raising
the cap on total position taken by the trader.
Conclusion
In the midst of financial crisis, the currency rates can be very volatile. Forex risk
management can be a daunting task in the circumstances and the management needs to be on
its toes and act proactively. The collapse of investment banks has created doubts on the
effectiveness of derivatives and corporates will have to use them with caution. However with
Off-Shore: Sell On-Shore: Buy
Forex Deal
Commodity
Arbitrage
62
the rising uncertainties in commodity prices, hedging using derivatives is an activity that
companies will still have to resort to. The head of Global Treasury of Essar Group, Mr N. S.
Paramasivam quotes ―Having seen the volatility in the commodity markets over the past few
years, we are now experimenting to find out if hedging is, indeed, effective‖ (Adhikari A
2008).
In the times to come, financial risk management will see new developments after going
through a phase of unprecedented events and the financial landscape across the globe may
never be the same again.
63
References:
Adhikari A (2008) ―India INC‘s New Hedgers‖ Business Today 2008
Bloomberg Currency Charts downloaded from www.bloomberg.com as on 25th
September
2008 published by Bloomberg L.P
Capitaline (2008) Capital LinePlus downloaded from http://www.capitaline.com/ as on 10th
September 2008
Central Statistical Organisation (CSO 2008) ―Growth of Use Based Industries‖ downloaded
from http://mospi.nic.in/cso_test1.htm as on 5th Sept 2008
Economic indicators downloaded http://www.fxwords.com as on 15th September 2008
Essarnet (August 2008) downloaded from http://essarnet.com as on 20 September published
by Corporate Communications, Essar Group
European Central Bank (ECB Feb 2006) ―The Accumulation of Foreign Reserves‖
downloaded from www.ecb.int as on 15th September 2008
GoCurrency.com ―What is the Indian Rupee (INR)? downloaded from
http://www.gocurrency.com/countries/india.htm as on 12th September 2008
Hegde I., Saha S., and Sen G (July 2008) EssarNomics downloaded from http://essarnet.com
as on 20 September published by Economics and Strategic Analysis Unit, Essar Group
Hull, J. C. Options, Futures and Other Derivatives, Fifth Edition, Prentice Hall 2002
IMF (April 2008) ―Currency Composition of Official Foreign Exchange Reserves‖
downloaded from www.imf.org as on 20th September 2008
IMF (July 2008) ―Global slowdown and rising inflation‖ downloaded from www.imf.org as
on 20th September 2008
Janssen C, Langager C and Murphy C (Feb 2008) ―Technical Analysis‖ downloaded from
http://www.investopedia.com/terms/t/technicalanalysis.asp as on 10th September 2008
published by Investopedia ULC
64
Mishkin.F (2004) Economics of Money, Banking and Financial Markets, Seventh Edition,
Columbia University
Russell M, (2008) ―Identifying Trades with DailyFX‖ downloaded from www.dailyfx.com as
on 26th September 2008
Treasury Board of Canada (TBC, March 2004) ―Integrated risk management implementation
guide‖ downloaded from http://www.tbssct.gc.ca/pubs_pol/dcgpubs/RiskManagement/guide-
PR_e.asp?printable=True as on 2nd September 2008
Waring D.(2007) ―Forex Trading‖ downloaded from www.informedtrades.com as on 1st
September 2008
65
Appendix 1: Financial Exposures of Essar Steel Ltd.
Category USD in
million
Rupee in
crores
Equivalent
USD liabilities
(in million)
Interest cost per
annum (%)
Foreign Currency Loans 281.30 1268.67 281.30 6.60
Long term Rupee loans
a) Financial Institutions
b) Banks (including MF)
1333.83
72.25
295.75
16.05
12.69
9.33
FRN Domestics 167.22 37.08 8.00
Working Capital Term
Loan
131.53 29.16 11.75
Priority Debt (BOI
INR loans)
234.37 51.97 11.75
UTI (As per OTS
plan)
647.65 143.60 8.00
Zero Cost Debt 252.94 56.08
281.30 4108.46 910.99 8.96
66
Appendix 2: Global Economic Indicators
67
Appendix 3: Forex Reserves
