Foreign Exchange Risk Management – a Case Study

Foreign Exchange Risk

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company.

One of the most difficult and persistent problems for the firms exposed to forex risk Frequent fluctuations in exchange rates – a major source of uncertainty for multinational and

domestic firms Current exchange rates are favourable for exports but imports are working out to be pricey. Indian IT sector – export oriented sector which requires frequent management and measurement

of exchange rate risk. Analysis of the forex exposure and its management of TCS Technologies Ltd.

Types of foreign exchange exposure

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company.

Transaction Exposure Sources - Payables and Receivables in foreign currency Imports,exports,capital flows across the country,debt servicing in foreign currency,dividend payments and

receipts in foreign currency.

Translation Exposure If the holding company has a foreign subsidiary or foreign currency assets or liabilities, there is a need for the

financial statements of the foreign subsidiary which are in foreign currency to be translated into the home currency of the parent.

This leads to translation gain or loss

Economic Exposure Operating exposure applicable for both MNCs and domestic companies. Risk of exchange gain/loss due to future cash flows or costs of capital arising from unexpected exchange rate

changes.

• Reviewed the foreign exchange risk management practices of a single large UK MNC.

• Instances were observed where corporate practices deviates from normative prescriptions do not necessarily imply sub-optimal behavior.

ALPA DHANANI(2003)

• Throws light on Korean & Swedish non-financial firms on their foreign exchange risk exposure & hedging practices.

• Korean firms more likely to focus on minimizing fluctuations of cash flows.

• Swedish firms minimizing on alternative hedging methods

BRNGT PRAMBORG(2005)

• Assessing the sensitivity of firm value to exchange rates.• Focus on 2 primary areas of enquiry theoretical foundation of

exchange risk exposure & empirical evidence on the link between stock returns & currency fluctuations.

• More complete understanding of time varying, horizon-dependent & non linear nature of exchange risk exposure is still required.

ALINE MULLER & WILLEM F.C VERSCHOOR (2006)

LITERARTURE REVIEW OF FOREIGN EXCHANGE RISK MANAGEMENT

Empirical evidence :- There is a positive relationship between bank size & foreign exchange exposure: ERIC WRONG (2008)

Reason:- Larger banks tends to have more significant foreign exchange operations & trading positions.

Larger banks also have more businesses with large and international corporations of which competitiveness & sensitivity to exchange rates movements

BIANCA DE POLI & JENS SINDERGAARD (2009) Examined the properties of foreign exchange rate risk premium in a canonical general equilibrium

small open economy model. Features assure that not only risk aversion but also precautionary savings are counter-cycle. Helps generate forex risk premium that co-varies negatively.

TIGRAN POGHOSYAN (2010) Provides the first empirical evidence on the relationship between US macro-economic variables,

international oil prices & foreign exchange risk in GCC countries. Analysis performed using stochastic discount factor methodology impose no arbitrage relationship

on the risk premium and its theoretically grounded macroeconomic determinants. Estimation result suggested macroeconomic development in US constitute important sources of

foreign exchange risk in GCC

• Surveyed the hedging techniques used in Indian firms• He observed the 2 techniques famous among Indian companies for

hedging Long dated & Short dated forward exchange contracts• Indian companies hedge their risks foreign currency forwards, swap &

options agreements in Over the Counter (OTC) markets.

VIJ MADHU (2009)

• A sketch of foreign exchange exposure management as practiced by various multinational companies in India.

• A comparative analysis of management of foreign exchange exposure by banking & non banking as well as foreign & Indian MNC’s operating in India.

• Most of the companies faced all three exposures Transaction, economic & translation

MANISHA GOEL (2011)

• Research study globalization and increased cross border flow of funds have increased the exposure to market risk hedging of such exposures has become critical

• Introduction of currency derivatives is a landmark achievement benefiting importers, exporters & companies with foreign exchange exposure

ANU JOSY JOY & Dr G S Gireesh Kumar(2011)

Indian IT sector

Indian IT and ITES sector lead the economic growth Direct and Indirect employment opportunity of nearly 2.8 million and 8.9 million

respectively Market size of the industry is expected to rise to $ 225 billion by 2020 Localized and clustered in 7 cities-Bangalore, Hyderabad, Chennai, New Delhi,

Kolkata, Mumbai and Pune Expansion to newer places due to infrastructure limit and scarcity of land

Factors leading to growth in the IT/ITES sectors are:

Low operating cost abd tax advantage Favorable government policies Technically qualified personnel in the country Rapid adoption of IT technologies in major sectors Strong growth in export demand Use of new and emerging technology SEZ are growth drivers

FE Exchange exposure of TCS

Income and expenses in foreign currencies are converted at exchange rates prevailing on date of transaction

Exchange differences arising on a monetary item is accumulated in a foreign currency translation reserve

Premium or discount on foreign exchange are amortised and recognised in the statement of P&L over the period of the contract

Sales and Exports

Particulars For the year ended March 31

2012 2011 2010

Percent of export sales

91.84 91.02 92.18

Activity in foreign currency

Forex exposure Hedge

Enters into foreign currency forward contracts and currency option contracts (accordance with the risk management policies ).

Contract period varies from 1 days to 8 years Hedge risk associated with foreign currency fluctuation relating to firm

commitments and forecasted transactions

Foreign Currency USD PS E AUD

Currency option contract (Rs in crores)

218.5 21.75 21.0 3.0

Fair Value (Rs in crores)

29.56 14.66 18.64 3.34

Cash flow Hedges- March 31, 2012

Hedging instruments are initially measures at fair value and are remeasured at subsequent reporting dates.

Changes in fair value of the derivatives that are effective as hedges of future cash flows are recognized in shareholder’s funds

When a hedge is discontinued, for forecasted transaction, any cumulative gain or loss on heading instrument recognized is retained in shareholder’s fund until the forecasted transaction occurs

If the hedge transaction is not expected to occur, recognized gain or loss is transferred to the profit and loss statement for that period

Conclusion

In international business, Exchange rate risk is one of the most important risks that firm faces

IT sectors mainly depends on exports. Hence exposed to the forex risk Companies manage exchange rate risk by hedging in currency forward and

options market Exports of TCS accounts for more than 90%. (Majority: US) Its major challenge is to hedge USD exposure Based on the data, it can inferred that the exposure of next 8 years can be

hedged through foreign currency forwards and options

Thank You

Foreign Exchange Risk Management – a Case Study

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