Foriegn Exchange Risk Mgmt

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    Summer project

    On

    Foreign Exchange Risk Management

    By

    Paresh S. Mahajan

    Atharva Institute of Management StudiesMarve Road, Malad (W), Mumbai 4000 95.

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    July 2005

    Summer project

    On

    ForeignExchangeRiskManagement

    By

    Paresh S. Mahajan

    Submitted to:

    Mr. Satish Kamat

    Finance Manager

    Mahindra Intertrade Limited

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    Mahindra Intertrade is part of the Mahindra Group, a global manufacturing

    conglomerate with annual revenues in excess of US $1 billion. The Mahindra Group

    has a significant presence in key sectors of the Indian economy. A consistently high

    performer, M&M has been ranked among the top ten private-sector companies in the

    country for several years.

    A corporate history spanning from 1945, the group expanded its operations from

    automobiles and tractors to secure a significant presence in many more important

    sectors - hospitality, trade and financial services, automotive components,

    information technology, telecom and infrastructure development. The group

    employs more than 12,600 people and has six state-of-the-art manufacturing

    facilities spread over 500,000 square meters. It has 33 sales offices that are

    supported by a network of over 500 dealers across the country. This network is

    connected to the company's plants by an extensive IT infrastructure. The M&M

    philosophy of growth is centered on a belief in people. As a result, the company has

    put in place initiatives that seek to reward and retain the best talent in the industry.

    Mahindra Intertrade is a wholly owned subsidiary of the Mahindra & Mahindra

    group, one of the 10 largest industrial houses in India. MIL undertakes imports,

    exports, third country business, domestic trading & marketing & distribution

    activities. The product portfolio is wide and diversified and includes steel, steel raw

    material, technical and application-engineering products, metals (non-ferrous),

    commodities, consumer products and engineering products.

    Mahindra Intertrade was incorporated from a division into a separate company in

    1999 to pursue unhindered & fast growth leveraging our skills & competencies.

    Mission Statement

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    "Build a Global trading Organization based on the Mahindra brand promises of

    reliability and credibility towards delivering a distinct value proposition to our

    business affiliates, customers, employees and shareholders. We seek to achieve this

    through continuously enhancing and leveraging our human and knowledge capital

    across products and services"

    Our Competencies

    Straddled across a wide range of products & services, Intertrade has efficiently

    leveraged its competencies in -

    Business Understanding

    Transaction Management

    Risk Management

    Relationship Management

    Financial Supporting Capabilities

    Trading Skills

    MIL have grown across products & services leveraging our skills & business

    acumen, supported by our rich parentage whenever we have needed it.

    And today, we deal in -

    Steel & Steel raw materials

    Non Destructive testing equipment

    Application Engineering products

    Consumer Goods

    Engineering Exports

    We have over 300 customers and principals across 4 continents in over 15 countries.

    Intertrade enjoys a strong presence in India with offices in all regions. We have

    robust business process integrated in SAP- capable of managing the complexities of

    international trade. We have a non-compromising focus on Good Corporate

    Governance.

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    Foreign Exchange RiskManagement Policy

    A. Normal Trade:

    Minimum of 50% of net exposure including cross currency exposure

    will stay covered. (Net Exposure = Imports + other remittances -

    Exports - Other Forex Earnings) and net open position in excess of

    50% of net exposure including cross currency exposure or US $ 2.5 M

    whichever is lower requires prior approval of MD.

    Hedging of anticipatory position requires prior approval of MD.

    Open position limit

    Treasury Manager US $ 1.50 M

    FC US $ 2.50 M

    MD US $ 10.00 M

    Stop loss limit restricted to Rs.100 Lakhs p.a. throughout the year net

    of exchange losses booked during the year. The stop loss is dynamic.

    B. Structured Trades:

    Maximum open position up to 50% of transaction value in respect of

    large value structured trade e.g. Merchanting/ Transit Trade and

    Export Performance.

    Open position limit:

    FC 50% of transaction value

    MD open position over 50% of transaction value

    within US $ 10 M per A above

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    Stop loss limit restricted to Rs.25 Lakhs p.a. throughout the year net of

    exchange losses booked during the year. The stop loss is dynamic.

    C. Overall Stop Loss Limit:

    Normal Trade Rs. 100 Lakhs

    Structured Trade Rs. 25 Lakhs

    Total Rs. 125 Lakhs

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    Foreign Exchange Exposure

    Definition

    Adler and Dumas defines foreign exchange exposure as the sensitivity of changes in

    the real domestic currency value of assets and liabilities or operating income to

    unanticipated changes in exchange rate.

    To understand the concept of exposure, we need to analyze this definition in detail. The

    first important point is that both foreign and domestic assets and liabilities could be

    exposed to exchange rate movements. E.g. if an Indian resident holds a dollar deposit and

    dollars value vis--vis the rupee changes, the value of deposit in terms of rupees changes

    automatically. On the other hand, if a person is holding a debenture in an Indian company,

    the value of the debenture may change due to an increase in general rates, which in turn

    may be the effect of depreciating rupee. Thus, even though no conversion from one

    currency to another in involved, a domestic asset can be exposed to movements in the

    exchange rates, albeit indirectly.

    The second important point is that only assets and liabilities, but even operating incomes

    can be exposed to exchange rate movements. A very simple example would be of a firm

    exporting its products. Any change in the exchange rate is likely to result in a change in the

    firms revenue in domestic currency terms.

    Thirdly, exposure measures the sensitivity of changes in real domestic-currency value of

    assets, liabilities and operating incomes. That is, it is the inflation adjusted values

    expressed in domestic currency terms that are relevant. Though this is theoretically a sound

    way of looking at exposure, practically it is very difficult to measure and incorporate

    inflation in the calculations.

    The last point to be noted is that exposure measures the responses only to the unexpected

    changes in the exchange rate as the expected changes are already discounted by the market.

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    In simple terms, definition means that exposure is the amount of assets; liabilities and

    operating income that is ay risk from unexpected changes in exchange rates.

    Sensitivity can be measured by the slope of the regression equation between two variables.

    Here are the two variables are the unexpected changes in the exchange rates and the

    resultant change in the domestic currency value of assets, liabilities and operating income.

    The second variable can be divided into four categories for the purpose of measurement of

    exposure. These are:

    Foreign currency assets and liabilities which have fixed foreign currency values.

    Foreign currency assets and liabilities with foreign-currency values that change

    with an unexpected change in the exchange rate.

    Domestic currency assets and liabilities.

    Operating incomes.

    Exposure When Assets and Liabilities Have Fixed Foreign

    Currency Values

    The measurement of exposure for the first category is category is comparatively simpler

    than for the remaining three. Let us see an example to understand the process of

    measurement. Assume that an Indian resident is holding a $1 million deposit. As the dollar

    appreciates by Rs.0.10, the value of the deposit also increases by Rs.0.1 million. Similarly,

    an unexpected depreciation of the dollar by Rs.0.10 will reduce the value of the deposit by

    Rs.0.1 million. This gives an upward sloping exposure line. On the other hand, if there

    were foreign liability which had its value fixed in terms of the foreign currency, it would

    give a downward sloping exposure line.

    When the foreign currency value of asset or liability does not change with a change in the

    exchange rate, the exposure is equal to the foreign currency value. While an exposure with

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    Operating Incomes

    Measurement of exposure on operating profits is the most difficult of all. Let us examine

    the case of a company using imported raw materials, whether it is selling its product in the

    domestic market or the international market. Let us say there is appreciation of the foreign

    currency. Firstly, whether the domestic price of the imported raw material will increase or

    not will depend on the response of the seller. The international price may or may not get

    reduced, depending upon the conditions prevailing in the international market. Even if we

    assume that the international price is not reduced and hence, the domestic currency price of

    the raw material increases, the effect on the operating profit is not easily predictable.

    Though the quantity of the raw material the company wants to purchase at the increased

    price would appear to be in its own hands, in reality it is dependent on several factors.

    These include availability and the price of the same or substitute raw materials in the

    domestic market, the possible response of the consumers in case the company wants to pass

    on the increased costs to them etc.

    Even companies which do not operate in the international markets, either as exporters or as

    importers, may be exposed to exchange rate changes. This could be due to presence of

    competitors. One way exchange rate movements affect such players is by affecting the

    production costs and/or prices of their competitor. Another way exchange rate changes may

    affect the domestic companies is by making its foreign competitors operations more or

    less profitable, thereby either driving it out of the market, or by acting as an inducement for

    more competitors to enter the market.

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    Types of Exposure

    Exposure can be classified into three kids on the basis of the nature of the item that is

    exposed, measurability of the exposure and the timing of estimation of exposure.

    Transaction Exposure

    Translation Exposure

    Operating Exposure

    Transaction Exposure

    Transaction exposure is the exposure that arises from foreign currency denominated

    transactions which an entity is committed to complete. It arises from contractual, foreign

    currency, future cash flows. For example, if a firm has entered into a contract to sell

    computers at a fixed price denominated in a foreign currency, the firm would be exposed to

    exchange rate movements till it receives the payment and converts the receipts into

    domestic currency. The exposure of a company in a particular currency is measured in net

    terms, i.e. after netting off potential cash inflows with outflows.

    Translation Exposure

    Translation exposure is the exposure that arises from the need to convert values of assets

    and liabilities denominated in a foreign currency, into the domestic currency. Any exposure

    arising out of exchange rate movement and resultant change in the domestic-currency value

    of the deposit would classify as translation exposure. It is potential for change in reported

    earnings and/or in the book value of the consolidated corporate equity accounts, as a result

    of change in the foreign exchange rates.

    Operating Exposure

    Operating exposure is defined by Alan Shapiro as the extent to which the value of a firm

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    stands exposed to exchange rate movements, the firms value being measured by the

    present value of its expected cash flows. Operating exposure is a result of economic

    consequences. Of exchange rate movements on the value of a firm, and hence, is also

    known as economic exposure. Transaction and translation exposure cover the risk of the

    profits of the firm being affected by a movement in exchange rates. On the other hand,

    operating exposure describes the risk of future cash flows of a firm changing due to a

    change in the exchange rate.

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    Management of Transaction and Translation Exposure

    Transaction exposure introduces variability in a firms profits. For example, the price

    received in rupee terms by an Indian exporter for goods exported will not be known by him

    till he converts the foreign currency receipts into rupees. This price varies with changes in

    the exchange rate. While transaction exposure arises out of the day-to-day activities of a

    firm, translation exposure arises due to the need to translate the foreign currency values of

    assets and liabilities into domestic currency.

    These differences in the two types of exposures result in some basic differences in the way

    they are required to be managed. Management of transaction exposure is essentially a day-

    to-day operation carried out by the treasurer. It involves continuous monitoring of

    exchange rates and the firms exposure, along with an evaluation of effectiveness of

    hedging techniques employed. On the other hand, management of translation exposure is a

    periodic affair, coming into the picture at the time of preparation of financial statements.

    This makes the management of translation exposure more of a policy decision, rather than

    a day-to-day issue to be handled by the treasurer.

    Management of exposure essentially means reduction or elimination of exchange rate risk

    through hedging. It involves taking a position in the forex and/or money market which

    cancels out the outstanding position. The hedging instruments are classified as external and

    internal instruments. Internal instruments are those which are a part of day-to-day

    operations of the company, while external instruments are the ones which are undertaken

    for the purpose of hedging exchange rate risk.. The various internal hedging techniques are:

    Exposure netting,

    Leading and lagging,

    Choosing the currency of invoice,

    Sourcing.

    Exposure Netting

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    Exposure netting involves creating exposures in the normal course of business which offset

    the existing exposures. The exposures so created may be in the same currency as the

    existing exposures, or in any other currency, but the effect should be that any movement in

    exchange rates that results in a loss on the original exposure should result in a gain on the

    new exposure. This may be achieved by creating opposite exposure in the same currency or

    a currency which moves in tandem with the currency of the original exposure. It may also

    be achieved by creating a similar exposure in a currency which moves in the opposite

    direction to the currency of the original exposure.

    Leading and Lagging

    Leading and lagging can also be used to hedge exposures. Leading involves advancing a

    payment i.e. making a payment before it is due. Lagging, on he other hand, refers to

    postponing a payment. A company can lead payments required to be made in a currency

    that is likely to appreciate, and lag the payments that it needs to make in a currency that is

    likely to depreciate.

    Hedging by Choosing the Currency of Invoicing

    One very simple way of eliminating transaction and translation exposure is to invoice all

    receivables and payables in the domestic currency. However, only one of the parties

    involved can hedge itself in this manner. It will still leave the other party exposed as it will

    be leading in a foreign currency. Also, as the other party needs to cover its exposure, it is

    likely to build in the cost of doing so in the price it quotes/ it is willing to accept.

    Another way of using the choice of invoicing currency as a hedging tool relates to the

    outlook of a firm about various currencies. This involves invoicing exports in a hard

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    currency and imports in a soft currency. The currency so chosen may not be the domestic

    currency for either of the parties involved, and may be selected because of its stability.

    Another way the parties involved in international transactions may hedge the risk by

    sharing the risk. This may be achieved by denominating the transaction partly in each of

    the parties involved. This way, the exposure for both the parties gets reduced.

    Hedging through Sourcing

    Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials

    in the same currency in which it sells its products. This results in netting of the exposure, at

    least to some extent. This technique has its own disadvantages. A company may have to

    buy raw material which is costlier or of lower quality than it can otherwise buy, if it

    restricts the possible sources in this manner. Due to this technique is not used very

    extensively by firms.

    The various external hedging techniques are:

    Forwards,

    Futures,

    Options, and

    Money markets.

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    Hedging through the Forward Market

    In order to hedge the transaction exposure, a company having a long position in a currency

    (having a receivable) will sell the currency forward, i.e., go short in the forward market,

    and a company having a short position in a currency (having a currency) will buy the

    currency forward i.e. go long in the forward market.

    The idea behind buying or selling a currency in the forward market is to lock the rate at

    which the foreign currency transaction takes place, and hence the costs or profits. For

    example, if an Indian firm is importing computers from the USA and needs to pay $1,

    00,000 after 3 months to the exporter, it can book a 3-month forward contract to buy $1,

    00,000. If the 3-month forward rate is Rs.42.50/$, the cost to the Indian firm will be locked

    at Rs.42, 50,000. Whatever be the actual spot price at the end of three months, the firm

    needs to pay only the forward rate. Thus, a forward contract eliminates transaction

    exposure completely.

    Hedging through Futures

    The second way to hedge exposure is through futures. The rule is the same as in the

    forward market i.e. go short in the futures if you are long in the foreign currency and vice

    versa. Hence, if the importer needs to pay $2, 50,000 after four months, he can buy dollar

    futures for the required sum and maturity. Futures can be similarly used for hedging

    translation exposure. As the gain or loss on the futures contract gets canceled by the loss or

    gain on the underlying transaction, the exposure gets almost eliminated. The main

    difference between hedging through forwards ands through futures is that while under a

    forward contract the whole receipt/payment takes place at the time of maturity of the

    contract, in case of futures, there has to be an initial payment of margin money, and further

    payments/receipts during the tenure of the contract on the basis of market movements.

    Hedging through Options

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    Options can prove to be a useful and flexible tool for hedging exposures. A firm having a

    foreign currency receivable can buy a put option on the currency, having the same maturity

    as the receivable. Conversely, a firm having a foreign currency payable can buy a call

    option on the currency with the same maturity.

    Hedging through options has an advantage over hedging through forwards or futures.

    While the latter fixes the price at which the currency will be bought or sold, options limit

    the downside loss without limiting the upside potential. That is, since the firm has the right

    to buy or sell the foreign currency but not the obligation, it can let the option expire by not

    exercising the right.

    Hedging through Money Market

    Money markets can also be used for hedging foreign currency receivables or payables, Let

    us say, a firm has a dollar payable after three months. It can borrow in the domestic

    currency now, convert it at the spot rate into dollars, invest those dollars in the money

    markets, and use the proceeds to pay the payables after three months.

    Open Position

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    It is a net long or short foreign currency or forward position whose value will change with

    the change in foreign exchange rate or futures price.

    Position means net commitment in a currency. It is square if sales equal purchases, long if

    purchases exceeds sales and short if sales exceeds purchases.

    Stop Loss Limit

    Stop loss indicates an amount of money that a particular portfolios single period market

    loss should not exceed. A limit violation occurs when a portfolios single period market

    loss exceeds stop loss limit. In such event, trader is usually required to unwind or hedge the

    material exposures.

    Stop Loss Order

    A stop loss order is an order to buy or sell when the price reaches a specified level. A stop

    loss order to buy, enter above the prevailing market price, becomes a market order when

    the contract is either traded or bid at or above the price. A stop loss order to sell, enter

    below the prevailing market price, becomes a market order when the contract is either

    traded or offered at or below the stop price. It is an order to sell at the market when a

    definite price is reached. It is usually used as a method of limiting losses by traders.

    MIL and Forex Risk Management

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    Mahindra Intertrade Limited is basically an import driven company. Approximately 90-

    95 % of its business is based on imports and rest on exports.

    International trade involves various complexities and problems. This may be due to various

    reasons. The parties to a sale contract are located in different countries and are governed by

    different legal systems. Also, the currencies of two countries are different. Further, the

    trade and exchange regulations applicable to both the parties may differ. In such a situation,

    a seller who ships goods will be apprehensive whether he will receive the payment from

    the buyer. The buyer, on the other hand, will be concerned whether the seller will ship the

    goods ordered for and deliver them in time. That is why documentary credit, commonly

    known as letter of credit came into existence as an ideal method for settling the

    international trade payments.

    HowLetter of Credit operates

    In order to make payment to the overseas supplier, the buyer of goods approaches his bank

    for opening a letter of credit in favor of the supplier. Mahindra Intertrade Limited is the

    importer i.e. importer in this illustration.

    After considering the request of the buyer and fulfillment of the necessary formalities, the

    issuing bank (i.e. the buyers bank) opens the letter of credit in favor of the supplier.

    The letter of credit is transmitted to the advising bank (usually an intermediary bank

    located in suppliers country) with a request to advise the credit to the beneficiary. After

    being satisfied with the authenticity of the credit, the advising bank advises the credit to the

    beneficiary (i.e. the supplier).

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    The beneficiary verifies the letter of credit and checks for any discrepancies vis--vis, the

    sales contract. If any discrepancies are noticed, the buyer is asked to incorporate the

    necessary changes/amendments to the LC. The supplier then proceeds to ship the goods.

    Shipment of goods is followed by submission of necessary documents by the supplier to

    the negotiating bank in order to obtain payment for the goods. The negotiating bank, upon

    receipt of commercial documents, and the bill of lading from the exporter, scrutinizes the

    documents in relation to the LC and if found to be in order, negotiates the bill and makes

    the payment to the supplier,

    The negotiating bank then claims reimbursement from the issuing bank by mailing the

    documents to it or any other bank authorized for the said purpose.

    The commercial invoice and other documents are presented by the issuing bank to the

    buyer of goods, who, on receipt of the same, checks the documents and accepts pays the

    bill. On acceptance/payment, the shipping documents covering the goods purchased are

    handed over to him.

    After completion of import procedures and receiving the goods, the other leg of transaction

    comes into picture. That is the import payment. Usually there is time lag between the

    import of the goods and payments for the same which exposes the parties to the exposure

    such as cross currency exposure due to possibility of changes in foreign exchange rate.

    Exposure is calculated in following manner:

    Net Exposure = Imports + other remittances - Exports - Other Forex Earnings

    Imports involve basically steel products such as billets, blooms, wire rods, angles,

    beams, coils/sheets of cold rolled, hot rolled etc., scrap, metal, alloys and

    equipments.

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    Other remittances involve expenses such as royalty and marketing services fees.

    Exportsbasically involve steel products such as raw material or semi finished steel

    products (pig iron, slabs), flat rolled steel products (Hot rolled Coil, Strip and

    Sheet, ElectricalSteel Sheets), and long steel products (Wire rods).

    Other Forex Earnings is in the form of agency commission.

    The trade at the MIL is divided into two categories, Normal Trade and Structured Trade.

    Normal Trade is in the form of import and exports of steel, metals etc. which is the

    regular and core activity of the company.

    Structured Trade is the trade which is not regular in the nature. These are not the core

    activities of the company and not the normal business of the company. This is the activity

    undertaken for the purpose of liquidity, cash flows and forex earnings. In structured trade,

    MIL acts between two legs of the transaction. For example, Merchanting involves a

    principal and a customer situated in different countries apart form MIL. Customer is inneed of goods manufactured by the principal. In this transaction MIL handles entire

    procedure right from securing orders to payment of proceeds including documentation. For

    such role, MIL gets commission.

    The regularity and the quantum of business involved in both types of trade differ. That is

    why the stop loss limit in both the cases is different. It is less in structured trade because

    the margins are very thin. It will not be meaningful to keep a stop loss limit on a higher

    side.

    Such kind of business brings into picture foreign exchange exposure. There are many

    instruments by which the foreign exchange risk can be hedged. But at Mahindra Intertrade,

    Only forward contracts are used to cover the exposure.

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    At MIL, amounts exceeding US $ 1, 00,000 are covered. If many payments are becoming

    due on the same date, then they are summed up so that the total exceeds the limit. It is not

    profitable to enter into forward contract to cover the small amounts because of the expenses

    like stamping charges which eat away the margins (profits).

    Suppose there is an import Letter of credit of US $ 1, 25,000 the payment of which is going

    to due on 15th Nov 2005. Whether to go for forward cover on a particular day depends on

    the spot rate. If Rupee is expected to appreciate against Dollar, then it is advisable to

    postpone the decision to cover the payables.

    Suppose to go for forward cover on 14th July 2005 for the above payment. The spot rate of

    1 US $ is Rs.43.5725. The premium for November forward contract is 0.1425. Then 1 paisa

    i.e. 0.01 is added as a commission. That means you have entered into forward contract for

    Rs.43.7250. No matter what will be the exchange rate on 15 th Nov 2005, company will be

    paying at this rate only.