Internship Report-Mukund Chandran GAIL

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013

STUDY OF VARIOUS FOREIGN EXCHANGE

HEDGING INSTRUMENTS

MUKUND CHANDRAN, GREAT LAKES INSTITUTE OF

MANAGEMENT, CHENNAI

GAIL (INDIA) LIMITED

24/04/2013 – 10/06/2013

6/10/2013

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | ii

A REPORT ON

STUDY OF VARIOUS FOREIGN EXCHANGE HEDGING

INSTRUMENTS

BY:

MUKUND CHANDRAN


DATE: 10-06-2013

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | iii

A REPORT ON

STUDY OF VARIOUS FOREIGN EXCHANGE HEDGING INSTRUMENTS

BY:

MUKUND CHANDRAN

ROLL NO.: 14128

PGDM 2012-2014

GREAT LAKES INSTITUTE OF MANAGEMENT, CHENNAI

COMPANY GUIDE:


CA MAMTA GUPTA

SR. MANAGER (F&A)

FINANCE

FACULTY GUIDE:

GREAT LAKES INSTITUTE OF MANAGEMENT, CHENNAI

PROF. RS VEERAVALLI

DIRECTOR-PGXPM, CO-DIRECTOR GEMBA &

ASSOCIATE PROFESSOR

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | iv

DECLARATION

I hereby declare that the Project Report “STUDY OF VARIOUS FOREIGN EXCHANGE

HEDGING INSTRUMENTS” is my own work to the best of my knowledge and belief. It

contains no material previously published or written by another person or material which to

substantial extent has been accepted for the award of any other degree, diploma or programme of

any other institute, except where due acknowledgement has been made in text.

MUKUND CHANDRAN Date: 10-06-2013

Roll No.: DM14128

Great Lakes Institute of Management, Chennai

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | vi

CERTIFICATE

This is to certify that Project Work entitled “STUDY OF VARIOUS FOREIGN EXCHANGE

HEDGING INSTRUMENTS” is a piece of work done by Mr. MUKUND CHANDRAN under

my guidance and supervision for the partial fulfillment of Post Graduate Diploma in

Management, a Programme offered by Great Lakes.

To the best of my knowledge and belief the Project Report:

a. embodies the work of the candidate himself / herself

b. has duly been completed

c. fulfills the requirements of the Rules & Regulations relating to the

Summer Internship of the Institute.

d. is up to the standard both in respect to contents and language for

being referred to the examiner

Date: 10-06-2013

PROF. R S VEERAVALLI

DIRECTOR-PGXPM, CO-DIRECTOR GEMBA &

ASSOCIATE PROFESSOR

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | vii

ACKNOWLEDGEMENT

With immense pleasure, I would like to present this project report for GAIL (India) Limited.

It has been an enriching experience for me to complete my summer training at GAIL, which

would not have possible without the goodwill and support of the people around. As a student

of GREAT LAKES INSTITUTE OF MANAGEMENT, CHENNAI I would like to express

my sincere thanks to all those who helped me during my training program.

Words are insufficient to express my gratitude towards CA Mamta Gupta (Senior Manager,

F&A) for giving me an opportunity to do my project work in the organization.

I am extremely thankful to my faculty guide Prof. R.S. Veeravalli for his valuable guidance and

support during and upon completion of this project.

Any omission in this brief acknowledgement does not mean lack of gratitude.

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | viii

EXECUTIVE SUMMARY

India is now well-integrated with the world economy & moves in tandem with global

developments, both on the economic front as well as on the currency front. Since liberalization in

the early 1990s there have been a lot of changes in the Indian economy which have changed the

face of the Indian Financial Sector.

With the dismantling of trade barriers, business houses started actively approaching foreign

markets not only with their products but also to source capital and direct investment

opportunities. India Inc today has reached the scale and size of the global order and several

Indian organizations are today world leaders in their respective industries. Arriving on the global

scenario subjects corporations to diversified revenue streams in various geographies, thus leading

to invoicing in global currencies such as USD, GBP and EUR among others. Similarly, access to

various borrowing mechanisms and debt markets has also led to increased non-INR exposure on

books.

The objective of this project is to study and give a detailed description of the various hedging

instruments available in the Foreign Exchange market along with the different techniques used by

corporates.

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | ix

TABLE OF CONTENTS

Acknowledgement vii

Executive Summary viii

List of Diagrams x

1.0 Introduction: About the Company 1

2.0 Foreign Exchange Risk Management 8

3.0 Hedging Instruments 14

4.0 Research Methodology 22

5.0 Data Analysis 23

6.0 Conclusion 27

7.0 Bibliography 38

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | x

LIST OF DIAGRAMS

Fig. 1.1 Highlights of GAIL (India) Limited for the financial year 2011-12. 5

Fig. 1.2 Major products and brands of GAIL (India) Limited. 6

Fig. 2.1 The foreign risk management framework adopted by corporates. 12

Fig. 3.1 The different hedging techniques available to corporates to use. 19

SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 1

CHAPTER – 1

INTRODUCTION: ABOUT THE COMPANY


INTRODUCTION

GAIL (India) Limited is the largest state-owned natural gas processing and distribution

company headquartered in New Delhi, India. It has following business segments: Natural Gas,

Liquid Hydrocarbon, LPG Transmission, Petrochemical, City Gas Distribution, Exploration and

Production, GAILTEL and Electricity Generation. GAIL has been conferred with the Maharatna

status on 1 Feb 2013, by the Government of India. Currently only six other Public Sector

Enterprises (PSEs) enjoy this coveted status amongst all central CPSEs.

HISTORY

GAIL (India) Limited was incorporated in August 1984 as a Central Public Sector Undertaking

(PSU) under the Ministry of Petroleum & Natural Gas (MoP&NG). The company was previously

known as Gas Authority of India Limited. It is India's principal Gas transmission and marketing

company. The company was initially given the responsibility of construction, operation &

maintenance of the Hazira – Vijaypur – Jagdishpur (HVJ) pipeline Project. Between 1991 and


1993, three liquefied petroleum gas (LPG) plants were constructed and some regional pipelines

acquired, enabling GAIL to begin its gas transportation in various parts of India.

GAIL began its city gas distribution in New Delhi in 1997 by setting up nine compressed natural

gas (CNG) stations.

GAIL today has reached new milestones with its strategic diversification into Petrochemicals,

Telecom and Liquid Hydrocarbons besides gas infrastructure. The company has also extended its

presence in Power, Liquefied Natural Gas re-gasification, City Gas Distribution and Exploration

& Production through participation in equity and joint ventures. Incorporating the new-found

energy into its corporate identity, Gas Authority of India was renamed GAIL (India) Limited on

22 November 2002.

GAIL (India) Limited has shown organic growth in gas transmission through the years by

building large network of trunk pipelines covering length of around 11,000 kilometres (6,800

mi). Leveraging on the core competencies, GAIL played a key role as gas market developer in

India for decades catering to major industrial sectors like power, fertilizers, and city gas

distribution. Currently GAIL transmits more than 160 mmscmd of gas through its dedicated

pipelines and have more than 70% market share in both gas transmission and marketing.


VISION ELEMENTS

Leading Company: Be the undisputed leader in the natural gas market in India and a significant

player in the global natural gas industry, by growing aggressively while maintaining the highest

level of operating standards.

Natural Gas & Beyond: Focus on all aspects of the natural gas value chain and beyond

including exploration, production, transmission, marketing, extraction, processing, distribution,

utilization including petrochemicals and power and natural gas related infrastructure, products

and services.

Global Focus: Create and strengthen significant global presence to pursue strategic, attractive

opportunities that leverage GAIL‟s capabilities while effectively managing business risks.

Customer Care: Anticipate and exceed customer expectation through the provision of the

highest quality infrastructure, products and services.

Value Creation for all Stakeholders: GAIL will create superior value for all stakeholders

including shareholders, employees, business partners, surrounding communities and the nation.

Environmental Responsibility: GAIL is committed to operational excellence in all we do with a

focus on continuous efforts to improve environmental performance for ourselves and our

customers and will be sensitive to the needs of the environment in all our actions.


“Be the Leading Company in Natural Gas and Beyond,

with Global Focus, Committed to Customer Care,

Value Creation for all Stakeholders and Environmental Responsibility”

CORE ORGANISATION VALUES

Ethics: We are transparent, fair and consistent in dealing with all people. We insist on honesty,

integrity and trustworthiness in all our activities.

People: We believe that our success is driven by the commitment and excellence of our people.

We attract and retain result-oriented people who are proud of their work and are satisfied with

nothing less than the very best in everything that they do. We encourage individual initiative by

creating opportunities for our people to learn and grow. We respect the individual‟s rights and

dignity of all people.

Health, Safety and Environment: We promote highest levels of safety in our operation, health

of our employees and a clean environment. We strive for continuous development of the

communities in which we operate.

Customer: We strive relentlessly to exceed the expectations of our customers, both internal and

external. Our customers prefer us.

Shareholders: We meet the objectives of our shareholders by providing them superior returns

and value through their investments in us.


Technology: We believe technology is a key to the future success of our organization. We

advocate ‘best-in-class’ technologies.

HIGHLIGHTS 2011-12

Figure 1.1: Highlights of GAIL (India) Limited for the financial year 2011-12.

MAJOR FIGURES FOR GAIL GROUP COMPANIES

GAIL Group Companies account for:

About 3/4th

of the natural gas transmitted through pipelines in India

More than ½ of the natural gas sold in India

Almost 1/5th

(21%) of polyethylene produced in country

LPG produced for every 10th

LPG cylinder in the country

Pipeline transmission of around 1/4th

of the country‟s total LPG

Gas supply for about ½ of the country‟s fertilizer produced

12% + 10 Years CAGR (PAT)

TURNOVER: Rs. 40,281 Crore (US$ 7907 mn)

PBDIT: Rs. 6,247 Crore (US$ 1210 mn)

PBT: Rs. 5,340 Crore (US$ 1034 mn)

PAT: Rs. 3,654 Crore (US$ 708 mn)

16% + 10 Years (Turnover) CAGR


Gas supply for about ½ of the country‟s gas-based power generation

Operating more than 2/3rd

of country‟s CNG stations

More than ½ of country‟s piped natural gas supply

16%+ 10 year turnover CAGR

12%+ 10 year PAT CAGR

3900+ manpower asset

MAJOR PRODUCTS AND BRANDS

Figure 1.2: Major products and brands of GAIL (India) Limited.

CITY GAS DISTRIBUTION

• CNG: Automobiles

• PNG: Cooking, Water Heating, AC, Space Heating, Steam Generation, Power Generation, Dryers, Furnaces, Boilers

PETROCHEMICALS

• G-Lex: Pressure Pipes, OFC Ducts, Thin Films, Monofilament, etc.

• G-Lene: Wire and Cable, Pipe Coating, Injection Moulding, Film, Lamination

TELECOM

• GAILTEL: Bandwidth Leasing, Infrastructure Leasing

LIQUID HYDROCARBONS

• G-Propane: Manufacture of Textiles, Glass, Picture Tubes, Automobile, Bearings, Forging, Casting, Melting Industry, Refrigerant in AC etc.

• G-Pentane: Artificial Ice Formation, Low temperature thermometers, Pesticides, Production of iso and normal Pentane


MISSION STATEMENT

“To accelerate and optimize the effective and

economic use of Natural Gas and its fractions

to the benefit of national economy”


CHAPTER – 2

FOREIGN EXCHANGE RISK MANAGEMENT

INTRODUCTION

Firms that deal in multiple currencies when it comes to their business face a risk (unanticipated

gain/loss) on account of sudden changes in exchange rates that are unanticipated, quantified in

terms of exposure. In terms of Foreign Exchange, Exposure is defined as a contracted, projected

or contingent cash flow whose magnitude is not certain at the current moment and depends on the

value of the exchange rates.

So it is quite clear that the process which includes identifying such risks faced by the firm and the

subsequent process of the implementation of protection from these risks by financial and

operational hedging will be called foreign exchange risk management.

HEDGING

A hedge is an investment position which is taken with the intention of offsetting potential

losses/gains that may be incurred by another accompanying investment.

Simply put, Hedging is coming up with a way to protect yourself against a loss. Since you can

never really be sure what the market will do, hedging can be thought of as a way to reduce the

amount of loss you will incur in case of an unexpected happening.


TYPES OF FOREIGN EXCHANGE EXPOSURES

Foreign Exchange Exposures can be classified into three types, they are as follows:

(i) Transaction Exposure

(ii) Economic Exposure

(iii) Translation Exposure

ECONOMIC EXPOSURE:

It measures the impact of changes in exchange rates on the firm‟s cash flows and thus earnings.

In other words, Economic Exposure is the extent to which a firm‟s market value, in any particular

foreign currency, is sensitive to the unanticipated changes in exchange rates. The aforementioned

currency fluctuations affect the values of the firm‟s operating cash flows, income statement &

competitiveness with respect to the market, hence market share & stock price.

Another type of exposure which comes under the privy of the Economic Exposure is the Balance

Sheet Exposure. The currency fluctuations affect a firm‟s Balance Sheet by changing the value of

their assets & liabilities, accounts payables & receivables, debts in foreign currencies, inventory

and also investments in foreign banks(usually in the form of Current Deposits).


TRANSLATION EXPOSURE:

Also knows as Accounting Exposure. It measures the impact of changes in exchange rate on the

financial statements of the group of company.

In other words, it can be stated as the sensitivity of the net income of a group of companies to the

fluctuation in exchange rates between a foreign subsidiary and its parent company. It results from

the need to restate foreign subsidiaries‟ financial statements into the parent‟s reporting currency.

TRANSACTION EXPOSURE:

It refers to the sensitivity of the future cash transactions of the firm to changes in the current

exchange rates.

It is also sometimes seen as a short-term economic exposure.

FOREIGN RISK MANAGEMENT FRAMEWORK

Once the process of recognizing the exposures is done, a firm puts its valuable resources in

managing it. The usual tools used by the firms are as follows:

(I) Forecasts: The first step for a corporate is to come up with a forecast on the market

trends and to come up with a conclusion on what the main trend is going to be on the

exchange rates. The period of forecasts is usually 6 months. The most important thing

is to base the forecasts on valid assumptions rather than wild guessing.

(II) Risk Estimation: Using the forecast, a Value at Risk and the probability of this risk is

calculated. Value at Risk is the actual profit/loss for a move in rates according to the


forecast. Then, the Systems Risk that can arise due to inadequacies such as reporting

gaps and implementation gaps in the firms‟ system of exposure management is

estimated.

(III) Benchmarking: Knowing the exposures and the risk estimates, the firm has to come

up with limits for handling this exposure. It also has to decide whether it wants to

manage itself as a Cost Centre or Profit Centre basis. A Cost Centre approach is a

defensive approach with the aim of ensuring that the Cash Flows of the firm are not

adversely affected beyond a particular point. A Profit centre approach is a more

aggressive approach where in the firm decides to generate profits on the exposures

over a period of time.

(IV) Hedging: The firms decide upon an appropriate hedging strategy based on the limits

that they have set to manage the exposures. The various instruments available for the

firm are: Futures, Forwards, Options, Swaps & Issue of Foreign Debt.

(V) Stop Loss: In the above steps we have seen that the firms risk management decisions

are based on the forecasts which are nothing but estimates of unpredictable trends.

Therefore it is very necessary to have stop loss arrangements in place in order to

rescue the firm in case the forecasts turn out wrong.

(VI) Reporting and Review: These policies are usually subjected to review based on

periodic reporting. The reports include profit/loss status on open contracts after

marking to market, the actual exchange rate/interest rate achieved on the exposures

and profitability in relation to the benchmark and the expected changes in overall

exposure due to forecasted exchange/interest rate movements. The review analyses


whether the benchmarks were valid and effective in controlling exposures and finally

whether the overall strategy is working or needs change.

Figure 2.1: The foreign risk management framework adopted by corporates.

APPROACHES TO RISK MANAGEMENT

Once the risk has been identified, the management then shifts its focus on the mitigation of these

risks based on their approach towards the risk.

The different approaches that managements have towards risk management are as follows:

REPORTING AND REVIEW

STOP LOSS

HEDGING

BENCHMARKING

RISK ESTIMATION

FORECASTS


(i) Conservative Approach: Corporates having this approach don‟t want to assume any

risk and consequently are ready to forego any opportunity gains that might come their

way in due course. They prefer to lock themselves from both the averse and favorable

movements by hedging the exposure as soon as it is encountered. The up-side to this

kind of approach is that there is little chance of cash-flow destabilization as the yields

and costs of the transactions are known beforehand. The down-side is that it is highly

unlikely that it will lead to optimum costs or yields.

(ii) Moderate Approach: In this approach, the corporate opts for partial hedging of

exposures whenever the rates are attractive and benchmarks are achieved. Partial

hedging leaves the door open for the company to take advantage of the opportunity

gains, keeping a part of its exposure hedged so that any movement of the exchange

rate can help it to average out the total cost. This approach can turn out to be fruitful

provided the timing and quantum is properly evaluated.

(iii) Aggressive Approach: Corporates having this approach actively trade in the

currency markets through continuous re-bookings and cancellations of the forward

contracts. In pursuit of getting the best gains, they indulge in continuous buying and

selling of currencies. In this, the treasure functions like a profit centre rather than a

cost centre. Corporates having this kind of an approach have an appetite for risk as

this is a high risk-high reward approach.

(iv) Indifferent Approach: In this approach all the exposures are left un-hedged. This

approach is considered to be highly speculative, as everything is left to chance. The

risk of destabilizing of cash flows is the highest in this approach.


CHAPTER – 3

HEDGING INSTRUMENTS

INTRODUCTION TO DERIVATIVES:

A Derivative is a security whose price is derived from one or more underlying assets. The

common underlying assets are stocks, bonds, commodities, currencies, interest rates and market

indexes. A derivative is just a contract between two or more parties. The main role of derivatives

is to reallocate risk among market participants.

In the following section we will talk about hedging strategies used by corporates in India using

derivatives assuming foreign exchange risk as the only risk involved.

HEDGING INSTRUMENTS:

The different hedging instruments that can be used by corporates are as follows:

(i) Forwards

(ii) Futures

(iii) Options

(iv) Swaps

(v) Foreign Debts


FORWARDS: A forward contract in the foreign exchange market is one that locks in the

price at which a corporate can buy or sell a currency on a future date. It is also called as „Outright

Forward Currency Transaction‟, „FX Forward‟.

In this, the depreciation of the receivable can be hedged against by selling a currency forward.

Similarly if there is a risk of a currency appreciation, then it can be hedged by buying the

currency forward.

For Example, if GAIL wants to buy crude oil in Euros say a year down the line, it can enter into a

forward contract to pay INR and buy EUR and lock in a fixed exchange rate for INR-EUR to be

paid after a year irrespective of the actual INR-EUR exchange rate prevailing at the time. The

downside in this agreement will be an appreciation of dollar which has been protected by a fixed

forward contract.

The advantage with the forward contracts is the fact that they can be tailored to the needs of the

firm and an exact hedge suiting the corporate can be obtained. The only downside to these

contracts is their non-marketability; they can‟t be sold to another party.

FUTURES: A Futures contract is very similar to a Forward contract, the difference

lying in their tailor ability and liquidity. A Futures contract is more liquid in nature as it is traded

in the futures market which provides organized exchange. There is an advantage of futures, it

eliminates the problem of double coincidence due to the presence of a central futures market.

Trading in futures requires a small initial outlay which is a proportion of the value of the future,

which can help in gaining or losing significant amounts of money based on the actual forward

price fluctuations.


Using the same example used in the forward contracts, GAIL has to go a EUR futures exchange

to purchase standardized euro futures equal to the amount that they are willing to hedge as the

risk is that of appreciation of the euro. Here comes the disadvantage of the futures, its tailor

ability is limited as only standard denominations are provided by the futures market which is

different from the forwards in which exact amounts can be bought.

OPTIONS: A Currency Option is a contract which gives the right, not an obligation, to buy or

sell a specific quantity of one foreign currency in exchange for another at a fixed price which is

called the Strike/Exercise Price. Since, the exercise price is fixed in nature it reduces the

uncertainty of exchange rate fluctuations thus limiting the losses of open currency positions.

There are two types of Options: one is a Call Option and the other a Put Option.

Call Options are used if the risk involved is of an upward price trend of the currency, whereas Put

Options are used if the risk is that of a downward price trend of the currency.

Taking the same example, if GAIL buys a Call Option, as the risk is of upward trend in Euro rate,

they have the right to buy a specified amount of euros at a fixed rate on a particular date, there are

two possibilities. The first possibility is that of a favorable exchange rate movement i.e. the Euro

depreciates, then GAIL can buy Euros at the spot rate i.e. the prevailing rate since they have

become cheaper. The other possibility being, if the Euro appreciates compared to say the pre-

existing spot rate, GAIL can exercise the Call Option to purchase it at the agreed Exercise Price.

In both the cases GAIL is benefited by paying a lower price to purchase the Euro.


SWAPS: A Swap is a foreign currency contract wherein the buyer and the seller exchange

equal initial principal amounts of two different currencies at the spot rate. Over the term of the

contract the buyer and the seller exchange fixed or floating rate of interest payments in their

respective swapped currencies. And at maturity the principal amount is effectively re-swapped at

a predetermined exchange rate so that both the parties end up with their respective currencies.

The advantages of swaps are that firms with limited appetite for exchange rate risk can achieve a

partially or completely hedged position using this, while leaving their underlying borrowing

intact. Another advantage is that swaps also allow firms to hedge their floating interest rate risk

on top of the exchange rate risk.

For Example, take a export oriented company that has entered into a swap deal for a notional

principal of USD 10 mn at an exchange rate of 53/dollar. The company pays US 6 months

LIBOR to the bank and receives 11.5% p.a. every 6 months on January 1, and July 1, for the next

5 years. This company would have earnings in Dollars and can use the same to pay off the

interest for this kind of borrowing, thus hedging its exposures.

FOREIGN DEBT: Foreign Debt can be used to hedge foreign exchange risk by taking

advantage of the International Fischer Effect relationship. According to International Fischer

Effect, an expected change in the current exchange rate between any two currencies is

approximately equivalent to the difference between the two countries‟ nominal interest rates for

that period of time. The rationale behind IFE is that a country with a higher interest rate will tend

to have a higher inflation rate. And this high amount of inflation should cause that country‟s

currency with the high interest rate to depreciate against a country with lower interest rates.


For Example, suppose an exporter is set to receive a fixed amount of Euros in a few months, say

6 months, the exporter will lose if the domestic currency appreciates against Euros in the interim,

so in order to hedge this, he can take a loan in Euros for 6 months and convert the same into

domestic currency at the existing exchange rate. According to this theory, the gain realized by

investing the proceeds from the loan taken would match the interest payment for the loan.

TECHNIQUES EMPLOYED:

A corporate depending upon the market situation may decide to use a technique or a set of

techniques to control their exposures. The techniques which are being by corporates are as

follows:


Figure 3.1: The different hedging techniques available to corporates to use.

Currency Futures: An agreement between two parties, to purchase/sell a currency at a future

date at a fixed price. In India, we are yet to have a futures exchange and clearing house for

financial futures, but in the west, currency futures trade on the futures exchange and are subject

to a daily settlement procedure to guarantee that each party that claims against the other party in

the contract will be paid.

Hedging Techniques

Currency Futures

Currency Options

Currency Swaps

Forward Currency

Transactions

Invoicing and Currency Clauses

Leads and Lags

Matching

Multi-lateral Netting


Currency Options: Currency options offer the right to the holder, not an obligation though, to

buy or sell foreign currency at an agreed (strike) price, within a specified period of time.

Exchange-traded options are present as well as OTC options.

Currency Swaps: A transaction between two parties in which they agree to an exchange of

payments over a specific time period. In a cross-currency swap, the parties exchange principals in

different currencies at an exchange rate prevalent at the time and reverse the exchange rate at a

later date, usually this is the same exchange rate prevalent when the currencies were first

exchanged.

Forward Currency Transactions: In this agreement the two parties agree to buy/sell a

currency at a later date at a fixed price. The advantage of such a contract is that you are protected

from an adverse movement in exchange rates as the exchange rate is locked in beforehand at an

agreed level.

Invoicing and Currency Clauses: In some cases, trading companies have the option to invoice

their cross-border sales/purchases in domestic currency, so that the other party involved absorbs

the exchange rate risk. Invoicing in third country currencies is also practiced. And sometimes

invoicing is done in terms of currency baskets, which consists of a composite index of different

world currencies are allotted predetermined weights.

Leads and Lags: The alteration of normal payment or receipts in a foreign exchange

transaction because of an expected change in exchange rate is known as leads and lags.

Accelerating the transactions is called „leads‟ which is done when firms making the payments


expect the foreign exchange rate to increase, whereas slowing down the transaction is known as

„lags‟ and arises when the exchange rate is expected to go down.

Matching: In cash flow matching, cash inflows in one of the pairing currencies can be

offset against cash flows in the other currencies. A corporate tries to balance its receivables and

payables in a currency. In order to achieve this, a short or long term loan or deposit may also be

undertaken.

Multi-lateral Netting: An agreement between multiple parties that transactions rather than

being settled individually be summed. This helps in streamlining the settlement process and also

reduces risk in the case of a default by making all the outstanding contracts null and void. The

disadvantage that it carries is that the risk is shared and the legalities that go with the agreement.


CHAPTER – 4

RESEARCH METHODOLOOGY

I. Policy Review

II. Compliance Appraisal

III. Variance Testing

Policy Review: The existing foreign exchange policy of the company was reviewed.

Compliance Appraisal: In this section, the accounting policy of the company is checked to

be in accordance to the IAS/IFRS standards.

Variance Testing: In this, random transactions were picked and were tested for their

congruence to the governing policy.


CHAPTER - 5

DATA ANALYSIS

OBJECTIVE OF IAS 21

The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign

operations in the financial statements of an entity and how to translate financial statements into a

presentation currency. The principal issues are which exchange rate(s) to use and how to report

the effects of changes in exchange rates in the financial statements.

BASIC STEPS FOR TRANSLATING FOREIGN CURRENCY AMOUNTS

INTO THE FUNCTIONAL CURRENCY:

Steps apply to a stand-alone entity, an entity with foreign operations (such as a parent with

foreign subsidiaries), or a foreign operation (such as a foreign subsidiary or branch).

1. the reporting entity determines its functional currency

2. the entity translates all foreign currency items into its functional currency

3. the entity reports the effects of such translation in accordance with paragraphs 20-37 [reporting

foreign currency transactions in the functional currency] and 50 [reporting the tax effects of

exchange differences].


FOREIGN CURRENCY TRANSACTIONS:

A foreign currency transaction should be recorded initially at the rate of exchange at the date of

the transaction (use of averages is permitted if they are a reasonable approximation of actual).

[IAS 21.21-22]

At each subsequent balance sheet date: [IAS 21.23]

o foreign currency monetary amounts should be reported using the closing rate

o non-monetary items carried at historical cost should be reported using the exchange rate at

the date of the transaction

o non-monetary items carried at fair value should be reported at the rate that existed when the

fair values were determined

Exchange differences arising when monetary items are settled or when monetary items are

translated at rates different from those at which they were translated when initially recognised or

in previous financial statements are reported in profit or loss in the period, with one exception.

[IAS 21.28] The exception is that exchange differences arising on monetary items that form part

of the reporting entity's net investment in a foreign operation are recognised, in the consolidated

financial statements that include the foreign operation, in other comprehensive income; they will

be recognised in profit or loss on disposal of the net investment. [IAS 21.32]

As regards a monetary item that forms part of an entity's investment in a foreign operation, the

accounting treatment in consolidated financial statements should not be dependent on the

currency of the monetary item. [IAS 21.33] Also, the accounting should not depend on which

entity within the group conducts a transaction with the foreign operation. [IAS 21.15A] If a gain


or loss on a non-monetary item is recognised in other comprehensive income (for example, a

property revaluation under IAS 16), any foreign exchange component of that gain or loss is also

recognised in other comprehensive income. [IAS 21.30]

TRANSLATION FROM THE FUNCTIONAL CURRENCY TO THE

PRESENTATION CURRENCY:

The results and financial position of an entity whose functional currency is not the currency of a

hyperinflationary economy are translated into a different presentation currency using the

following procedures: [IAS 21.39]

o assets and liabilities for each balance sheet presented (including comparatives) are translated

at the closing rate at the date of that balance sheet. This would include any goodwill arising

on the acquisition of a foreign operation and any fair value adjustments to the carrying

amounts of assets and liabilities arising on the acquisition of that foreign operation are treated

as part of the assets and liabilities of the foreign operation [IAS 21.47];

o income and expenses for each income statement (including comparatives) are translated at

exchange rates at the dates of the transactions; and

o all resulting exchange differences are recognised in other comprehensive income.

Special rules apply for translating the results and financial position of an entity whose functional

currency is the currency of a hyperinflationary economy into a different presentation currency.

[IAS 21.42-43]


Where the foreign entity reports in the currency of a hyperinflationary economy, the financial

statements of the foreign entity should be restated as required by IAS 29 Financial Reporting in

Hyperinflationary Economies, before translation into the reporting currency. [IAS 21.36]

The requirements of IAS 21 regarding transactions and translation of financial statements should

be strictly applied in the changeover of the national currencies of participating Member States of

the European Union to the Euro – monetary assets and liabilities should continue to be translated

the closing rate, cumulative exchange differences should remain in equity and exchange

differences resulting from the translation of liabilities denominated in participating currencies

should not be included in the carrying amount of related assets. [SIC-7]

DISPOSAL OF A FOREIGN OPERATION:

When a foreign operation is disposed of, the cumulative amount of the exchange differences

recognised in other comprehensive income and accumulated in the separate component of equity

relating to that foreign operation shall be recognised in profit or loss when the gain or loss on

disposal is recognised. [IAS 21.48]

The company‟s foreign policy is in accordance to the required IAS21 norms.


CHAPTER – 6

CONCLUSION

HEDGING IN PRACTICE IN THE INDIAN SCENARIO

INTRODUCTION

In this section we will see how the hedging is done by corporates plying their trade in the Indian

markets. We will see how the companies use Forward Contracts, Options, Swaps and also how

they manage Foreign Debts and much more. We will also deal with how the benchmarking and

monitoring is done by Indian Corporates.

RBI(RESERVE BANK OF INDIA) REGULATIONS

The exposures for which the rupee forward contracts are allowed under the existing RBI

notification for various participants are as follows:

(I) Residents:

Genuine underlying exposures out of trade/business

Exposures due to foreign currency loans and bonds approved by RBI

Receipts from GDR issued

Balances in EEFC accounts

(II) Foreign Institutional Investors:

They should have exposures in India


Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in

market value/ inflows

(III) Non−resident Indians/ Overseas Corporates:

Dividends from holdings in a Indian company

Deposits in FCNR and NRE accounts

Investments under portfolio scheme in accordance with FERA or FEMA

HEDGING IN PRACTICE

PERIOD TO CONSIDER

The first question that one is exposed to when we think of Foreign Exchange Hedging is what

exposures to include in terms of the period to consider. Most corporates in India follow a rolling

12 month basis with some following the rolling 6 month basis as well. According to this, all

exposures falling due for payment (interest and loan repayments included) considered on a rolling

12 or 6 month basis respectively.

PORTFOLIO OR NOT?

Another important aspect of Indian Corporates is that they manage the exposure on a portfolio

basis rather than on an individual basis. This is not to say that none of the Corporates manage the

exposures on an individual basis, but here we are going to be talking about hedging on a portfolio

basis.

Portfolio basis is a better way to manage exposures in the minds of the Corporates as, in the

presence of a large number of transactions it becomes difficult to keep track of the individual


transactions. Managing exposures on a portfolio basis reduces the focus on individual

transactions and allows for a more holistic approach to risk management. The individual

transactions are included in the total transactions month-wise and managed accordingly on a

portfolio basis.

BENCHMARKING

A very important part of the Risk Management Process is the Benchmarking. In the Indian

markets usually stop loss levels are applied in relation to a benchmark and in ideal conditions the

benchmark should be the exchange rate used for costing, or for preparation of the corporate

budget, but these never serve as a practical benchmark because of the volatility of the exchange

rates which makes such a rate unrealistic in relation to market conditions when the exposure is

actually born.

Some companies use the forward exchange rate applicable to the maturity of an exposure, ruling

when the exposure is identified for risk management purposes plus the bank spread as the

benchmark.

In case of a foreign currency loan, if a hedge hasn‟t yet been taken, then the interest and principal

repayment amounts are included as an exposure if any payment falls within the next 12 months,

assuming that the firm applies a rolling 12 month basis with exposures. For Example, if there are

four exposures due in March 2014 of US$ 700,000 each which have been benchmarked at

different times at Rs.53 per $, Rs.54.75 per $, Rs.52 per $ and Rs.53.5 per $ respectively, then the

total portfolio of US$ 2.8 mn will have a benchmark average exchange rate of Rs.53.375 per $.


As we said, the benchmark rates take into account the bank spreads, which may be as follows:

For US$ Exposures: 0.6 paise per $

For Non-US$ Exposures: 6 basis points (bps)

How are these spreads used by the corporates is as follows:

For Example, if a US$ 100 payable is due in June 2013 for which the forward rate existing on the

day the exposure is recognized is Rs.54.50 per $, then the benchmark rate for that particular 100

USD would become Rs.54.5060 per $.

Now for the currencies which are quoted on an indirect basis, it will be exercised as follows:

If a 100 EUR payable is due in June 2013 and the forward rate is US$ 1.40 per EUR, the

benchmark rate for the USD:EUR will be $ 1.4006 per EUR and the corresponding USD

exposure would be benchmarked at Rs.54.5060 per $.

PRINCIPLE OF STOP LOSS

There is the stop loss principle which is used by companies in order to protect the firm from the

adverse movements of the exchange rates. Here is how it works:

Suppose, if a future payable has been benchmarked at Rs.54 per $. It has been left unhedged in

the expectation of getting a more favorable exchange rate than Rs.54 (the favorable movement

will be appreciation in the INR). In case the rupee starts falling and the stop loss which had been

decided was say 200 paise per $, then such an exposure should be hedged when the ruling

forward rate for the payable in question goes to Rs.56 per $.


This system protects the corporates in situations where there is adverse movement, but if the

movement is favorable they continue to benefit from it.

As we said companies apply benchmarking as a portfolio basis, So this is how the stop loss

system works in a portfolio situation:

Considering the previous example that we used of a US$ 2.8 mn payable which was

benchmarked at an average benchmark exchange rate of Rs.53.375 per $. If the company desires

to keep the portfolio loss less than or limited to Rs.42 lacs, then the entire portfolio should be

covered at an average rate of Rs.54.875 per $. Just in case one of those US$ 700,000 payables

have been benchmarked at Rs.52.175 per $, then the balance net open position must be hedged at

a maximum average rate of Rs.55.275 per $, in order to maintain the effective rate for the

exposure at Rs.54.875 per $.

CURRENCY OPTIONS

Now we will discuss how the corporates use the currency options to hedge their risks. In the

corporate scenario, an option contract is treated as an insurance contract – just as the best

insurance contract is the one on which no claim is made, the ideal option contract is the one

which is never exercised. The premium paid will be a dead loss, thus it is useful to consider

OTMF(Out of the Money) Forward Option Contracts( i.e. the strike rate is worse than the

existing forward rate) for risk management.

For Example, if a call option is taken to cover a payable which is due after 3 months at a strike

rate of Rs.56 per $, the premium payable would be say 90 paise per $. However if we use Rs.57,

the premium involved will come down to 50 paise per $. Since an option contract is taken by a


corporate when it expects a favorable rate movement but wants to protect itself from the adverse

movement, it is better to pay the lower premium albeit at a worse strike rate.

Some corporates have a separate budget for the option premium to be paid. But any premium

paid for the benchmarked portion of the exposures would be a part of the portfolio loss.

CURRENCY FORWARDS

Now coming to Forward Contracts, they are usually used when an adverse exchange rate

movement is expected (rupee depreciation), whereas OTMF Option contracts are preferred when

a favorable exchange rate movement is expected. Forward or option contracts are usually not

taken for maturity exceeding that of the underlying exposure. Also, the total notional amount of

the forward and option contracts does not exceed the amount of the exposure.

Explaining this using an example, in April-August 2011 when the rupee was stable in a narrow

range for a long time and was expected to strengthen, an option contract would have been the

ideal choice- as long as the exchange rate remained range-bound one could benefit from the

stability, but when the rupee declined, the downside risk was limited.

A 3 month call option contract with a strike rate of Rs.46.25 per $ was available in mid-May

2011 at a cost of 54 paise per $. This wouldn‟t have been exercised in mid- August 2011 when

the spot rate was Rs.45.35 per $ to get an effective rate of Rs.45.89 per $. However a 3-month

call option contract with a strike rate of Rs.46.25 per $ was available in July 2011 at a premium

of 22 paise per $. This would have been exercised in October 2011 to get an effective rate of

Rs.46.47 per $ instead of the prevailing spot exchange rate of around Rs.49 per $.


COMBINED STEP-UP HEDGING AND STAGGERED STOP LOSS

Another important technique used by corporates is the Combined Step-Up hedging and Staggered

Stop Loss, in this, the transactions in excess of a certain amount say US$ 10 mn instead of being

covered at a single stop loss level of say 180 paise worse than the forward rate, is covered by

using different stop loss levels. In this one-third of the transaction value is covered at the rate of

90 paise worse than the benchmark rate, another one-third of the transaction value at a rate of 180

paise worse than the benchmark rate and the balance at a rate of 270 paise worse than the

benchmark rate. Simultaneously, one-third of the transaction value is covered if the exchange rate

improves by 135 paise compared to the benchmark rate, another one-third when an improvement

of 270 paise takes place and the balance one-third when there is a gain of 405 paise over the

benchmark rate.

For Example, if a payable which is benchmarked at Rs. 53.50 per $, one third should be covered

if either Rs.52.15 or Rs.54.40 is available on the forward market, another one-third when

Rs.50.80 or Rs.55.30 is seen and the balance one-third when Rs.49.45 or Rs.56.20 is crossed. In

the end, the net overall open position is to be brought down to zero when the portfolio loss limit

is breached.


OPEN POSITION AND STOP LOSS LEVELS

The maximum MTM portfolio loss is usually fixed at around 2% per quarter and 8% per annum

of the previous financial year‟s PAT. The limit is usually managed on quarterly basis. Once this

limit is crossed all the exposures are automatically hedged.

Then there might be limits put on transactions exceeding a certain amount, say US$ 6 mn. They

may be managed separately. The individual stop loss levels attached to them will be around 150

paise per $ for USD exposures and 3% for any other non-$ currency. Though these transactions

will be monitored separately they continue to be a part of the overall net open position limit. And

also the gain/loss incurred in these transactions will be a part of the portfolio loss limit.

MONITORING

Now comes the monitoring aspect of a treasury department. Usually the day to day forward rates

are monitored and compared to the benchmark. It might be done on a weekly basis or whatever

suits the corporate. The periodicity is usually increased whenever the portfolio loss for the

specified period exceeds say 40-50% of the allowed limit (depends on the risk appetite of the

corporate). Then there might be a limit of 80% post which reporting needs to be done to the

FRMC. In any case open position can‟t be kept once the portfolio loss exceeds 1.75% of the

previous financial year‟s PAT in a quarter.

In case there are uncertainities about maturities, hedging can be done for the latest possible

delivery date.

In case of a change in the delivery dates, the premium/discount prevailing on the date of change

should be adjusted in the existing benchmark. For example, If a USD payable has been

benchmarked for March at an exchange rate of Rs.55.25 per $. In March, it is postponed to June.


Suppose the 3 month premium is 35 paise, the new benchmark for the very same exposure will

become Rs.55.60 per $.

BORROWINGS

A company with say a moderate approach to risk gives preference to rupee and foreign currency

borrowings, both short-term and medium-term almost in the same proportion as the cash flows in

different currencies. However, in general the foreign currency loan does not exceed 60% of the

total loans of the company.

A company avails debt in USD for following reasons:

1. Domestic inflation rate is, and is likely to remain, higher than in the U.S. which implies

that USD interest rates are likely to remain lower than for the Indian rupee. Thus,

borrowing in USD is cost effective from the interest cost angle.

2. Maintaining borrowings in the currency of cash flow (USD) also provides a hedge against

appreciation of the rupee against the invoicing currency.

3. If the rupee depreciates against the borrowed currency, this need not be a cause of

concern as the costlier debt servicing will be more than compensated by higher rupee

realization on the economic exposures.

RISK MANAGEMENT PROCESS

It completely depends upon the corporate if they want a part or whole of the exposure of Forex

loan be kept open, in the hope of gaining from profitable movement of exchange rate, the

company keeps a pre-determined stop loss level, which usually should not exceed the cost of


rupee finance, and if this level is hit a hedge must be taken automatically. The desired stop loss

level should be decided by the FRMC.

For example, a USD $100 million loan drawn at an average exchange rate of Rs.50 and an

effective spread of 1.5% over USD LIBOR, had a fully hedged cost of 8% p.a. compared to a

rupee interest cost of 10% p.a. This rate of 10% would become the benchmark for short-term

exposures, since long-term exposures are susceptible to greater swings in exchange rates and

hedging costs.

An alternative strategy to this is to keep a graded stop loss limit. In this case, the cost of a fully

hedged foreign currency loan is say 8%p.a. and the alternative rupee finance is at say 13% p.a.

One-third of the loan amount should be hedged when the effective cost exceeds 11.5% (mid-

point), and a further one-third should be hedged when the effective cost becomes 113% p.a. and

14.5% p.a.

INTEREST RATE RISK

A loan at a fixed rate has an implicit opportunity cost (if interest rate falls, company would not be

able to take advantage of the low rate). A loan at a floating rate has the inherent risk of interest

rates moving up leading to a higher-than budgeted cost. The global best practice is to keep a mix

between fixed and floating rates such that a minimum 30% is at fixed rate, a minimum 30% of

the borrowing at floating rate, and only for the balance amount the Treasury can decide whether

to keep the loan at fixed or at floating rate.


Interest rate risk is also managed by using interest rate caps and forward rate agreements (FRAs).

Caps are call options on the interest rate and limit the downside risk of an interest rate increase.

FRAs are forwards contracts on interest rates, and may be used in place of Interest Rate Swaps.

EEFC ACCOUNTS

Export Earners‟ Foreign Currency Accounts can be opened in relation to foreign currency

inflows. Hence, an EEFC account is opened for the foreign exchange receipts and payments. The

objective should be of matching receipts and payments in each currency as closely as possible in

order to eliminate transaction costs.

Given the two way movement of the rupee, there is little advantage in keeping large balances in

EEFC accounts with a view to profiting from exchange rate movements though.

SHORT-TERM FOREX FINANCE

This kind of finance is undertaken in order to take advantage of the lower cost of finance even on

a fully hedged basis. In such cases, a forward cover to hedge the exchange rate risk is taken in

order to ensure that the arbitrage opportunity by way of lower interest cost is locked into.

Hedging decisions should not be evaluated in retrospect. It could lead to misinterpretation even

speculation and also inappropriate to quantify loss or profit on the basis of cash flows


CHAPTER – 7

BIBLIOGRAPHY

Investopedia

http://www.investopedia.com/

Wikipedia

http://www.wikipedia.org/

Asani Sarkar, Indian Derivatives Markets, Oxford Companion to Economics in India, 2006

pp 1-7

Reserve bank of India

http://www.rbi.org.in/Scripts/BS_FemaNotifications.aspx

Nevada Business

http://www.nevadabusiness.com/2013/04/risk-management-a-necessary-consideration/

V Skills

http://www.vskills.in/certification/article/foreign-exchange-risk-management-

%E2%80%93-importance-external-treasury-management-solutions-smes


Deloitte IAS Plus

http://www.iasplus.com/en/standards/ias21

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