Summer project On Foreign Exchange Risk Management

By Paresh S. Mahajan

Atharva Institute of Management Studies

Marve Road, Malad (W), Mumbai 4000 95.

July 2005 Summer project On

Foreign Exchange Risk Management

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

"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.

Fo ig re n A.

Ex h n e cag

Risk Ma a e e t n g mn

Po y lic

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 FC MD US $ US $ US $ 1.50 M 2.50 M 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 MD 50% of transaction value open position over 50% of transaction value within US $ 10 M per A above

 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 Structured Trade Total Rs. 100 Lakhs Rs. 25 Lakhs Rs. 125 Lakhs

F re nE c a g E p su o ig x h n e x o re D fin n e itio 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.

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.

Ex o re We Ase a d L b p su h n s ts n ia ilitie H v F e F re n s a e ix d o ig C rre c V lu s u ny a e 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

a positive sign is referred to as a long exposure, the one with a negative sign is referred to as a short exposure.

Ex o re We th F re n u n y V lu o Ase a d p su h n e o ig -C rre c a e f s ts n Lb ia ilitie C a g s w aC a g inth E c a g R te s h n e ith h n e e xhn e a Though the change in foreign currency value may not be directly attributable to the movement in the exchange rate, the link between the two is certainly there due to common underlying factors. For example, inflation in a country, denoting a general increase in price levels would result in the value of any asset like real estate going up. At the same time, it would result in depreciation of the currency. In such a case, the degree of exposure would depend on the response of the exchange rate and of the assets value to the change in the underlying variable. Sometimes exchange rate movement does affect the foreign-currency value of the foreign asset or liability in an indirect way. Example, if there is a depreciation of the foreign currency; the foreign central bank may consider it imperative to increase the interest rates in the economy in order to defend its currency. In such a situation, the value of an asset in the form of an interest bearing security would stand reduced.

Ex o reo D m sticAse a dL b p su n o e s t n ia ilitie s Domestic assets and liabilities are not directly exposed to exchange rate movements, as no conversion from a foreign currency to the domestic currency is involved. Yet, even these assets and liabilities may be indirectly affected through interest rates. In the case of these assets and liabilities, the possibility of measurement of exposure and the degree of exposure would again depend on the predictability of the change in domestic prices. The calculation of exposure would also be done in the same way as for foreign assets and liabilities whose value change with a change in the exchange rate.

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Op ra gIn o e e tin c m s 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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Ty e o E p su p s f x o re 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

T n c nE p su ra sa tio x o re 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. T n tio E p su ra sla n x o re 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. O e tin E p su p ra g x o re 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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Mn g m n o T n c na dT n tio E p su a a e e t f ra sa tio n ra sla n x o re 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 dayto-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.

E p su N ttin x o re e g

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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.

L a in a dL g in ed g n ag g 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.

H d in b C o sin th C rre c o In o in e g g y h o g e u n y f v ic g 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.

H d in th u hS u in e g g ro g o rc g 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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H d in th u hth F rw rdMrk t e g g ro g e o a a e 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.

H d in th u hF tu s e g g ro g u re 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. H d in th u hO tio s e g g ro g p n

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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.

H d in th u hMn yMrk t e g g ro g o e a e 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.

O e P sitio pn o n

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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.

S pL ss L it to o im 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.

S pL ss O e to o rd r 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.

M a dF re R Mn g m n IL n o x isk a a e e t

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Mahindra Intertrade Limited is basically an import driven company. Approximately 9095 % 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.

H wL tte o C d o e te o e r f re it p ra s 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. Exports basically 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, Electrical Steel 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 in need 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 15th Nov 2005, company will be paying at this rate only.

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