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
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A REPORT ON STUDY OF VARIOUS FOREIGN EXCHANGE HEDGING INSTRUMENTS

BY: MUKUND CHANDRAN

GAIL (INDIA) LIMITED

DATE: 10-06-2013
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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: GAIL (INDIA) LIMITED 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
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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 Roll No.: DM14128 Great Lakes Institute of Management, Chennai

Date: 10-06-2013

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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. c. d. has duly been completed fulfills the requirements of the Rules & Regulations relating to the Summer Internship of the Institute. 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

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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.

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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.

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TABLE OF CONTENTS
Acknowledgement Executive Summary List of Diagrams 1.0 2.0 3.0 4.0 5.0 6.0 7.0 Introduction: About the Company Foreign Exchange Risk Management Hedging Instruments Research Methodology Data Analysis Conclusion Bibliography vii viii x 1 8 14 22 23 27 38

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LIST OF DIAGRAMS

Fig. 1.1 Highlights of GAIL (India) Limited for the financial year 2011-12. Fig. 1.2 Major products and brands of GAIL (India) Limited. Fig. 2.1 The foreign risk management framework adopted by corporates. Fig. 3.1 The different hedging techniques available to corporates to use.

5 6 12 19

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CHAPTER 1 INTRODUCTION: ABOUT THE COMPANY GAIL (INDIA) LIMITED

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

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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.

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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 GAILs 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.

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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 individuals 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.

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Technology: We believe technology is a key to the future success of our organization. We advocate best-in-class technologies.

HIGHLIGHTS 2011-12
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

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 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 countrys total LPG Gas supply for about of the countrys fertilizer produced
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Gas supply for about of the countrys gas-based power generation Operating more than 2/3rd of countrys CNG stations More than of countrys piped natural gas supply 16%+ 10 year turnover CAGR 12%+ 10 year PAT CAGR 3900+ manpower asset

MAJOR PRODUCTS AND BRANDS

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

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

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MISSION STATEMENT To accelerate and optimize the effective and economic use of Natural Gas and its fractions to the benefit of national economy

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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.
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TYPES OF FOREIGN EXCHANGE EXPOSURES

Foreign Exchange Exposures can be classified into three types, they are as follows: (i) (ii) (iii) Transaction Exposure Economic Exposure Translation Exposure

ECONOMIC EXPOSURE: It measures the impact of changes in exchange rates on the firms cash flows and thus earnings. In other words, Economic Exposure is the extent to which a firms 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 firms 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 firms 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).

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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 parents 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
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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
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whether the benchmarks were valid and effective in controlling exposures and finally whether the overall strategy is working or needs change.

FORECASTS

RISK ESTIMATION

BENCHMARKING

HEDGING

STOP LOSS

REPORTING AND REVIEW

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:
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(i)

Conservative Approach: Corporates having this approach dont 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.
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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) (ii) (iii) (iv) (v) Forwards Futures Options Swaps Foreign Debts

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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 cant 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.
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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 preexisting 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.

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

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Currency Futures Multi-lateral Netting Currency Options

Matching

Hedging Techniques

Currency Swaps

Leads and Lags

Forward Currency Transactions Invoicing and Currency Clauses

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.
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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

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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.

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CHAPTER 4 RESEARCH METHODOLOOGY

I. II. III.

Policy Review Compliance Appraisal Variance Testing

Policy Review:

The existing foreign exchange policy of the company was reviewed. In this section, the accounting policy of the company is checked to

Compliance Appraisal:

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.

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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].

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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 o

foreign currency monetary amounts should be reported using the closing rate non-monetary items carried at historical cost should be reported using the exchange rate at the date of the transaction

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

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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];

income and expenses for each income statement (including comparatives) are translated at exchange rates at the dates of the transactions; and

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]

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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 companys foreign policy is in accordance to the required IAS21 norms.

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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: (II) 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

Foreign Institutional Investors: They should have exposures in India

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

(III)

Nonresident 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
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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 hasnt 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 $.

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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 $.
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This system protects the corporates in situations where there is adverse movement, but if the movement is favorable they continue to benefit from it. As we said companies apply benchmarking as a portfolio basis, So this is how the stop loss system works in a portfolio situation: Considering the previous example that we used of a US$ 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
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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 wouldnt 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 $.
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COMBINED STEP-UP HEDGING AND STAGGERED STOP LOSS Another important technique used by corporates is the Combined Step-Up hedging and Staggered Stop Loss, in this, the transactions in excess of a certain amount say US$ 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.

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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 years 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 cant be kept once the portfolio loss exceeds 1.75% of the previous financial years 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.
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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
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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% (midpoint), 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.

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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

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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

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Deloitte IAS Plus http://www.iasplus.com/en/standards/ias21

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