Research Paper

On

Foreign Exchange Risk Management

Submitted In Partial Fulfillment

Of the Requirement

Of Masters of Business Administration

Table of Contents
EXECUTIVE SUMMARY............................................................................................2
CHAPTER 1: PLAN OF THE RESEARCH.......................................................................7
1.1. INTRODUCTION.................................................................................................8
1.1.1. Features of Forex Market......................................................................................9
1.1.2. Functions of Forex Market...................................................................................10
1.1.3. Structure of Forex Market....................................................................................11
1.1.4. Needs for Foreign Exchange................................................................................12
1.1.5. What Does Forex Provide?..................................................................................12
1.1.6. Methods of Quoting Exchange Rates......................................................................12
1.1.7. Types of Transactions.........................................................................................14
1.1.8. Factors Affecting Exchange Rates..........................................................................15
1.1.9. Factors Affecting Indian Rupee.............................................................................16
1.1.10. FORIEGN EXCHANGE RISK...........................................................................20
Classification of Foreign Exchange Risk.........................................................................20
1.1.11. Trends in currencies fluctuation...........................................................................24
1.1.12. Foreign Exchange exposure................................................................................26
Types of Foreign exchange exposure..............................................................................26
Managing the Transaction Exposure........................................................................28
Differences between Forward Contracts & Future Contracts.................................................31
1.2. OBJECTIVES....................................................Error! Bookmark not defined.
1.3. SCOPE.............................................................Error! Bookmark not defined.
1.4. LITERATURE REVIEW......................................................................................36
CHAPTER 2: COMPANY PROFILE.............................................................................39
2. COMPANY’S INTRODUCTION...........................................................................40
2.1. Company History................................................................................................40
2.2. Company Profile.................................................................................................40
2.3. Company Layout.................................................................................................43
2.4. Company’s Role and Vision...................................................................................44
2.5. Sales Performance...............................................................................................45
2.6. Profitability........................................................................................................46
2.7. Market Share......................................................................................................47
2.8. SWOT Analysis..................................................................................................48
CHAPTER 3: RESEARCH METHDOLOGY...................................................................49
3. RESEARCH METHODOLOGY................................................................................50
CHAPTER 4: ANALYSIS AT HSCI.............................Error! Bookmark not defined.
4 . FOREIGN EXCHANGE RISK MANAGEMENT AT HSCI.......Error! Bookmark not
defined.
4.1. Foreign currency exposure faced by HSCI..............Error! Bookmark not defined.
4.2. Foreign currency transactions at HSCI..................Error! Bookmark not defined.
4.3. HSCI’s exposure elasticity.................................Error! Bookmark not defined.
4.4. Analysis of HSCI’s delta...................................Error! Bookmark not defined.
4.5. Determining the foreign exchange exposure............Error! Bookmark not defined.
4.5.1. Imports payment system at HSCI...............Error! Bookmark not defined.
4.5.2. Estimating the forex exposure....................Error! Bookmark not defined.
4.5.3. Tracking Chart of Honda city, Japan...........Error! Bookmark not defined.
4.5.4. Statement of Exposure.............................Error! Bookmark not defined.
4.5.5. Booking of forward contract......................Error! Bookmark not defined.
4.5.6. Currency Options as an alternative for Forward Contracts.......Error! Bookmark not
defined.
4.6. Situational Analysis.........................................Error! Bookmark not defined.
4.6.1. Situation A...........................................Error! Bookmark not defined.
4.6.2. Situation B...........................................Error! Bookmark not defined.
4.6.3 Situation A V/s Situation B............................Error! Bookmark not defined.
CONCLUSION........................................................................................................51
SUGGESSTIONS.....................................................................................................53
BIBLIOGRAPHY.....................................................................................................54
BIBLIOGRAPHY
EXECUTIVE SUMMARY

Foreign Exchange, in common parlance, is the exchange of one currency for another. This
exchange is done at a particular rate called the exchange rate or the FX Rate. The FX Rate is
the price of one currency in terms of another. As is true with rates, FX rate too is for a pre-
determined settlement date i.e. the date on which the actual exchange of the currencies
involved would take place.

Foreign exchange risk is the risk that profits will change if FX rates change. FX risks present
complicated transfer pricing issues. What FX risks does the Honda Siel Cars India Ltd bear?
If not, what adjustments are appropriate? Foreign exchange risk is related to the variability of
the domestic currency values of assets, liabilities or operating income due to unanticipated
changes in exchange rates, whereas foreign exchange exposure is what is at risk. This project
focuses on an FX risk management and how to structure the provisions to adjust results when
exchange rate changes occur.

The Liberalized Exchange Rate Management System (LERMS) was introduced in March
1992, and as a result the foreign exchange market in India effectively became a two-tire one,
with a dual exchange rate system in force. One rate was the administered one at which
specified type or proportion determined by demand and supply in the market and applied to
the remaining transactions. In March 1993, this system was abolished and now a single
market determined rate is applicable for all transactions.

The volatility of exchange rates can’t be traced to the single reason and consequently, it
becomes very difficult to precisely define the factors that affect exchange rates. Under
today’s system of floating FX rates, currencies often move dramatically over short periods. In
one two-day period the yen/U.S. dollar exchange rate moved nearly 20 percent. Empirical
studies demonstrate that FX volatility can significantly affect companies’ profits.

Multinational businesses face several types of FX risk, including financial, translational,

transactional and economic FX risk. We focus here on economic risk, also known as
operational or competitive FX risk. Economic risk arises, for example, when a multinational
business incurs costs in one currency and generates sales in another. Profits may decrease if
the cost currency appreciates against the sales currency.

Multinational businesses have tools to reduce economic FX risk. They may use financial
instruments to hedge unfavorable FX moves, although doing so entails explicit costs. They
also may change their operations to reduce FX risk. For instance, they may change the
denomination of cash deposits, restructure contracts, relocate plants, or change the source of
capital or production materials. They may share FX risks with related parties or pass the costs
or benefits of FX changes through to unrelated customers or suppliers. But even businesses
that hedge or optimally structure their operations to reduce FX risk may be disadvantaged if a
competitor experiences a favorable FX move.

The project started with the primary objective of understanding the foreign exchange risk
exposed at Honda Siel Cars India Ltd and the secondary objective is to study the existing
foreign exchange risk at the company and evaluate the risk by using different tools and
techniques. The next subject the project discusses about the research methodology, involves
the collection, analysis and interpretation of data. In this there are sub sections such as
research plan, research design, research instruments, data collection and sampling and the
limitations.

Project elaborates on the concept of foreign exchange market by defining the features,
functions, structure of foreign market. This concept evaluates the needs of such marketplace
for the organization and helps in meeting the demands and supply internationally. What are
the different types of risk are being exposed to HSCI and how they are to be hedged with
different hedging strategies. While analyzing the HSCI foreign exchange risk management
two situations have been taken on the basis of which the suggestions and findings is been
done. The analysis of risk management helps HSCI in gaining competitive advantage among
its competitors such as Maruti, Toyota etc.

Business firms like Honda Siel Cars India Ltd. have internationalized their activities
considerably. This trend has manifested itself not only in increased involvement in
international trade and foreign operations, but also in the fact that even firms without explicit
international transactions have become subject to the direct and indirect effects of foreign
competition to a much larger extent than in the past. Thus, the impact of exchange rate
changes on business operations tends to be pervasive; the concern is not limited to specific
financial functions such as corporate treasury.
CHAPTER 1: PLAN OF THE RESEARCH
1.1. INTRODUCTION

The international currency market - the foreign exchange, is a special kind of the world
financial market. The Foreign Exchange, also referred to as the "Forex" or "Spot FX"
market, is the largest financial market in the world, with over $3 trillion changing hands
every single day. If you compare that to the $30 billion a day volume that the New York
Stock Exchange trades, you see how giant the Foreign Exchange really is. In fact it is thirty
times larger than all of the US Equity and Treasury markets combined!

What is traded on the Foreign Exchange? The answer is money. Forex trading is where the
currency of one nation is traded for that of another. Trader’s purpose on this market is to get
profit as the result of foreign currencies purchase and sale in accordance with a known
principle “buy cheaper – sell higher” and to convert profits made in foreign currencies, buy
or sell products and services in a foreign country, into their domestic currency. Forex trading
is always traded in pairs. The most commonly traded currency pairs are traded against the
US Dollar (USD). They are called ‘the majors'. The major currency pairs are the Euro Dollar
(EUR/USD); the British Pound (GBP/USD); the Japanese Yen (USD/JPY); and the Swiss
Franc (USD/CHF). As there is no central exchange for the Forex market, these pairs and
their crosses are traded over the telephone and online through a global network of banks,
multinational corporations, importers and exporters, brokers and currency traders i.e. the FX
market is considered as an Over The Counter (OTC) or 'inter-bank' market.

On the spot market, according to the BIS study, the most heavily traded products were:
✔ EUR/USD - 28%
✔ USD/JPY - 17%
✔ GBP/USD (also called cable) - 14%

And the US currency was involved in 89% of transactions, followed by the euro (37%), the
yen (20%) and sterling (17%). (Note that volume percentages should add up to 200% - 100%
for all the sellers, and 100% for all the buyers). Although trading in the euro has grown
considerably since the currency's creation in January 1999, the foreign exchange market is
thus still largely dollar-centered.
Forex is different in compare to all other sectors of the world financial system thanks to his
heightened sensibility to a large and continuously changing number of factors, accessibility
to all individual and corporative traders, exclusively high trade turnover which creates an
ensured liquidity of traded currencies and the round – the clock business hours which enable
traders to deal after normal hours or during national holidays in their country finding
markets abroad open. Just as on any other market the trading on Forex, along with an
exclusively high potential profitability, is essentially risk - bearing one.

1.1.1. Features of Forex Market

• Location – it is described as Over The Counter (OTC) market as there is no physical
place where the participants meet to execute the deals, as we see in case of stock market.
It is more of an informal arrangement among the banks and brokers operating in the
financial centre, purchasing and selling currencies, connected to each other by
telecommunication like telex, telephone, and a satellite communication network, SWIFT.

• Size of the market- It is the largest financial market in the world, with a daily average
turnover of US$1.9 trillion — 30 times larger than the combined volume of all U.S.
equity markets.

The most recent, bank of international settlement survey stated that over $900 billion
were traded worldwide each day. During peak volume period, the figure can reach
upward of US $2 trillion per day. The corresponding to 160 times the daily volume of
NYSE

• 24- Hour market - It is a true 24-hour market, Forex trading begins each day in
Sydney, and moves around the globe as the business day begins in each financial center,
first to Tokyo, London, and New York. Unlike any other financial market, investors can
respond to currency fluctuations caused by economic, social and political events at the
time they occur - day or night.

In India, the market is open for the time the banks are open for their regular banking
business. No transaction takes place on Saturdays.

• Efficiency – Developments in communication have largely contributed to the

efficiency of the market the participants keep abreast of current happenings by access to
services like Dow Jones Telerate Reuter. Any significant development in any market is
 almost instantaneously received by other markets situated at far off places. This makes
the forex market very efficient as if the functioning is under one roof.

• Currencies traded – in most markets USD is the vehicle currency i.e. a currency
used to denominate international transactions. USD is involved as one of the currencies in
87% of the transactions followed by EURO (37%), Japanese Yen (20%) and Pound
Sterling (17%).

1.1.2. Functions of Forex Market

A foreign exchange market performs three important functions:

• Transfer of Purchasing Power:

The primary function of a foreign exchange market is the transfer of purchasing power
from one country to another and from one currency to another. The international clearing
function performed by foreign exchange markets plays a very important role in
facilitating international trade and capital movements.

• Provision of Credit:

The credit function performed by foreign exchange markets also plays a very important
role in the growth of foreign trade, for international trade depends to a great extent on
credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit
facilities are available also for exporters. The Euro-dollar market has emerged as a major
international credit market.

• Provision of Hedging Facilities:

The other important function of the foreign exchange market is to provide hedging
facilities. Hedging refers to covering of export risks, and it provides a mechanism to
exporters and exporters to guard themselves against losses arising from fluctuations in
exchange rates.
1.1.3. Structure of Forex Market
There are four levels of participants in the foreign exchange market.

Figure 1.1: Structure of Forex Market

• At the first level, are tourists, exporters, exporters, investors, etc. These are the immediate
users and suppliers of foreign currencies.

• At the second level, are the commercial banks, which act as clearing houses between
users and earners of foreign exchange.

• At the third level, are foreign exchange brokers through whom the nation’s commercial
banks even out their foreign exchange inflows and outflows among themselves?

• Finally at the fourth and the highest level is the nation’s central bank, which acts as the
lender or buyer of last resort when the nation’s total foreign exchange earnings and
expenditure are unequal. The central then either draws down its foreign reserves or adds
to them.
1.1.4. Needs for Foreign Exchange

We can see some cases of barter trades that have taken place and continue to take place. For
example, Iraq’s oil-for food and medicines deal with the UN, Iran paying with oil for its
imports, our own barter agreement with Russia in settlement of our debt across escrow
account, Cuba paying for its much needed food, medicines and raw materials with sugar and
so on. Though we see these isolated cases of barter trades, the world primarily deals for
money.
In this global village, which has almost as many currencies as countries, business activity
would come to near standstill if each country insisted on dealing in its own currency and
none other. With growing importance of international trade and maturity in financial
markets, the major international trade participants have come to accept certain currencies as
“traded currencies” or “major currencies”. These currencies are termed as such based on the
strength of their economies and their financial markets, the political backing of the countries,
international acceptability, liquidity and depth of their markets, economic, currency and
political stability. The World Bank, leading international leading agencies and world bodies
have given a further boost to these currencies, using them in their dealings too. A country’s
external reserves are denominated in these currencies. This is what necessitates Foreign
Exchange.

1.1.5. What Does Forex Provide?

Foreign Exchange provides us:

✔ The method or mechanism to conduct and settle the proceeds of International trade,
✔ The means to obtain / provide technology, expertise and the sharing of information,
✔ The means to minimize the risks of currency fluctuations – primarily through the use of
various tools and financial instruments, and
✔ Trading opportunities to generate incremental income.

1.1.6. Methods of Quoting Exchange Rates

a. Two -way quotation
It is customary in foreign exchange market to always quote two rates means one rate for
buying and another for selling. This helps in eliminating the risk of being given bad rates i.e.
if a party comes to know what the other party intends to do i.e., buy or sell, the former can
take the latter for a ride.

There are two parties in an exchange deal of currencies. To initiate the deal one party asks for
quote from another party and the other party quotes a rate. The party asking for a quote is
known as ‘Asking party’ and the party giving quote is known as ‘Quoting party’

b. Direct and Indirect Quotation

• Direct quotation

In direct quotation foreign currency is kept constant and change in price is Indicated by the
change in the number units of the domestic currency equivalent to one unit of foreign
currency. It is also known as home currency quotation. E.g. US $1 = Rs. 40.3400/3500

In direct quotation the principle adopted by banks is to buy foreign currency at a lower price
and sell it at a higher price

• Indirect quotation

In indirect quotation, the home currency is kept constant and the change in price is indicated
by the change in the number units of the foreign currency equivalent to one unit of domestic
currency. E.g. Rs. 100 = US $2.1252/1260

In indirect quotation the principle adopted by banks is to buy foreign currency at a higher
price and sell it at a lower price.

In India, with the effect from August 2, 1993, all the exchange rates are quoted in direct
method, i.e. US $1 = Rs. 49.3400 GBP1 = Rs. 69.8700

a. American and European quotation

The interpretation of quotation as direct and indirect is not confinement when the market
quotes rates for two currencies neither of which is the domestic currency. To avoid multiple
quotations, international market adopts USD as the standard currency and exchange rates are
quoted in terms of or against this currency.
The quotation is in American terms when the rate is expressed as so many units of USD per
unit of foreign currency. It is in European terms when the quotation is the number of foreign
currency per unit of USD.

In international markets, barring few exceptions, all rates are quoted in European terms.

a. Cross Rate

As stated earlier, the exchange rate in the forex market is quoted in terms of the standard
currency i.e. USD. The exchange rate between a pair of currencies ,neither of which being
USD is worked by using the rate for each of these currencies in terms of USD .such rate is
known as cross rate. E.g. rate of JPY in terms of INR is required and we have following two
rates:-

1 USD = 110 JPY

1 USD = Rs.40.5

Then 1 JPY =40.5/110= 0.3681

Hence 1 JPY = Rs.0.3681 is the cross rate obtained from standard rates of both the
currencies.

b. Forward rates

The forward exchange rate is the rate that is contracted today for the exchange of currencies
at a specified date in the future. More often the forward rate of a currency may be costlier or
cheaper. The difference between the forward rate and the spot rate is known as the “forward
margin” or “swap points”. The forward margin can be at premium or at discount. Under
direct quotation , premium is added to spot rate and discount is deducted from the spot rate to
arrive at the forward rate

1.1.7. Types of Transactions

i. Spot transactions

The transaction where the exchange of currencies takes place two days after the date of
contract is known as the spot transaction. The date on which the contract is made is known as
the “deal date” and the date on which the currencies are to be exchanged is known as “value
date”. Both the currencies are paid on the same day so that there is no loss of interest to either
of the parties.

When no qualifications are added ,a transaction in the interbank market is a spot transaction.
But funds may be required urgently in which case it may require early settlement. in that case
a special quotation may be asked for delivery on the same day or on the next day.

The transaction in which the currencies are exchanged on the same day of the transaction, the
transaction is known as cash or ready transaction. It is also known as value today.

ii. Forward transaction

The transaction in which the exchange of currencies takes place at a specified future date,
subsequent to the spot date, is known as a forward transaction or outright forward transaction.

A forward contact for delivery one month means the exchange of currencies will take place
after one month. The date for forward contract will be calculated from the spot date. For
e.g.,1 month forward contract is entered into on 22nd April will fall due on 24th May.

iii. Swap transaction

It is a deal between the same counterparties in which the same currency for same value is
purchased and sold for different maturities. For e.g. ICICI Bank and HDFC Bank agree under
which ICICI Bank buys USD 1 million spot and sells it forward for 2 months.

iv. Non deliverable forwards

Under this the actual delivery of forward contract does not takes place. On the due date ,the
spot rate for the currency concerned is compared with the forward rate agreed under the
contract and the difference is settled.

1.1.8. Factors Affecting Exchange Rates

In a free market, it is the demand and supply of the currency which should determine the
exchange rates but demand and supply is the dependent on many factors, which are
ultimately the cause of the exchange rate fluctuation, some times wild.

The volatility of exchange rates can not be traced to the singe reason and consequently, it
becomes difficult to precisely define the factors that affect exchange rates. How ever, the
more important among them are as follows:
✔ Balance of payments
✔ Strength of economy
✔ Fiscal policy
✔ Interest rates
✔ Monetary policy
✔ Political factor
✔ Exchange control
✔ Central bank intervention
✔ Speculation
✔ Technical factors
✔ Expectations of the foreign exchange market

1.1.9. Factors Affecting Indian Rupee

As we know that Forex market for Indian currency is highly volatile where one cannot
forecast exchange rate easily, there is a mechanism which works behind the determination of
exchange rate. One of the most important factors, which affect exchange rate, is demand and
supply of domestic and foreign currency. There are some other factors also, which are
having major impact on the exchange rate determination. After studying research reports on
relationship between Rupee and Dollar of last four years we identified some factors, which
have been segregated under four heads. These are:

1. Market Situation.
2. Economic Factors.
3. Political Factors.
4. Special Factor.
1. Market Situation:
India follows the “floating rate system” for determining exchange rate. In this system
“market situation” also is pivot for determining exchange rate. As we know that 90% of the
Forex market is between the inter-bank transactions. So how the banks are taking the
decision for settling out their different exposure in the domestic or foreign currency that is
impacting to the exchange rate. Apart from the banks, transactions of exporters and
importers are having impact on this market. So in the day-to-day Forex market, on the basis
of the bank and trader’s transactions the demand and supply of the currencies increase or
decrease and that is deciding the exchange rate. On the basis of this study we found out the
different types of the decisions, which is affecting to market. These are as follows:

✔ In India, there are big Public Sectors Units (PSUs) like ONGC, GAIL, IOC etc. all the
foreign related transactions of these PSUs are settled through the State Bank of India.
E.g. India is importing Petroleum from the other countries so payment is made through
State Bank of India in the foreign currency. When State Bank of India (SBI) sells and
buys the foreign currency then there will be noticeable movement in the rupee. If the SBI
is going for purchasing the Dollar then Rupee will be depreciated against Dollar and vice
versa.

✔ Foreign Institutional Investor’s (FIIs) inflow and outflow of the currency is having the
major impact on the currency. E.g. U.S. based company is investing their money through
the Stock markets BSE or NSE so her inflows of the Dollars is increasing and when it is
selling out their investments through these Stock markets then outflows of the Dollars
are increasing. However if the FIIs inflowing the capital in the country then there will be
the supply of the foreign currency increases and Demand for the Rupee will increases
and that will resulted appreciation in the rupee and vice versa.

✔ Importer and Exporter’s trading is also affecting to the rupee. Like if an Indian exported
material to U.S. so he will get his payments in Dollars and that will increase the supply
of Dollars and increase of demand of rupee and that will appreciate the rupee and vice
versa.

✔ Banks can be confronted different positions like oversold or over bought position in the
foreign currency. So bank will try to eradicate these positions by selling or purchasing
the foreign currency. So this will be increased or decreased demand and supply of the
currency. And that will cause to appreciation or depreciation in the currency.

✔ As we know that in India there is a floating rate system. In India Central Bank (RBI) is
always intervene in the trade for smoothen the market. And this RBI can achieve by
selling foreign exchange and buying domestic currency. Thus, demand for domestic
currency which, coupled with supply of foreign exchange, will maintain the price foreign
 currency at the desired level. Interventions can be defined as buying or selling of foreign
currency by the central bank of a country with a view to maintaining the price of a given
currency against another currency. US Dollar is the currency of intervention in India.

2. Economic Factors:
In the Forex Market Economic factors of the country is playing the pivot role. Every country
is depending on its prospect economy. If there will be change in any economy factors, which
will directly or indirectly affected to Forex market. Here there are two types of economic
factors. These are as follows:

A. Internal Factors.

B. External Factors.

A. Internal Factors:
✔ Industrial Deficit of the country.
✔ Fiscal Deficit of the country.
✔ GDP and GNP of the country.
✔ Foreign Exchange Reserves.
✔ Inflation Rate of the Country.
✔ Agricultural growth and production.
✔ Different types of policies like EXIM Policy, Credit Policy of the country as well
reforms undertaken in the yearly Budget.
✔ Infrastructure of the Country

B. External Factors:
✔ Export trade and Import trade with the foreign country.
✔ Loan sanction by World Bank and IMF
✔ Relationship with the foreign country.
✔ Internationally OIL Price and Gold Price.
✔ Foreign Direct Investment, Portfolio Investment by the country.
✔
3. Political Factors:
In India election held every five years mean thereby one party has rule for the five years. But
from the 1996 India was facing political instability and this type of political instability has
created hefty problem in the different market especially in Forex market, which is highly
volatile. In fact in the year 1999 due to political uncertainty in the BJP Government the
rupee has depreciated by 30 paise in the month of April. So we can say that political can
become important factor to determine foreign exchange in India.
Due to political instability there can be possibility of de possibility delaying implementation
of all policies and sanction of budget. So that will create also major impact on trade.

4. Special Factors:

✔ Till now we have seen the general factors, which will affect the Forex market in daily
business. And on that factors the different players in the market have taken the decision.
But some times some event happened in such a way that it will really change the whole
scenario of the market so we can called that event special factors. However traders have
to really consider those things and take the decisions. We will see these types of factors
in detailed:

✔ In the year 1998, when BJP government has done “Pokhran Nuclear Test” at that time
rupee has been depreciated around 85 paise in day and 125 paise in seven days. Her main
fear was that U.S., Australia and other countries have stop to sanctions the loans So this
type of event will have major impact on the market. And due to this the decision
procedure of the trader also varies.

In the year 2000,India has faced Kargil war, which is also affected to the market. By this war
the defense expenditures are raised and due to that there will be increase in the fiscal deficit.
And become obstacle in the growth of the economy. So this type of event has impact on the
Forex market.
1.1.10. FORIEGN EXCHANGE RISK

It is defined as the net potential gain or loss which can arise from exchange rate changes due
the foreign exchange exposure of an enterprise. It covers two possibilities i.e. possibility of
making loss due adverse exchange rate movement and the possibility of making profit due to
the favorable exchange rate movement.

An enterprise engaged in export/import trade will be affected by the change in the rate of
exchange between the domestic currency and the currency in which the transaction is
designated. For instance an Indian company which imported its parts and equipments from
France when the euro was quoted at Rs.58 per euro will suffer a loss if the euro appreciates to
Rs.59 per euro by the time imports payment becomes payable

Classification of Foreign Exchange Risk

1) Position Risk
2) Gap or Maturity or Mismatch Risk
3) Translation Risk
4) Operational Risk
5) Credit Risk

1. Position Risk
The exchange risk on the net open FX position is called the position risk. The position can
be a long/overbought position or it could be a short/oversold position. The excess of foreign
currency assets over liabilities is called a net long position whereas the excess of foreign
currency liabilities over assets is called a net short position. Since all purchases and sales are
at a rate, the net position too is at a net/average rate. Any adverse movement in market rates
would result in a loss on the net currency position.

For example, where a net long position is in a currency whose value is depreciating, the
conversion of the currency will result in a lower amount of the corresponding currency
resulting in a loss, whereas a net long position in an appreciating currency would result in a
profit.
Given the volatility in FX markets and external factors that affect FX rates, it is prudent to
have controls and limits that can minimize losses and ensure a reasonable profit.
The most popular controls/limits on open position risks are:

A) Daylight Limit: Refers to the maximum net open position that can be built up a
trader during the course of the working day. This limit is set currency-wise and the overall
position of all currencies as well.
B) Overnight Limit: Refers to the net open position that a trader can leave overnight –
to be carried forward for the next working day. This limit too is set currency-wise and the
overall overnight limit for all currencies. Generally, overnight limits are about 15% of the
daylight limits.

2. Mismatch Risk/Gap Risk

Where a foreign currency is bought and sold for different value dates, it creates no net
position i.e. there is no FX risk. But due to the different value dates involved there is a
“mismatch” i.e. the purchase/sale dates do not match. These mismatches, or gaps as they are
often called, result in an uneven cash flow. If the forward rates move adversely, such
mismatches would result in losses. Mismatches expose one to risks of exchange losses that
arise out of adverse movement in the forward points and therefore, controls need to be
initiated.

The limits on Gap risks are:

A) Individual Gap Limit: This determines the maximum mismatch for any calendar
month; currency-wise.
B) Aggregate Gap Limit: Is the limit fixed for all gaps, for a currency, irrespective of
their being long or short. This is worked out by adding the absolute values of all overbought
and all oversold positions for the various months, i.e. the total of the individual gaps,
ignoring the signs. This limit, too, is fixed currency-wise.
C) Total Aggregate Gap Limit: Is the limit fixed for all aggregate gap limits in all
currencies.

3. Translation Risk
Translation risk refers to the risk of adverse rate movement on foreign currency assets and
liabilities funded out of domestic currency.
There cannot be a limit on translation risk but it can be managed by:
I. Funding of Foreign Currency Assets/Liabilities through money markets i.e.
borrowing or lending of foreign currencies

II. Funding through FX swaps

III. Hedging the risk by means of Currency Options

IV. Funding through Multi Currency Interest Race Swaps

4. Operational Risk
The operational risks refer to risks associated with systems, procedures, frauds and human
errors. It is necessary to recognize these risks and put adequate controls in place, in advance.
It is important to remember that in most of these cases corrective action needs to be taken
post-event too.

The following areas need to be addressed and controls need to be

initiated.

A) Segregation of trading and accounting functions: The execution of deals is a

function quite distinct from the dealing function. The two have to be kept separate to ensure
a proper check on trading activities, to ensure all deals are accounted for, that no positions
are hidden and no delay occurs.

B) Follow-up and Confirmation: Quite often deals are transacted over the phone
directly or through brokers. Every oral deal has to be followed up immediately by written
confirmations; both by the dealing departments and by back-office or support staff. This
would ensure that errors are detected and rectified immediately.

C) Settlement of funds: Timely settlement of funds is necessary not only to avoid

delayed payment interest penalty but also to avoid embarrassment and loss of credibility.
D) Overdue contracts: Care should be taken to monitor outstanding contracts and to
ensure proper settlements. This will avoid unnecessary swap costs, excessive credit balances
and overdrawn Nostro accounts.

E) Float transactions: Often retail departments and other areas are authorised to create
exposures. Proper measures should be taken to make sure that such departments and areas
inform the authorised persons/departments of these exposures, in time. A proper system of
maximum amount trading authorities should be installed. Any amount in excess of such
maximum should be transacted only after proper approvals and rate.

5. Credit Risk
Credit risk refers to risks dealing with counter parties. The credit is contingent upon the
performance of its part of the contract by the counter party. The risk is not only due to non
performance but also at times, the inability to perform by the counter party.

The credit risk can be

✔ Contract risk: Where the counter party fails prior to the value date. In such a case, the
FX deal would have to be replaced in the market, to liquidate the FX exposure. If there
has been an adverse rate movement, this would result in an exchange loss. A contract
limit is set counter party-wise to manage this risk.

✔ Clean risk: Where the counter party fails on the value date i.e. it fails to deliver the
currency, while you have already paid up. Here the risk is of the capital amount and the
loss can be substantial. Fixing a daily settlement limit as well as a total outstanding limit,
counter party-wise, can control such a risk.

✔ Sovereign Risk: refers to risks associated with dealing into another country. These risks
would be an account of exchange control regulations, political instability etc. Country
limits are set to counter this risk.

1.1.11. Trends in currencies fluctuation

The foreign exchange rates are very volatile and fluctuate a lot. The charts given below
shows the trends in currency fluctuations over the last financial year. Volatility in three
exchange rates i.e. INR/USD, JPY/ USD/ and INR/ 100 JPY have been studied .The volatility
of a currency against another currency can estimated by calculating its standard deviation.
Standard deviation of an exchange rate determines the amount of risk in that exchange rate
i.e. how volatile its movement is. This give an estimated of the
volatility in Foreign exchange rates of currencies in which HSCI USD/ INR

makes import payments. Mean 40.31634

Standard
Deviation 0.88402
Minimum 39.26188
Fig. 1.2: Volatility in INR/1 USD Maximum 43.42162
Source: http://usd.cer24.com/inr/search/k/1-usd-in-inr-history/

JPY/ USD

Mean 113.4687
Fig 1.3: Volatility in JPY/USD
Source: http://www.exchange-rates.org/history/JPY/USD/G
Standard
Deviation 6.917889
INR/ 100 JPY
Minimum 96.9252
Mean 35.33321
Maximum
Median 124.039
35.09
Standard
Deviation 1.861036
Fig 1.4: Volatility in INR/100 JPY Minimum 32.76
Source: inr.exchangerates24.com/jpy/history/?q=30 Maximum 41.91

After analysis of the trends in three exchange rates it can be said that all three exchange rates
had shown a great amount of riskiness and volatility. The volatility shown by JPY/USD was
highest as the standard deviation of this exchange rate has been the highest followed by
INR/100 JPY and INR/USD.

1.1.12. Foreign Exchange exposure

Exchange exposure is defined as the extent to which transactions, assets and liabilities of an
enterprise are denominated in currencies other than the reporting currency of the enterprise
itself .the reported currency is normally the national currency of the parent company.

Exposure arises because the enterprise denominates transactions in a foreign currency or it

operates in a foreign market. The exposure is measured by the value of the assets and
liabilities or transactions denominated in foreign currency

Types of Foreign exchange exposure

a) Transaction Exposure

The gain or loss that arises on account of exchange rate fluctuations when the foreign
currency denominated transaction is settled and converted into domestic currency is
referred to as transaction exposure. It refers to the risk associated with the changes in
the exchange rate between the time an enterprise initiates a transaction and settles it.

Whenever a firm has foreign-currency-denominated receivables or payables, it is

subject to transaction exposure, and the eventual settlements have the potential to
affect the firm’s cash flow position. Transaction exposure is simply the amount of
foreign currency that is receivable or payable.

The transaction losses or gains are absorbed in the profit and loss account for the year
concerned and thus affect the profit of the company. Alternative ways of hedging
transaction exposure are used to minimize the effect of foreign currency fluctuation.

b) Translation exposure

The risk that a company's equities, assets, liabilities or income will change in value as
a result of exchange rate changes. This occurs when a firm denominates a portion
of its equities, assets, liabilities or income in a foreign currency. It is also known as
"accounting exposure".

Accountants use various methods to insulate firms from these types of risks, such as
consolidation techniques for the firm's financial statements and the use of the most
effective cost accounting evaluation procedures. In many cases, this exposure will be
recorded in the financial statements as an exchange rate gain (or loss).

c) Operating exposure
Operating exposure is defined by Alan Shapiro as “the extent to which the value of a
firm stands exposed to exchange rate movements, the firm’s 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.

Operating exposure has an impact on the firm's future operating revenues, future
operating costs and future operating cash flows. Clearly, operating exposure has a
longer-term perspective. Given the fact that the firm is valued as a going concern
entity, its future revenues and costs are likely to be affected by the exchange rate
changes.

The firm's ability to adjust its cost structure and raise the prices of its products and
services is the major determinant of its operating risk exposure.

d) Exposure elasticity

The percentage change in profits per percentage change in the exchange rate

It is known as delta. In order to determine delta for a company which imports and
don’t export is as follows.

δ = - [h (1/r -1)]

h= foreign currency-denominated costs as a percent of total costs

r= the profit rate”

Some interpretations that can be drawn by measuring Delta can be

• Sign of the delta i.e. positive or negative helps in determining the

direction in which the profit rate will move with the increase /decrease in
foreign currency exchange rate. Negative delta means profit decreases
with the increase in value of the home currency and vice versa
 • Value of the delta helps in determining the extent of change that a change
in foreign exchange rate of the currency can have on the profit rate. E.g.
If the delta is (-4), this means that a 1% increase in the foreign currency
exchange rate can decrease the profit rate by 4%
• Higher the delta means greater the exposure. This is because greater the
delta means greater will be the effect on profit rate with a change in the
foreign currency exchange rate.
• A company having delta of “0” means its foreign exchange payables are
equal to foreign exchange receivables.

Managing the Transaction Exposure

a) Internal hedge

i) Exposure netting

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.

ii) Leading and lagging

Leading and lagging can also be used to hedge exposures. Leading involves advancing a
payment i.e. making a payment before it is due. Lagging, on the 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.

iii) Hedging by Choosing the Currency of Invoicing

One very simple way of eliminating transaction and translation exposure is to invoice all
receivables and payables in the domestic currency. However, only one of the parties involved
can hedge itself in this manner. It will still leave the other party exposed as it will be leading
in a foreign currency. Also, as the other party needs to cover its exposure, it is likely to build
in the cost of doing so in the price it quotes/ it is willing to accept.

Another way of using the choice of invoicing currency as a hedging tool relates to the
outlook of a firm about various currencies. This involves invoicing exports in a hard 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.

iv) Hedging through Sourcing

Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in
the same currency in which it sells its products. This results in netting of the exposure, at
least to some extent. This technique has its own disadvantages. A company may have to buy
raw material which is costlier or of lower quality than it can otherwise buy, if it restricts the
possible sources in this manner. Due to this technique is not used very extensively by firms.
 b) External Hedge

i) Forward contract

A forward contract is an arrangement whereby an agreed amount of foreign currency is

bought or sold for a specified future delivery at a predetermined rate of exchange.

The parties to the contract may be a bank and its customer .the contract may also be between
two banks.

A forward contact is an OTC product and can be customized to meet the particular needs of a
customer with respect to currency, amount, and maturity date .it is available at the counters of
the bank dealing in foreign exchange. An exporter can who has a payable due in 1 month
may hedge its position by entering into a forward contract when he apprehends that the
currency in which the transaction is denominated will appreciate in future.

As the size and other terms can be tailor made according to the requirements of the customer,
the forward contracts provide a perfect hedge but the opportunity to gain from favorable
movement in the rates is also lost.

Outright forwards in major currencies are available over-the-counter from dealers for
standard contract periods or “straight dates” (one, two, three, six, and twelve months); dealers
tend to deal with each other on straight dates. However, customers can obtain “odd-date” or
“broken-date” contracts for deals falling between standard dates, and traders will determine
the rates through a process of interpolation.
The agreed-upon maturity can range from a few days to months or even two or three years
ahead, although very long-dated forwards are rare because they tend to have a large bid-asked
spread and are relatively expensive.
The customized forward contracts for nonstandard dates or amounts are generally more
costly and less liquid, and more difficult to reverse or modify in the event of need than are
standard forward contracts.
The forward rate for any two currencies is a function of their spot rate and the interest rate
differential between them.
The figure below shows the trend of Inter Bank Forward Premia of USD over the last
financial year. The premia is at higher rate when the value of USD is expected to rise with
respect to INR. Similar it is at a lower rate or even at discount when the value of USD is
expected to fall with respect to INR
Fig 1.5: Inter-Bank Forward Premia of U.S. Dollar
Source: http://www.rbi.org.in/scripts/WSSView.aspx?Id=14898

Futures
It is an agreement entered into with the specified future exchanges to buy or sell a standard
amount of foreign currency at a specified price for delivery on a specified future date.

Differences between Forward Contracts & Future Contracts

The major differences between the forward contracts and futures contracted are as follows:

➢ Nature and size of Contracts: Futures contracts are standardized contracts in that
dealings in such contracts is permissible in standard-size sums, say multiples of
125,000 German Deutschmark or 12.5 million yen. Apart from standard-size
contracts, maturities are also standardized. In contrast, forward contracts are
customized/tailor-made; being so, such contracts can virtually be of any size or
maturity.
 ➢ Mode of Trading: In the case of forward contracts, there is a direct link between the
firm and the authorized dealer (normally a bank) both at the time of entering the
contract and at the time of execution. On the other hand, the clearinghouse interposes
between the two parties involved in futures contracts.

➢ Liquidity: The two positive features of futures contracts, namely their standard-size
and trading at clearinghouse of an organized exchange, provide them relatively more
liquidity vis-à-vis forward contracts, which are neither standardized nor traded
through organized futures markets. For this reason, the future markets are more liquid
than the forward markets.

➢ Deposits/Margins: while futures contracts require guarantee deposits from the

parties, no such deposits are needed for forward contracts. Besides, the futures
contract necessitates valuation on a daily basis, meaning that gains and losses are
noted (the practice is known as marked-to-market). Valuation results in one of the
parties becoming a gainer and the other a loser; while the loser has to deposit money
to cover losses, the winner is entitled to the withdrawal of excess margin. Such an
exercise is conspicuous by its absence in forward contracts as settlement between the
parties concerned is made on the pre-specified date of maturity.

➢ Default Risk: As a sequel to the deposit and margin requirements in the case of
futures contracts, default risk is reduced to a marked extent in such contracts
compared to forward contracts.

➢ Actual Delivery: Forward contracts are normally closed, involving actual delivery of
foreign currency in exchange for home currency/or some other country currency
(cross currency forward contracts). In contrast, very few futures contracts involve
actual delivery; buyers and sellers normally reverse their positions to close the deal.
Alternatively, the two parties simply settle the difference between the contracted price
and the actual price with cash on the expiration date. This implies that the seller
cancels a contract by buying another contract and the buyer by selling the contract on
the date of settlement.

The current exchange control regulations do not permit futures trading in currencies in
India

i) Options contract
Currency options are derivative instruments, which give buyer of the option the right but not
the obligation to execute a specified transaction in the underlying currency pair. It gives the
buyer the flexibility to execute settlement of option or not.

The rate at which one currency can be purchased or sold is one of the terms of the option and
is called the exercise price or strike price

These are different from other derivatives like forwards and futures in a way that it provides
downside protection against risk and also an upside benefit from favorable movements in the
underlying exchange rates.

Since the person has the right to buy or sell the foreign currency, but not the obligation, it can
let the option expire by not exercising its right, in case the exchange rates move in its favor,
thereby making the profits it would not have made had it hedged through currency forwards
or currency futures.

However, the above advantage does not come free because the above feature currency
options generally cost more than other tools of hedging. The other advantage offered by
options is flexibility in selecting the exchange rate at which a currency can be bought or sold
unlike for forwards or futures in which there is only one exchange rate There are two types of
Currency options i.e. CALL & PUT as elucidated below.

Fig. 1.6: Types of Currency Options

Call: An option which gives the option buyer the right to purchase (go long) a particular
currency at a specific rate. If the buyer exercises the call option, he will acquire a long
currency position and someone who has sold an option will be assigned a short currency
position at the same time.
Put: An option which gives the option buyer the right to sell (go short) a currency and
someone who has sold an option will be assigned a long currency position at the same time.

Profit/loss from an option – The profit/loss arising from currency options under various
circumstances are as under.

Fig1.7: Profit/loss from an option

ii) Money market hedge

This is also known as spot market hedge .under this method the company which has an
exposure in a foreign currency covers it by borrowing or investing the concerned currency in
the money market and squares its position on the due date. For e.g. let us that an exporter has
to pay USD 100,000 after 1 month .the exchange rate of USD/INR is quoted as follows:
Spot Rs.39
1 month Forward Rs.40
If he wants to hedge through forward market, he can book forward contract at Rs.42, in
which case on due date cash flow will be Rs.42 lakhs.
The other way he can cover his position is to purchase dollar immediately in the spot
market and invest it in the money market. The value of dollars invested will be so decided
that together with the interest earned, the amount received from the investment at the end
of 1 month will be USD 100,000. Assuming an interest rate of 10% on the investment, the
principal required to be invested is USD 90909.09
For buying USD 90909.09, the company has to pay Rs 35, 45,454.51 to buy USD at spot
rate of Rs 39.
By making such a money market hedge the company ends up buying the USD with a
reduced amount of cash flow, which is even lower than the cash flow if the company
would have bought the USD at spot price of Rs.39.
So by using money market hedge the company manages the risk of appreciation in the
value of USD and also manages to buy USD for future period at an outflow of funds which
is even lower than the outflow of funds in case the whole amount USD was bought at spot
price.
1.4. LITERATURE REVIEW

Exchange rate exposure is becoming an increasingly important issue in international financial

management. Exchange rate fluctuations are a major source of risk for multinational
corporations. To mitigate exchange rate uncertainty, it has been claimed that hedging; not
only financial hedging, but also operational hedging can protect companies from unexpected
exchange rate movements of exchange rates. Firms that are exposed to exchange risk can
actively reduce currency by two ways. On the other hand, firms can hedge exchange rate risk
by financial hedging, entering into derivatives contracts such as forwards, futures or options.
The motivation of this study came from the recent rise in volatility in the money markets of
the world and particularly in the US Dollar. Hedging with derivative instruments is a feasible
solution to this situation. Firm hedges the risk only when it is able to select the correct
derivative instrument. A large number of studies have been taken place till now on the basis
of which this conclusion is made:-

The study by Anuradha and Runa, they attempted to evaluate the various alternatives
available to the Indian corporate for hedging financial risks. By studying the use of hedging
instruments by major Indian firms from different sectors, the paper concludes that forwards
and options are preferred as short term hedging instruments while swaps are preferred as long
term hedging instruments. The high usage of forward contracts by Indian firms as compared
to firms in other markets underscores the need for rupee futures in India. In addition, the
paper also looks at the necessity of managing foreign currency risks, and looks at ways by
which it is accomplished. A review of available literature results in the development of a
framework for the risk management process design, and a compilation of the determinants of
hedging decisions of firms. The paper concludes by pointing out that the onus is on Reserve
Bank of India, the apex bank of the country, and its Working Group on Rupee Futures to
realize the need for rupee futures in India and the convertibility of the rupee. [Anuradha
Sivakumar and Runa Sarkar (Corporate Hedging for Foreign Exchange Risk)]

This paper investigates the impact of firm-wide risk management practices on the foreign
exchange exposure of 208 U.S. multinational corporations (MNC) over the period 1994 to
1998.
Firm-wide risk management is referred to here as the coordinated use of both financial
hedges, such as currency derivatives, and operational hedges, described by the structure of a
firm’s MNC foreign subsidiary network. We find that the use of currency derivatives,
particularly forward contracts, is associated with reduced levels of foreign-exchange
exposure. Furthermore, MNCs with dispersed operating networks have lower levels of
currency exposure. These findings are robust to alternative ways of measuring foreign
exposure. Finally, our results strongly support the view that MNCs hedging in a coordinated
manner can significantly reduce exposure to currency risk. These results strongly suggest that
operational and financial hedges are complementary risk management strategies. [David A.
Cartera, Christos Pantzalisb, and Betty J. Simkins, (Firmwide Risk Management of
Foreign Exchange Exposure by U.S. Multinational Corporations), 2003]

The paper reports the results of an empirical study into the foreign exchange risk
management of large German non-financial corporations. Of the 154 firms that were
addressed, a total of 74 took part in the study. The managers of these firms were asked about
the measurement of exchange risk, about their management strategies, and about
organizational issues. The results can be summarized as follows. The majority of the firms
are concerned about managing their transaction exposure. Most firms adopted a selective
hedging strategy based on exchange rate forecasts. Only a small minority of firms does not
hedge foreign exchange risk at all, and only few companies hedge their transaction exposure
completely. Looking in more detail at the management of the firms' exposure to the US-
dollar, we found that only 16% of the firms were fully hedged. The majority of firms’ had
realized hedge ratios between 50 and 99%. The study found a number of interesting
discrepancies between the positions of the academic literature and corporate practice. For
instance, numerous firms are concerned about their accounting exposure and some firms are
actively managing it. The exposure concept favored by the academic literature, that is,
economic exposure, is of little importance in practice. Further the paper found that almost
half of the firms manage their exchange positions on the basis of the micro hedge approach.
In other words, they forego the possibility to establish the firm's net exposure by balancing
out cash outflows and inflows first. The most interesting finding from an academic point of
view, however, is the widespread use of exchange rate forecasts and of exchange risk
management strategies based on forecasts (selective hedging). By adopting such strategies,
the managers indicate that they do not believe that the foreign exchange markets are
information efficient and they are able to beat the market with their own forecasts. [Martin
Glaum (Foreign Exchange Risk Management in German Non-Financial Corporations:
An Empirical Analysis)]

This research has produced results relevant to speculating and hedgingactivities in the
leveraged spot market. The paper has developed a new speculating and hedging approach in
the foreign exchange market using leveraged spot markets, an application which has received
scant attention in the literature. Speculators can have a broader range of financial alternatives
that allow them to take advantage of favorable currency movement, while at the same time
reducing the riskiness of speculation by receiving risk-free income from a positive interest
rate differential between two countries. From a hedger’s perspective, hedging using the
leveraged spot market can yield a superior outcome when compared to traditional hedging
tools such as unleveraged forward contracts. [ Hirshman-Herfindal concentration index.
Ching Hsueh Liu (Foreign Exchange Hedging and Profit Making Strategy using
Leveraged Spot Contracts)]

This paper analyzes the corporate demand for interestrate-risk management in Australia.We
show that previous studies have faced data limitations in order to measure relevant variables.
For example, due to limitations in the information available in financial reporting, most
previous studies were not able to quantify firms’ financial risk exposures. In consequence, the
usual dependent variable used to measure the extent of financial hedging is the ratio of
principal notional amount of derivatives to firm size. Most previous studies explicitly
recognise the limitations of using this variable, but no better variable was available under
the accounting standards in force at the time the data was generated. Therefore, this study
builds on previous studies in the sense that it is able to measure the interest-rate-risk
exposures of non-financial Australian companies. [Ebook Corporate Interest Rate Risk
Management With Derivatives In Australia: Empirical Results, Thu, 11/26/2009 -
03:40]

On the basis of above research papers and e-book information, it can be concluded that the
practice of corporate risk management has changed dramatically over the past two decades. It
helped in framing certain objectives for this project thus selecting between the different types
of derivative instruments for hedging the risk of HSCI.
CHAPTER 2: COMPANY PROFILE
 1. COMPANY’S INTRODUCTION
2.1. Company History

The history of the Honda Motor Company began with the vision of one man –Soichiro Honda
.Whose dream was personal mobility for everyone .Soichiro Honda founded the Honda
Motor Company in 1948.He liked the smell of petrol so much that it inspired him to design &
engineer the first product of this company –a 50 cc motorized bike on a bicycle frame –in his
small shed at Hamamatsu ,in the same year. Honda is a global company with a global point
view & a five –region global strategy that is reflected in a solid commitment to local markets
& economies. ‘Challenging the limits’ is a phrase commonly heard across the length &
breadth of Honda .It was made popular by its founder, Soichiro Honda ,who knew that his
fledgling company had to out- think & out- perform its competitors every step of the way in
order to survive. After all, he started out at a time when his country was devastated by war.

2.2. Company Profile

Honda Siel Cars India Ltd. (HSCI) was incorporated in December 1995 as a joint venture
between Honda Motor Co. Ltd., Japan and Siel Limited, a Siddharth Shriram Group
company, with a commitment to providing Honda’s latest passenger car models and
technologies, to the Indian customers. The Honda City, its first offering introducing in 1997,
revolutionized the Indian passenger car market and has ever since been recognized as an
engineering marvel in the Indian automobile industry. The success of City as well as all its
other models has led HSCI to become the leading premium car manufacturer in India. The
total investment made by the company in India till date is Rs. 1620 crores. The company has
a capacity of manufacturing 100,000 cars per annum.

Establishment in 1948, Honda Motor Co, Ltd, is one of the leading manufacturers of
automobiles & the largest manufacturer of motorcycles in the world. The company is
recognized internationally for its expertise & leadership n developing & manufacturing a
wide variety of products that incorporate Honda’s highly efficient internal combustion engine
technologies, ranging from small general purpose engines to specialty sports cars.
Approximately 17.2 million Honda products were sold worldwide during the fiscal yr ended
March 31, 2008 .Throughout all of its operations –from product development & manufacture
to sales –Honda maintains a commitment to materialize company’s vision of “Value Creation
“, “Globalization” & “Commitment to the future” with the aim of sharing the joy with the
customers worldwide, thus becoming a company that society wants to exist.

Seeking to maximize customer satisfaction levels, they work together with numerous
business partners to supply Honda products to countries worldwide .Integral in this effort is
global network of 441 subsidiaries & affiliates (317 consolidated subsidiaries, 21 non –
consolidated subsidiaries &103 affiliates).

Honda is a company that gave new meaning to mobility. It thinks globally & acts locally. It
creates products after continuous research in order to give a cleaner, innovative output.

Other aspects like environment protection, safety measures, and community development are
taken into consideration.

HONDA –wants to continue as a company whose existence will be valued by the people. At
Honda, dreams are what drive employees. Honda started with an auxiliary engine –equipped
bicycle in 1948 & has continued to deliver innovative products that contribute to the mobility
of individuals & the well-being of society. Honda respects people & value their individual
differences & this has led to a free, vital corporate culture that encourages creativity. Today,
Honda develops & produces its own original products & technologies for a diverse range of
markets, from small power engines to scooters & sports cars.

Honda has always sought to provide genuine satisfaction to people around the world. They
strive to deliver products & services that customers in each locality want most. The result is
over 124 manufacturing facilities in 28 countries outside of Japan, producing the
motorcycles, automobiles & power products that bring them into contact with over 17 million
customers each year.

At the same time, Honda recognizes its social responsibilities as a corporate citizen to be
proactive in pursuing solutions to environmental & safety issues. Honda management is
working to reduce impact on the global environment at all stages of operations , from
development & production to sales .By implementing policies to improve the efficiencies
with which they use energies & other natural resources , reduce the harmful emissions &
increase the fuel efficiencies of our products , & create green factories , therefore helping to
solve the world’s environmental problems. As a manufacturer of mobility products, it also
considers it as its responsibility to create cars that are safer not only for occupants, but or
pedestrians as well. Honda is committed to promoting safer driving & to making mobility
safer for everyone.

Fig: 2.1. Honda’s Network

2.3. Company Layout

Table 2.1: Company’s Layout

Divisions Departments
Finance and Finance: Financial planning, arrangement and monitoring of
Account funds, day to day banking etc.

Accounts: Maintaining the books of accounts, finalization of

Balance sheet.

Costing: Maintenance of cost records, budget variances etc.

Excise & Tax: Filing & filling of returns and assessment of

cases.
MANUFACTURING PPC: Production Planning and Control.

Imports: Logistics Planning and clearance of imports.

Material Service: Receipt of parts on line.

Weld Shop: Welding of parts onto the white body.

Paint Shop: Surface treatment and painting of white body and

bumpers.

Engine Assembly: Assembly and testing of engines

manufactured.

Final Assembly: Manufacture of complete car unit with all

assemblies and subassemblies after receiving painted body
from Paint Shop.

Vehicle Quality: Finished product checked for quality.

Parts Quality: To ensure quality of local parts.

Material Quality: Material testing and calibration of

 equipments.

Production Administration: Training Safety, Administration

activities of manufacturing division.

Utility: Operation and Maintenance of utilities and civil

structure.

Quality Engineering: Study/Control drawings /

specifications, Product development and Homologation.
INFORMATION Information Technology: Maintenance
TECHNOLOGY and updation of website /webmail etc., software development

AFTER SALES Service & CRM: Service to customers as to

maintain the reliability of product and build long term
relationship with customer.

Parts: Strategic planning of spare part.

Sales: Monitor the daily sales volume, targets set & achieved,
etc.
MARKETING Marketing: Consists of activities like advertising, sales
promotion, event management,merchandising, market
research, product planning and public relations.

Dealer Development: Infrastructure development and

maintenance, dealer audit.

Commercial: Deals with vehicle dispatch and activities

thereon.

ADMINISTRATION Administration: Provides administrative support to the

organization which includes transportation, uniform, security,
canteen etc.
 HR: Performs activities like manpower planning, recruitment
and selection, performance management, training and
development etc.

AR: Personnel functions for line associates, attendance,

payroll management and compliance to labour laws.

CS & Legal: Looks after compliance with legal and company

laws.

2.4. Company’s Role and Vision

Fulfilling the global needs of personal mobility in the new automotive society - go hand
in hand with the corporate philosophy: maintaining a global viewpoint, they are dedicated
to supplying products of the highest efficiency and quality at a reasonable price for
worldwide customer satisfaction.
In India, it is through HSCI that customers can enjoy the benefits of Honda's expertise.
Soichiro's vision was international in character. His desire was to lead the world in
technology, and make a significant contribution to the creation of a better society. As a
result, most of the products that Honda developed started out by making a difference.
Honda is a global company with a global viewpoint and a four-region global strategy that
is reflected in a solid commitment to local markets and economies.
However, the most enduring challenge has been to satisfy the ever-changing needs
of their customers. This is the essential spirit of Honda.
The Company's vision is "To be a Company that the Society would want to Exist". It
strongly believes in Co-existence and Co-evolution, wherever it operates.

2.5. Sales Performance

Share of different models in March 2010 total sales shows that City continues to dominates
other models as it accounts for about 73% of the total sales followed by Civic, CRV and
Accord

Fig 2.2: Share of different models in March 2010

The company has also registered and sold 61815 units during the last financial compared to
52420 units prior to last financial year that is an 18% increase in sales, which shows that the
increase in sales of different models in 2009-10 has been very low.

Fig 2.3: Sales over the years

2.6. Profitability

HSCI was making losses before year 2001-02, after which it has shown a continuous increase
in PBT. It recorded its highest increase in profit by 59.12% in the year 2006-07 over its entire
life, which was mainly as a result of a tremendous increase in sales in that year. After
showing such an increase in PBT it showed a downside movement in the year 2007-08.
Consequently, The PBT has shown decrease by 18.91 % in the year 2008-09 which is mainly
because of the increase in sales was less than the increase in expenses.

Fig 2.4: PBT over the years

2.7. Market Share
Fig.2.5. Honda’s market share

13%
A
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IF
9
O
1
C
2
Tusco
Endeavour
Other
33%
CR-V
21%
c
3
6
0
k
t%
i4
8
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s
c
e
o
th
%
s
n
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y
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a
s

PREMIUN SUV SEGMENT C SEGMENT

UD SEGMENT
 2.8. SWOT Analysis
Honda motor company is not just an average Japanese car manufacturer. Originally know for
motorcycles, Honda has managed to elude the dominate keiretsu system in Japan and become
one of the dominant automobile manufacturers in the world.
STRENGTHS

Honda has a reputation for producing high quality products for motorcycles to lawn mowers.
• They are the largest manufacturer of motorcycles in the world.
• Honda has won many awards for initial quality and customer satisfaction.
• Their research has afforded them competitiveness in innovative products.
• They were a pioneer in engineering low emissions internal combustion and hybrid
technology.
• Honda is the only other manufacturer outside of Mitsubishi to branch out into many
other areas outside of automobiles, like motorcycles, scooters, power equipments (generators),
Asimo Robot.
WEAKNESSES

• Their prices are higher for non-luxury vehicles than comparable models by other
manufacturers.
• Their vehicles also have a reputation for being underpowered.
• Due to the latest technology being used in Honda products it is difficult to keep the
prices low.
OPPORTUNITIES

• To continue progressing low emission vehicles and alternative power sources.

• Another area of opportunity would be developing nations like China and India. These are large
markets, and cheap dependable transportation would be a hot seller.
• Opportunity to make a good command over mid size segment through Honda Jazz which have already
hit Indian roads. It will be competing with Maruti – Suzuki swift, Chevrolet UVA, Skoda Fabia,
Hyundai Getz

THREATS

• Too many competitors in automotive industry.

• Expanding market size of compact cars ( currently it is around 76% )
• Regaining the lead of low emissions is a risky proposition as other companies are coming out with
new and cost effective ideas of producing low emission vehicles.
• Increasing steel prices will make it difficult for the companies to continue the current pricing strategy
CHAPTER 3: RESEARCH METHDOLOGY
 3. RESEARCH METHODOLOGY

3.1. Research Design

The study has been exploratory as it attempts to analyze & evaluate the existing data system,
through the financial data. Here the comparison is done on the various derivative instruments
offered by HSCI and is used to check how did it perform with currency fluctuations and how
much risk can be hedged.

3.2. Sources of data

The data used in the project is secondary data. Therefore, the sources from which data has
been collected are Annual Reports of HSCI 2007 – 08 and 2008 – 09, Journals, Websites,
Books, Magazines, Publications, Articles.

3.3. Methods of data Collection

Primary Data: Data collected through personal interview with mentor guide at HSCI and
Colleagues working with.
Secondary Data: Data collected using Annual Reports of HSCI 2007 – 08 and 2008 – 09,
Journals, Websites, Books, magazines, Publications, Articles.

3.4. Limitations

• Lack of Practical exposure in the area of Risk Management

• Lack of Formal Sources of Data

• Limitation of time to study vast topic foreign exchange risk management in such a
small span of time

CONCLUSION

The amount of foreign exchange exposure faced by HSCI is quite large which is evident from
the delta which has been calculated in Table 4.1. This shows that the profit rate of HSCI
becomes very vulnerable to the fluctuation in foreign currency exchange rate. This means the
amount of forex risk which is faced by HSCI is quite high which is mainly due to a high
volume of imports made by HSCI.

Thus in order to reduce the forex risk it is necessary to reduce the delta and bring it down to
zero. As evident from the Fig.4.1 and 4.2 that in order to reduce the delta either the profit rate
has to be increased or the percentage of expenses denominated in foreign currency has to be
decreased.

As it can be seen in Fig.4.1 that even if the profit rate was increased to 91% from 6.13% the
delta was close to “0” i.e.0.05 but Fig.4.2 shows that the delta came down to “0” when the
percentage of expenses were decreased from 54% to 0%.

Thus decreasing the percentage of expenses denominated in foreign currency from 54% to
0% seems more meaningful and realistic than increasing the profit rate to 91% from 6.13%
and then also not being able achieving a zero delta.

HSCI is currently using Currency Forward Contracts for hedging the forex risk. The forward
contracts provide a perfect hedge but the opportunity to gain from favorable movement in the
rates is also lost. This has been illustrated through a situational analysis done in part 4.6.
Fig.4.5 clearly shows that though forward contract provides a perfect hedge against adverse
movements but when there are favorable trends it provides negative returns.

On the other hand Fig. 4.6 shows how options contract not only prevents loss from
unfavorable trends by limiting the amount of loss to the extent of value of option premium
but also provides positive returns in favorable trends. Fig. 4.7 shows how returns from
forward contract and options contract move in the same direction when the trend is
unfavorable and moves in the opposite directions when the trend is favorable.

This proves that options contract is a better instrument than forward contract to hedge forex
risk as it not only protects the firm from risk of unfavorable movements in the foreign
exchange but it also helps in taking advantage of the favorable trends.
SUGGESSTIONS
 • In order to reduce the foreign exchange exposure and reduce the amount of risk it is
suggested to HSCI to reduce it’s the percentage of expenses denominated in foreign
currency which will in turn help them in reducing their exposure elasticity. This is
because the best way to manage the risk is to avoid it which can be done by using
internal hedging method like Hedging through Sourcing or by increasing the amount
of indigenization level.

• HSCI should regularly calculate its Exposure Elasticity as it will help them in
managing their forex risk in a better way and will also help them in reducing the value
of delta.

• HSCI should consider derivative instrument such as options to manage their forex risk
instead of forward contract as currency option can be a better alternative than the
forward contract as they not only provide downside protection against risk and also an
upside benefit from favorable movements in the underlying exchange rates.

BIBLIOGRAPHY

➢ BOOKS
• C.Jeevanandham, Foreign Exchange and Risk Management, Himalaya publication house,
Sultan Chand and Sons, 2007, Tenth Edition, Page 159 to 170.
• John C. Hull, Options, Futures and Derivatives, PHI , 2008, Seventh Edition, Page 212 to
217
• P.G. Apte, International Financial Management, Tata McGraw Hill, 1995, 5th edition, 117
to 121, 271 to 289.

➢ WEBSITES
• http://in.reuters.com/ HONDA MOTOR CO.,LTD. (HMC.N)/spot rate.aspx/(July
27,2010)
• http://www.rbi.org.in/Scripts/publications.aspx/Report on Currency and Finance 2008-
09(June 9,2010)
• http://burnyourfuel.com/2010/04/05/news/honda-siel-cars-india-march-2010-sales-figure/
(July 27, 2010)
• http://www.iief.com/Research/CHAP10.PDF, Neeraj Gambhir and Manoj GoelForeign
Exchange Derivatives Market in India -Status and Prospects, August 11, 2010
• http://finance.wharton.upenn.edu/weiss/wpapers/00-3.pdf,
• www.vsb.org/docs/valawyermagazine/jj01kelley.pdf(Foreign Currency Risk: Minimizing
Transaction Exposure, August 11, 2010
• http://rbidocs.rbi.org.in/rdocs/content/PDFs/76927.pdf ,Comprehensive guidelines on
derivatives, June 9, 2010
• http://usd.cer24.com/inr/history/2010-07-01,volatility rates for INR/USD currency , 28 jul
2010)
• http://www.acrobatplanet.com/non-fictions-ebook/ebook-corporate-interest-rate-risk-
management-derivatives-australia-empirical-res, puput ,15 aug2010

➢ PAPERS/ JOURANLS/ LEGAL DOCUMENTS

• Honda’s Annual Report, 2008-09
• Sivakumar Anuradha and Sarkar Runa, ‘Corporate Hedging for foreign exchange risk in
India’ RBI’s Report on ‘Currency and Finance’ 2008, Chapter VI, Foreign Exchange
Market, july 27 2010
• Bodnar, Gordan M. (Johns Hopkins U) Marston, Richard C. (U of Pennsylvania) A
simple model of foreign exchange exposure , August 11, 2010
• Records of back dated forward contracts and options, july 28, 2010
• Srinivasan Sayee & Youngren Steven `Using Currency Futures to Hedge Currency Risk’,
july28,2010