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ABSTRACT
Indian economy in the post-liberalisation era has witnessed increasing awareness of the need for
introduction of various risk management products to enable hedging against market risk in a cost
effective way. This industry-wide, cross-sectional study concentrates on recent foreign exchange risk
management practices and derivatives product usage by large non-banking Indian-based firms. The
study is exploratory in nature and aims at an understanding the risk appetite and FERM (Foreign
Exchange Risk Management) practices of Indian corporate enterprises. This study focusses on the
activity of end-users of financial derivatives and is confined to 501 non-banking corporate
enterprises. A combination of simple random and judgement sampling was used for selecting the
corporate enterprises and the major statistical tools used were Correlation and Factor analysis. The
study finds wide usage of derivative products for risk management and the prime reason of hedging is
reduction in volatility of cash flows. VAR (Value-at-Risk) technique was found to be the preferred
method of risk evaluation by maximum number of Indian corporate. Further, in terms of the
external techniques for risk hedging, the preference is mostly in favour of forward contracts,
followed by swaps and cross-currency options This article throws light on various concerns of Indian
firms regarding derivative usage and reasons for non-usage, apart form techniques of risk hedging,
risk evaluation methods adopted, risk management policy and types of derivatives used.
was increasing awareness of the need for The corporate enterprises in India are increasingly
introduction of financial derivatives in order to alive to the need for organised fund management
enable hedging against market risk in a cost and for the application of innovative hedging
effective way. Earlier, the Indian companies had techniques for protecting themselves against
been entering into forward contracts with banks, attendant risks. Derivatives are the tools that
which were the Authorised Dealers (AD) in foreign facilitate trading in risk.
exchange. But many firms preferred to keep their
risk exposures un-hedged as they found the The foreign exchange market is still evolving and
forward contracts to be very costly. In the current corporate enterprises are going through the
formative phase of the development of the foreign movements in transition from a passive to an active
exchange market, it will be worthwhile to take role in risk management. There is no organised
stock of the initiatives taken by corporate information available on how the corporate
enterprises in identifying and managing foreign enterprises in India are facing this challenge. It is in
exchange risk. this context that a review of the perceptions and
concerns of the corporates, in relation to
II. SIGNIFICANCE OF THE STUDY derivatives and of their initiatives in tuning the
organisational set up to acquire and adopt the
India had earlier followed a tightly regulated requisite skills in risk management, assumes
foreign exchange regime. The liberalisation of the significance. Appropriate policy and other
Indian economy started in 1991. The 1992-93 measures can then be taken to accelerate the
Budget provided for partial convertibility of Indian process of further development of foreign exchange
Rupee in current accounts and, in March 1993, the market and also upgrade foreign exchange risk
Rupee was made fully convertible in current management (FERM) with higher professionalism
account. Demand and supply conditions now and increased effectiveness.
govern the exchange rates in our foreign exchange
market. A fast developing economy has to cope III. OBJECTIVES OF THE STUDY
with a multitude of changes, ranging from
individual and institutional preferences to changes a) To ascertain the FERM practices, and product
in technology, in economic policies, in regulations usage, of Indian non-financial corporate
etc. Besides, there are changes arising from enterprises.
external trade and capital account interactions. b) To know the attitudes, perceptions and
These generate a variety of risks, which have to be concerns of Indian firms towards FERM.
managed. c) To understand the level of awareness of
derivatives and their uses, among the firms.
There has been a sharp increase in foreign d) To ascertain the organisation structure, policy-
investment in India. Multi-national and trans- making and control process adopted by the firms,
national corporations are playing increasingly which use derivatives, in managing foreign
important roles in Indian business. Indian corporate exchange exposure.
units are also engaging in a much wider range of
cross border transactions with different countries IV. CURRENCY RISK MANAGEMENT
and products. Indian firms have also been more TECHNIQUES
active in raising financial resources abroad. All
these developments combine to give a boost to A firm may choose any one or any set of
cross-currency cash flows, involving different combinations of the following techniques (Figure-
currencies and different countries. 1) to manage foreign exchange rate risks.
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Foreign Exchange Risk Management Practices
Matching
i) Matching:-Cash inflows in one of the pairing exchange rate risk. Similar choices of invoicing in
currencies can be offset against cash flows in the third country currencies may also be negotiated
others. A firm can balance its receivables and with trading partners. There are instances of
payables in the same currency. Firms may also invoicing in terms of currency baskets, comprising
deliberately influence the balance by arranging a composite index of different national currencies
short or long term loans or deposits. that have been allotted predetermined weights.
Judiciously employed, this can help in reducing the
ii) Multi-lateral Netting:- The netting can be done impact of volatility of exchange rates.
between inflows and outflows of different
currencies arising from cross-border transactions of
v) Forward Currency Transactions:- This
the different entities in the group. This, of course, involves an agreement between two parties, a buyer
requires a comprehensive information system and a seller, to buy/sell a currency at a later date at
concerning foreign exchange dealings of the group
a fixed price. Forward currency contracts can be
companies. easily arranged with banks, which are ADs in
foreign exchange. A forward contract has the
iii) Leads and Lags:- Within the boundaries of the
advantage of locking in the exchange rate at an
terms of the trading contracts or in keeping with agreed level, protecting from adverse movement in
prevailing commercial practices and within the exchange rates.
existing regulations, payments to trading partners
or foreign subsidiaries, in currencies whose values
are expected to appreciate or depreciate, can be vi) Currency Futures:- This involves an agreement
accelerated or delayed. between two parties, a buyer and a seller, to
purchase/sell a currency at a later date at a fixed
iv) Invoicing and Currency Clauses:- Trading price, and that it trades on the futures exchange and
companies may, sometimes, have options to is subject to a daily settlement procedure to
invoice their cross-border sales or purchases, in guarantee each party that claims against the other
domestic currency, so that the other party absorbs party will be paid. In India, we are yet to have a
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Sathya Swaroop Debasish
futures exchange and clearing house for financial Jesswein et al, (1993) in their study on use of
futures. derivatives by U.S. corporations, categorises
foreign exchange risk management products under
vii) Currency Options:- Currency options offer the three generations: Forward contracts belonging to
holder the right, but not the obligation, to buy or the First Generation; Futures, Options, Futures-
sell foreign currency at an agreed price, within a Options, Warranties and Swaps belonging to the
specified period of time. Generally, on most Second Generation; and Range, Compound
exchanges, options are not constructed on the Options, Synthetic Products and Foreign Exchange
underlying market, but rather convey the right to Agreements belonging to the Third Generation.
buy or sell the futures contract. There can be The findings of the Study showed that the use of
exchange-traded options as also OTC options. the third generation products was generally less
than that of the second-generation products, which
viii) Currency Swaps:- A financial swap is a was, in turn, less than the use of the first generation
transaction in which two parties agree to an products. The use of these risk management
exchange of payments over a specified time period. products was generally not significantly related to
It is ordinarily marked by an exchange of the size of the company, but was significantly
principals, which may be actual or notional. In a related to the company’s degree of international
cross currency swap, the counter-parties exchange involvement.
principals in different currencies at an exchange
rate that is usually the current spot rate and reverse Phillips (1995) in his study focused on derivative
the exchange at a later date, usually at the same securities and derivative contracts found that
exchange rate. organisations of all sizes faced financial risk
exposures, indicating a valuable opportunity for
ix) Money Market Hedging:- Companies that have using risk management tools. The treasury
need to raise medium term foreign currency loans professionals exhibited selectivity in their use of
should explore the possibility of reducing currency derivatives for risk management.
risk by raising them in currencies in which they
have medium term exposure in terms of receivables Howton and Perfect (1998) in their study examines
and assets in these currencies. the pattern of use of derivatives by a large number
of U.S. firms and indicated that 60% of firms used
V. REVIEW OF LITERATURE some type of derivatives contract and only 36% of
the randomly selected firms used derivatives. In
Collier and Davis (1985) in their study about the both samples, over 90% of the interest rate
organisation and practice of currency risk contracts were swaps, while futures and forward
management by U.K. multi-national companies. contracts comprised over 80% of currency
The findings revealed that there is a degree of contracts. Hentschel and Kothari (2000) identify
centralised control of group currency risk firms that use derivatives. They compare the risk
management and that formal exposure management exposure of derivative users to that of nonusers.
policies existed. There was active management of They find economically small differences in equity
currency transactions risk. The preference was for return volatility between derivative users and
risk-averse policies, in that automatic policies of nonusers. They also find that currency hedging has
closeout were applied. little effect on the currency exposure of firms'
equity, even though derivatives use ranges from
Batten, Metlor and Wan (1992) focussed on foreign 0.6% to 64.2% of the firm's assets. Our findings are
exchange risk management practice and product very important since no previous work has
usage of large Australia-based firms. The results examined the FERM practice in Indian context.
indicated that, of the 72 firms covered by the This study will be a pioneering attempt in Indian
Study, 70% of the firms traded their foreign scenario and first of its kind to survey the Indian
exchange exposures, acting as foreign exchange companies and their risk management practices.
risk bearers, in an attempt to optimise company
returns. Transaction exposure emerged as the most VI. METHODOLOGY OF THE STUDY
relevant exposure.
An exploratory survey, by way of extensive
literature review of books, journals and other
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Foreign Exchange Risk Management Practices
published data related to the focus of the study, as were incomplete in many respects. The respondents
also concerned websites, was carried out to gather are spread over 18 different major industry
background information about the general nature of classifications. The sample covers both old
the research problem. economy corporates like Manufacturing, Minerals,
Trade, Oil etc., and new economy corporates
A. Sources of Data including Information Technology (IT),
Information Technology Enabled Services (ITES),
The main part of the Study deals with Indian Business Process Outsourcing (BPO) etc., and they
corporate enterprises’ awareness of and attitudes to vary notably in size. The respondents to the
foreign exchange risk exposure. The required data questionnaire are financial executives with
was collected through the pre-tested questionnaire responsibility for FERM and for hedging foreign
administered on a judgement sample of 501 exchange risk exposure by use of derivatives. The
corporate enterprises, located in different parts of Study is exploratory in nature and aims at an
the country. The administration of the understanding of the risk appetite and FERM
questionnaire was done through multiple channels, practices of Indian corporate enterprises. It also
which included surface mail, e-mail and personal embraces an understanding of the policy or other
involvement. Information relating to contemporary constraints or impediments faced by the enterprises
practices abroad was obtained from published in managing foreign exchange exposure. The
sources such as journals, reports, and from related Study has its focus on the activity of end-
websites. users of derivatives and, hence, is confined to non-
banking corporate enterprises. Since banks both
B. Sample for the Study use and sell derivatives, they have not been
included in the scope of the Study. Risk
The survey was accomplished with the pre-tested management practices of Indian subsidiaries of
questionnaire administered on 501 corporate MNCs are determined by their parent companies
enterprises in India (banks and subsidiaries of and, hence, they do not form part of this Study. In
foreign multi-nationals not included), having analysing the responses, the Microsoft Excel
foreign exchange exposure. A combination of Spreadsheet and the Statistical Package for Social
simple random and judgement sampling was used Sciences (SPSS) have been used. Factor
for selecting the corporate enterprises for the Analysis, using Principal Component Method,
exploratory Study. As against the 850 was done wherever there was need to reduce
questionnaires circulated, 588 responses were variables into factors. Correlation analysis was also
received. Of these, 37 had to be eliminated, as they done, as needed.
4%
4% 10% 10%
4%
19%
8%
4% 10% 4%
11%
2% 4%
2% 4%
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Sathya Swaroop Debasish
VII. RESULTS AND FINDINGS OF THE category, reflecting the dominance of international
STUDY transactions in that sector. The foreign transactions
were mostly denominated in US dollars, with Euro,
A. Profiles of Respondents Pound Sterling, Japanese Yen, Swiss Franc and
The enterprises covered in the sample are from 18 Deutsche Mark following in that order.
categories of industries(Figure-2). Four sectors
including Paints, Print Media, Gems and Jewellery, B. Use of Derivatives
and Textiles did not respond. Thus, the Study Among the 501 respondents (Figure-3), 266
covers responses from 501 enterprises. The sizes of companies (53%) reported using derivatives and
the enterprises, in terms of turnover as well as the others are not using derivatives. Quite a few
international involvement (expressed as the sum of returned the questionnaire blank, with the apology
values of imports and exports and external that they are not using derivatives. It seems many
commercial borrowings) varied considerably. enterprises are yet to tune in to the need for
Maximum number of responses came from the IT planned management of exchange risk exposure.
Factor Analysis reveals that the main factor As to the nature of the transactions that are
responsible for non-use of derivatives is confused considered for hedging, the responses indicate that
perceptions of derivatives use, with its hedging is resorted to mostly in respect of
components, concerns about the appropriateness of transactions involving contractual commitments,
derivatives in specific situations, risk of the rather than foreign repatriations. There also seems
products and general reluctance and fear. Then
to be a preference to restrict the hedging horizon to
comes the technical and administrative factor
comprising difficulty in pricing and policy less than a year.
constraints, followed by the cost effectiveness
factor which questions the utility of derivatives, Even among the users of derivatives (Figure-4), the
given the high costs involved. concerns or anxieties about their use arise on
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Foreign Exchange Risk Management Practices
several counts. Factor analysis of these, reduced (iv) Lack of adequate knowledge about the use of
them to four factors: derivatives.
(i) Confused perception, including lack of clarity 65% of the respondents were of the view that
about investor expectations, difficulties in enough range of derivative instruments are not
pricing and valuing, difficulties in evaluating available yet. This has the effect of restricting
the risk and lack of understanding as to how to arbitrage opportunities. A good majority felt the
monitor and evaluate hedging outcome. need for Rupee-Dollar Options (not in vogue at the
time they responded to the questionnaire, but
(ii) Policy and legal issues, covering assessment subsequently introduced in July 2003), while others
of credit risk, inadequate support from the wished that Exchange-Traded Futures were
Board, tax and legal considerations and available.
disclosure requirements.
From the above, it can be seen that the Indian
(iii) Monetary considerations, concerned with corporate enterprises are somewhat halting in their
transaction costs and liquidity problems. approach to the use of derivatives.
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Sathya Swaroop Debasish
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Foreign Exchange Risk Management Practices
seem to be the least preferred. 90% of the respondents have a working system of review of
respondents are happy with the expertise that is the performance of the treasury department. Value-
outsourced. This may be an indication of the at-Risk (VAR), Stress or Scenario Test and Price
inadequacy of in-house talent, in managing Value of a Basis Point are among the tools widely
exchange rate exposure. Or, it may be that used for evaluating the risk associated with
outsourcing advice is found to be less expensive usage of specific derivatives. 34% of the
and more effective. Factor analysis has short-listed respondents that use derivatives do not have a
three factors as the sources of guidance in system of evaluating risks. VAR technique was the
exchange risk management. They are, in the order preferred method of risk evaluation by maximum
of priority, ‘derivatives dealers’, ‘consultancies’ number of Indian corporate. Providing information
and then, ‘in-house expertise’. Banks, by virtue of on the use of derivatives, in the published financial
their active involvement in selling derivative statements, is not yet mandatory in India. 51% of
products, have an edge over other agencies, in the respondents do not make any mention about the
being able to provide specialised information, use of derivatives, in their annual reports. 22% of
relevant to foreign exchange risk management. them provide a brief summary, 19% of them make
a mere mention and 8% of the respondents report
J. Review and Performance Measurement in detail. Further, 93% of the respondents feel
happy with their respective risk management
As shown in Figure- 6, about 60% of the practices.
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Sathya Swaroop Debasish
reference to Currency risk, next in importance Applied Corporate Finance, Vol. 7, No. 3,
being Interest Rate risk and, marginally, Equity Fall (1994)
risk. The greatest preference is for simple Forward
Contracts. Swaps, and Cross Currency Options are [5] Bodnar, M. Gordon, Hayt, S. Gregory and
moderately used. 40% of respondents consider the Marston, C. Richard : “1998 Wharton Survey
treasury department as a ‘Service Centre’, 28% as a of Financial Risk Management by US Non-
‘Cost Centre’, and 20% as a ‘Profit Centre’. There Financial Firms”, Financial Management,
is a noticeable preference for outsourcing advice Winter, Vol. 27, No. 4, pp 70-91 (1998)
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cases, Banks provide the necessary expertise and New Delhi: Prentice Hall of India Private
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Risk Management practices in India are evolving at Accounting and Business Research, Autumn,
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The framework developed in this research is based
[10] Copeland, Tom and Copeland, Maggie:
on a mental model of a medium-to-large
“Managing Corporate Foreign Exchange
manufacturing company producing industrial
Risk: A Value Maximising Approach”
components, as perceived by the researcher. The
Financial Management, Vol. 28, No. 3, pp
complex nature of the relationship between the
68-75, Autumn (1999)
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of special diagnostic and analytical tools. Decisions Smith, Stephen D. : “Derivatives and
and actions in the area of FERM may have impact Corporate Risk Management: Participation
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A larger interactive model capable of embracing all Industry” Journal of Risk & Insurance, Vol.
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[12] Dash, Shridhar Kumar: “Efficiency of Indian
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