Foreign Exchange Risk Management Analysis

Foreign Exchange Risk Management Analysis Chapter 1 Introduction This chapter will introduce the reader to the subject at hand and why the chosen research area is of interest and relevance for further development. Finally, the chapter includes a problem discussion, which in turn ends up in the research purpose of the thesis. 1.1 Background of the Study The deepening of globalization process has led to an increase in foreign exchange transactions in international financial markets. This has determined a higher volatility of exchange rates, and, implicitly, an increased foreign exchange risk. There are many types of risks, but only few of them can bring losses as large as foreign exchange risk. In these conditions, the development of new modern and effective methods for managing foreign exchange risk becomes a great necessity for the players in international financial activity. Foreign exchange risk management is crucial for companies frequently trading in the international market. Empirical research shows that profits of multinational companies are affected by volatile floating foreign exchange rates. Nevertheless, small firms trading exclusively on their domestic markets also become increasingly exposed to foreign currency fluctuations. Actually, small firms depend on the volatility of the main currencies because many of them out-source their production to foreign countries. This means that they incur costs in a foreign currency (wages, taxes, material, etc.) and they also need to manage this exposure. Other small firms are exposed indirectly given that their strategic position can be affected by volatile FX rates. By definition, all entrepreneurial activities incur risks, and coping with risk has therefore always been an important managerial function. In recent years, however, risk management has received increasing attention in both corporate practice and the literature. This is particularly true for the management of financial risks, i.e. the management of foreign exchange risk, interest rate risk and other financial market risks. A major reason for this is the development of markets for derivative financial instruments. Forward contracts, futures, options, swaps and other, more complex financial instruments today allow firms to transfer risks to other economic agents who are better able, or more willing, to bear them. In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation and the oil shock. Corporates struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivatives foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. The interest in the potential vulnerability of multinational firms to foreign exchange rate risk is heightened by the wide currency fluctuations experienced during the last few decades and this issue has engendered a considerable amount of research (Muller, A., Verschoor, W.F.C. 2006). In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. However derivative use is still a highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only (Giddy et.al. 1992). 1.2 Problem Statement Transaction exposure to foreign exchange risk results from the effect of (unanticipated) changes in the spot exchange rate on the base currency value of foreign currency cash flows (contractual payables and receivables). Financial hedging of transaction exposure is implemented by taking an opposite position (to the spot position) on a currency derivate (such as forwards, futures and options) or by using money market hedging. In some cases, however, financial hedging may not be possible or it may be too expensive. For example, forwards, futures, and options may not be available for some currencies or for long maturities, and it may not be possible to obtain credit lines in certain currencies (which precludes money market hedging). This observation is particularly valid for countries where financial markets are rudimentary. If a firm facing (transaction) exposure to foreign exchange risk cannot indulge in financial hedging, it may resort to the operational hedging techniques of risk sharing and currency collars, which can be implemented by using customised hedge contracts embedded in the underlying trade contracts. Under a risk sharing arrangement, the benefits accruing to one party of a transaction as a result of a favourable change in the exchange rate (which is necessarily an unfavourable change for the other party) are shared by the two parties. A currency collar, on the other hand, is used to set a minimum value for the base currency value of cash flows at the expense of setting a maximum value. Thus, it involves a trade-off between potential loss and potential gain. The unpredictability of forex market may erode or even eliminate the profit margin built into an international sale at the time the sale was carried out, when selling on terms of weeks and even months. Foreign exchange rate keeps on fluctuating and they depend upon the market forces of demand and supply (Platt, G. 2007). Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Historically, the foremost instrument used for exchange rate risk management is the forward contract. Forward contracts are customized agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement would easily eliminate exchange rate risk, but it has some shortcomings, particularly getting a counter party who would agree to fix the future rate for the amount and time period in question may not be easy. In India many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk. Of course the bank in turn may have to do some kind of arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because there exists no formal trading facilities, building or even regulating body. 1.3 Research Objectives and Questions There is a need to identify, quantify, and evaluate a firms risk exposure and to choose appropriate procurement strategies. The general objective of this study is to incorporate procurement and marketing decisions into a single hedging model, considering risk factors typically faced by firms in the textiles and garment industry. There are several reasons to explain why foreign risk management has gained in popularity over the last decades. The most important reason lies in the increased volatility of exchange rates, interest rates, and commodity prices, causing firms cash flows to become more uncertain. Secondly, firms tend to focus more on their core business, which makes them less diversified. As a consequence, the volatility of firms cash flows may increase. A third reason for the growing importance of foreign risk management can be found in the globalization of business activities, in which competition has increased and profit margins have declined. A final explanation we offer is the growing number of opportunities to manage risks. Based on the problem discussion our research objectives are formulated as follows: To review and critically analyse the practices adopt by the Indian exporters to hedge the forex risk. To evaluate the impact of foreign exchange risk on exporters and exports of a country like India To critically compile the issues faced by the Indian exporters in hedging foreign exchange risk. Based on the above stated research objectives the following research questions have been developed: RQ 1: How the export company determines foreign exchange risk? RQ 2: Which level the company can actively manage foreign exchange risk? RQ 3: How it can hedge the forex risk? RQ 4: What techniques are preferred by company in its forex risk management? 1.4 Relevance of Research Currently there is a scarcity of research papers about currency exposure management in companies in emerging markets. Theoretical studies like that of Copeland and Copeland (1999) are usually supported by the findings from developed countries (the USA, Canada, the UK). Therefore, the application of such studies might be complicated in developing markets. Researchers that analyze the foreign exposure management in companies often use large samples and questionnaires to evaluate the derivate use, and are successful in describing countries with well-developed markets. For emerging markets like India such quantitative approaches are extremely rare. Most often the situation with currency exposure management and application of derivatives by non-financial institutions is reflected in the newspapers. Yet, these articles are not academic papers and serve only as descriptions of the situation. Therefore, this study will be distinctive in several areas. First, it concentrates on India and will contribute to the increase in the number of academic studies about emerging markets. Second, it will contribute to the business community , as it will analyze the application of derivatives by exporting companies for hedging currency exposure and reveal the causes higher or lower popularity of derivatives. Third, it will apply the theoretical model which was developed based on the practice in developed countries, and test if the results from model application match the empirical findings in reality in India. 1.5 Outline of the Study This dissertation consists of five chapters (see Figure 1.1). In chapter one, a relative broad description is given in the beginning, providing the reader with a background and discussion of issues related to the problem area. This discussion lands in a specific research problem, which has been broken down into research questions. Chapter two gives a presentation of theories relevant for the research problem. Continuously, a description and justification of the methodological approaches chosen in this thesis is given in Chapter three. In chapter four the received empirical data is presented and contains an analysis of the collected data against the theory. Finally, conclusions and implications are presented in chapter five. Literature Review This chapter reviews the literature theory of foreign exchange risk management include the concepts of foreign exchange risks, its characteristics by different types, and hedge theory of foreign exchange risks. 2.1 Foreign exchange risk Whenever a company is running overseas business, the company is exposed to different categories of risk including commercial risk, financial risk, country risk and foreign exchange risk (Oxelheim 1984). Country Risk Foreign Exchange Risk Financial Risk Commercial Risk Figure2.1 The company risk Source: Oxelheim 1984, p14 Foreign exchange risk is commonly defined as the additional variability experienced by a multinational corporation in its worldwide consolidated earnings that results from unexpected currency fluctuations. It is generally understood that this considerable earnings variability can be eliminated-partially or fully-at a cost, the cost of Foreign Exchange Risk Management. (Jacques, 1981). According to Shapiro (2006), foreign exchange rate exposure can be defined as a measure of the potential changes in a firms profitability, net cash flow and market value because of a change in exchange rates. 2.2 The existing classifications of foreign exchange risks In the recent literature of foreign exchange exposure management, the types of exposures are usually summarized and simplified into three categories, translation, transaction, and economic ( Cowdell, 1993; Girnblatt and Titamn, 1998; Eitman et. al.,1998 and Shapiro, 2006). It is conventionally stated that the exposure to currency risk is categorized into three factors; seen below in figure 2.2. Figure 2.2 Types of currency risk exposure Source: Eun et al.,2007 Transaction Exposure The transaction exposure concept concentrates on contractual commitments which involve the actual conversion of currencies. A firms transaction exposure thus consists of its foreign currency accounts receivables and payables, its longer-term foreign currency investments and debt, as well as those of its foreign currency cash positions which are to be exchanged into other currencies. Until these positions are settled, their home currency value may be impaired by unfavorable parity changes. There exist four possibilities by which transaction exposure may arise (Eiteman 2007): When prices are stated in foreign currencies and the firm decides to purchase or sell goods or services. When borrowing or lending funds while contractual agreements on repayment are to be make in a foreign currency. When becoming a party to an unimplemented foreign exchange forward contract. When incurring liabilities or acquiring assets which are denominated in foreign currencies. The total transaction exposure consists of quotation exposure, backlog exposure and billing exposure, see figure 2.3: Figure 2.3 The life span of a transaction exposure Source: Eiteman et al., 2007 2.2.2 Economic Exposure The economic exposure, also called the operating exposure, measures any change in the present value of a company resulting from changes in future operating cash flows caused by unexpected changes in currency exchange rates. The analysis of economic exposure assesses the result of changing exchange rates on a companys own operations over coming months and years and on its competitive position in comparison with other companies. By measuring the effects on future cash flows related to economic exposure, the goal is to identify strategic moves or operating techniques that a company might wish to adopt in order to enhance its value in the face of unexpected exchange rate changes (Eiteman et al., 2007). Loderer and Pichler (2002) assert that firms often manage economic exposure by lending and borrowing in foreign currencies. He cites the following reasons for not hedging economic exposure: firms are unable to measure the size and the currency of future expected cash flows with much confidence, firms already hedge transaction exposure, firms consider that in the long term currency fluctuations offset each others. Surprisingly, the cost of hedging economic exposure is not an obstacle. 2.2.3 Translation exposure By consolidating its financial statements, a parent company with foreign operations must translate the assets and liabilities of its foreign subsidiaries, which are stated in a foreign currency, into the reporting currency of the parent firm. Basically, foreign subsidiaries must restate their local currency into the main reporting currency so the foreign values can be added to the parents reporting currency denominated balance sheet and income statement. The translation is usually used for measuring a subsidiarys performance(McInnes, 1971), providing accurate information for decision makers and investors (Ross, 1992; Bartov, 1995), and for both internal and external users (Sercu and Uppal, 1995). The common reason for translation from a foreign currency into the home currency is to meet the requirements of accounting regulations of home countries. External Hedging Methods As it is shown, the exposure to currency risk may involve current business transactions, future business transactions as well as financial statement translations. However, as there are factors or risk, so are there strategies for dealing with them. For companies, there are a number of external methods to use for the management of currency risk, namely the use of financial derivatives. The name derivative arises from the fact that the value of these instruments is derived from an underlying asset like a stock or a currency. By using these instruments it is possible to reduce the risks associated with the management of corporate cash flow, a method known as hedging. Financial market hedging instruments include (Butler, 2004): Fig 2.4: External Hedging Techniques 2.3.1 Foreign Exchange Forwards A foreign exchange forward is an agreement to buy or sell one currency at a certain future date for a certain price with a specific amount. It is the most common instrument used to hedge currency risk. The predetermined exchange rate is the forward exchange rate. The amount of the transaction, the transaction date, and the exchange rate are all determined in advance where the exchange rate is fixed on the day of the contract but the actual exchange takes place on a pre-determined date in the future. In major currencies, forward contracts can be available daily with maturities of up to 30, 90 or 180 days (Bodie Marcus 2008). A survey by Belk and Glaum (1990) indicates that the most common method used to hedge exchange rate risk is the forward contract. An empirical study of Pramborg (2002), also demonstrates that firms can be fully hedged with forward contracts. 2.3.2 Currency Futures In principle, a futures contract can be arranged for any product or commodity, including financial instruments and currencies. A currency futures contract is a commitment to deliver a specific amount of a specified currency at a specified date for an agreed price incorporated in the contract. The futures perform a similar function to a forward contract, but it has some major differences. Fig 2.5 Currency Futures The specific characteristics of currency futures include (Pike et.al., 1992): They are marketable instruments traded on organized futures markets. Futures can be completed (liquidated) before the contracted date, whereas a forward contract has to run to maturity. They are relatively inflexible, being available for only a limited range of currencies and for standardized maturity dates. The dealings occur in standard lot sizes, or contracts. They require a down-payment of margin of about 5 percent of the contract value, whereas forward contracts involve a single payment at maturity. Futures are usually cheaper than forwards contracts, requiring a small commission payment rather than a buy / sell spread. Table 2.1 provides a clearer summary of the major differences between forward and futures contracts. Table 2.1: Major Differences between Forward and Futures Contracts Forward Contracts Futures Contracts Customized contracts in terms of size and delivery dates Standardized contracts in terms of size and delivery dates Private contracts between two parties Standardized contracts between a customer and a clearing house Difficult to reverse a contract Contract may be freely traded on the market Profit and loss on a position is realized only on the delivery date All contracts are marked to market- the profit and loss are realized immediately. No explicit collateral, but standard bank relationship necessary Collateral (margins) must be maintained to reflect price movements Delivery or final cash settlement usually takes place. Contract is usually closed out prior to Maturity Source: Hull (2006), Moffett et al (2006) and Solnik and McLeavey (2004). 2.3.3 Currency options A foreign exchange option which is different from currency forward contracts and currency futures is to give the holder of the contract the right to buy or sell a certain amount of a certain currency at a predetermined price (also called strike or exercise price) until or on a specified date, but he is not obliged to do so. The seller of a currency option has obligation to perform the contract. The right to buy is a call; the right to sell, a put. There is option premium needed to pay by those who obtain such a right. The holder of a call option can benefit from a price increases (profit is the difference between the market price and the strike price plus the premium), while can choose not to excise when the price decreases (locked in loss of the option premium). Vice versa is for the holder of a put option. For the advantages of simplicity, flexibility, lower cost than the forward, and the predicted maximum losswhich is the premium, the currency option has become increasing popular as a hedging devise to protect firms against the exchange movements. Whenever there is uncertainty in the size of cash flows and the timing of cash flows, currency option contracts would be superior to traditional hedging instruments such as forward contracts and futures contracts. Grant and Marshall (1997) examined the extent of derivative use and the reasons for their use by carried out surveys in 250 large UK companies, found that a widespread use of both forwards and options(respectively 96% and 59%). The pointed that comparing to the primary reasons for the use of forwards were company policy, commercial reasons and risk aversion, a good understanding of instrument, and price were prominent while the primary reasons to use option for company management. 2.3.4 Currency Swaps Currency swaps are a hedging instrument for which two parties agree to swap a debt denominated in one currency for that in another currency. For example, an agreement between two firms to swap their debts of which one is denominated in Euro and that in US dollar (Leger and Fortin, 1994). In order to explain the use of currency of swaps, a Japanese firm that has exports to Australia is given as an example. The Japanese firm wants to protect its Australian-dollar receivables by using currency swap to match inflows in one currency with outflows in a foreign currency (natural hedging). Assuming the Japanese firm is not well recognized in the US financial markets, it may obtain funds from a domestic bank to swap with another firm that has dollar-denominated debt. This process is carried out by the swap dealers (usually banks) as an intermediary. The common objective of this type of transaction is that firms want to alter various future currency cash flows in its schedules into a particular currency for which its future revenues will be generated (Eiteman et.al 1998). The preference of particular currency is caused by several factors, such as, capital market segmentation, differences in regulation governing investment by institutional investors and asymmetry in the tax treatment of interest income and capital gains/losses (Jacque 1996). Although there are other types of swaps involving foreign currencies, such as, foreign currency forward swaps, plain vanilla, and a three-way back-to-back currency swap, they are designated primarily for hedging interest rate exposure. 2.4 Internal hedging methods For the reason that external hedging techniques with derivatives to manage foreign exchange exposure are often costly, many multinational firms would rather turn to consider using internal hedging devices such as Michael (2006): Currency matching, which involves pairing suitably a multinational firms foreign currency inflows and outflows with respect to amount and timing Currency netting, which involves the consolidated settlement of receivables, payables and debt among the subsidiaries of a multinational firm Invoicing in domestic currency, which reduces transaction risk primarily related to exports and imports. 2.5 Fundamental Philosophy behind Hedging We have presented that authors embrace hedging as insurance, and hedging as a value-enhancing tool. We believe the common view of hedging can be summarized as follows: Hedging is one of the three most fundamental reasons for the existence of the financial market, alongside speculative and arbitrage activities (JÃ ¼ttner, 2000). The hedging industry is evolving just like the rest of the business world. In fact, there is no definite set of tools or technique that can define hedging. As the world changes, new hedging mechanisms are derived; and as time passes, these mechanisms are refined and evolve into something new that can be better applied to the contemporary commercial marketplace (Batten et al, 1993; Faff and Chan, 1998; Alster, 2003;). Hedging is not a way of making money, but to assist management in better managing corporate revenue through reducing the corporate exposure to volatility in the foreign currency markets (Nguyen and Faff, 2002, 2003a; Anac and Gozen, 2003; Alster, 2003; De Roon et al., 2003; and Dinwoodie and Morris 2003). When used prudently, hedging can be effective insurance as well as a value-enhancing exercise for corporations. Effective hedging programs have been proven to allow corporations to minimize or transfer their foreign currency exposure. The diminished exposure to foreign currency fluctuations allows more stable and predictable cash-flows, notably in terms of revenue. As a result, firms are then capable of making more comprehensive financial plans, including more reliable estimations on tax, income after tax and dividends payable to shareholders. It is believed that a dividend payout is often of significant appeal to long-term, current or prospective shareholders (Nguyen and Faff, 2002, 2003b; Alster, 2003; Anac and Gozen, 2003; De Roon et al., 2003; and Dinwoodie and Morris, 2003). The three main questions surrounding hedging: when, what and how to hedge are shown in Figure 2.2 below as a decision tree. How to Hedge? Hedge Ratio 10% 50% 100% OR Any Ratio between 0.1%-99.9% What to Hedge? When to Hedge? Financial Tools Forward Futures Options Swap Hedge Under Currency Risk Exposure Non-Financial Tools Leading Lagging Fully participating market movements No Hedge Fig 2.7 Generic Hedging Decision Tree The question to hedge or not to hedge is a complex and controversial one in financial risk management. Natural hedges carry no explicit out of pocket cost and intrinsically form a better offset to economic exposures and so generally are preferred to synthetic hedges. Synthetic hedging can be likened to insurance, where the company incurs an explicit cost to reduce the risk or volatility inherent in its business results. The cost must be weighed against the risk-reducing benefits of the transactions, taking into account their precision and effectiveness. The real drivers of any hedging decision are 1) what is the risk tolerance of the company; and 2) what cost is acceptable for entering into transactions to reduce or eliminate the risk. Foreign currency-denominated activities engaged by Indian Exporters Expected payments of foreign exchange from trade Expected receipts of foreign exchange from trade Liabilities Assets Debt Debt Equity Net trade foreign exchange exposure (before derivates) Net balance sheet foreign exchange exposure (before derivatives) Foreign exchange Derivatives Net foreign exchange exposure (after derivatives) Fig 2.8: Decision to Hedge Foreign Currency Exposures Some managers feel strongly that hedging either should always be done or never done, and their approaches vary tremendously. Indeed, there is an academic perspective that hedging is never appropriate since risks like FX exposure represent diversifiable risks from the shareholder perspective, and thus, the cost is wasted effort for shareholders. Some managers share this view, but most multinational businesses of significant size engage in some financial hedging transactions. Major arguments for and against hedging are displayed in Table 2.2 Table 2.2: Theoretical Arguments on Hedging For Against Managing earnings volatility for FX risk can reduce a firms potential cost of financial distress. PPP and CIP imply compensating levels of FX rates and prices. Firms in financial distress face higher contracting costs with customers, suppliers, and employees. FX rates even out over time. Firms that hedge and reduce their earnings volatility pay less taxes over the long run if tax rates increase the income levels. With transactions costs, hedging is a losing bet on average. Managing FX risk and smoothing earnings volatility has a positive effect on stock price and shareholder value. Shareholders can diversify their own portfolios to compensate for FX risk.