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SYNOPSIS

TITLE: ANALYZE THE VARIOUS HEDGIMG TECHNIQUES USED BY

LUDHIANA EXPORTERS TO PROTECT THEMSELVES FROM

FOREIGN EXCHANGE EXPOSURE

SUBMITTED BY: GAGANDEEP KAUR

UNIVERSITY REGISTRATION NUMBER: 1174711,

SIGNATURES OF STUDENT: __________________________________

SIGNATURES OF THE RESEARCH ADVISOR: __________________

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SYNOPSIS

TITLE ANALYZE THE VARIOUS HEDGIMG TECHNIQUES USED BY

LUDHIANA EXPORTERS TO PROTECT THEMSELVES FROM

FOREIGN EXCHANGE EXPOSURE

INTRODUCTION

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is

defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the

moment and depends on the value of the foreign exchange rates. The process of identifying risks

faced by the firm and implementing the process of protection from these risks by financial or

operational hedging is defined as foreign exchange risk management. This research project limits

its scope to hedging only the foreign exchange risks faced by firms.Risk management techniques

vary with the type of exposure (accounting or economic) and term of exposure. Accounting

exposure, also called translation exposure, results from the need to restate foreign subsidiaries

financial statements into the parents reporting currency and is the sensitivity of net income to

the variation in the exchange rate between a foreign subsidiary and its parent.

Economic exposure is the extent to which a firm's market value, in any particular currency, is

sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value of the

firms operating cash flows, income statement, and competitive position, hence market share and

stock price. Currency fluctuations also affect a firm's balance sheet by changing the value of the

firm's assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign

currency, investments (CDs) in foreign banks; this type of economic exposure is called balance

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sheet exposure. Transaction Exposure is a form of short term economic exposure due to fixed

price contracting in an atmosphere of exchange-rate volatility. The most common definition of

the measure of exchange-rate exposure is the sensitivity of the value of the firm, proxied by the

firms stock return, to an unanticipated change in an exchange rate. This is calculated by using

the partial derivative function where the dependant variable is the firms value and the

independent variable is the exchange rate

A key assumption in the concept of foreign exchange risk is that exchange rate changes are not

predictable and that this is determined by how efficient the markets for foreign exchange are.

Research in the area of efficiency of foreign exchange markets has thus far been able to establish

only a weak form of the efficient market hypothesis conclusively which implies that successive

changes in exchange rates cannot be predicted by analysing the historical sequence of exchange

rates.

Hedging as a tool to manage foreign exchange risk

There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel hedging

techniques are speculative or do not fall in their area of expertise and hence do not venture into

hedging practices. Other firms are unaware of being exposed to foreign exchange risks. There are

a set of firms who only hedge some of their risks, while others are aware of the various risks they

face, but are unaware of the methods to guard the firm against the risk. There is yet another set of

companies who believe shareholder value cannot be increased by hedging the firms foreign

exchange risks as shareholders can themselves individually hedge themselves against the same

using instruments like forward contracts available in the market or diversify such risks out by

manipulating their portfolio. There are some explanations backed by theory about the irrelevance

of managing the risk of change in exchange rates. For example, the International Fisher effect

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states that exchange rates changes are balanced out by interest rate changes,the Purchasing

Power Parity theory suggests that exchange rate changes will be offsetby changes in relative

price indices/inflation since the Law of One Price should hold.Both these theories suggest that

exchange rate changes are evened out in some form or the other.Also, the Unbiased Forward

Rate theory suggests that locking in the forward exchange rate offers the same expected return

and is an unbiased indicator of the future spot rate. But these theories are perfectly played out in

perfect markets under homogeneous tax regimes.

CURRENCY RISK MANAGEMENT TECHNIQUES

A firm may choose any one or any set of combinations of the following techniques to manage

foreign exchange rate risks.

i) Matching:-Cash inflows in one of the pairing currencies can be offset against cash flows in

the others. A firm can balance its receivables and payables in the same currency. Firms may also

deliberately influence the balance by arranging short or long term loans or deposits

ii)Multi-lateral Netting:- The netting can be done between inflows and outflows of different

currencies arising from cross-border transactions of the different entities in the group. This, of

course, requires a comprehensive information system concerning foreign exchange dealings of

the group companies.

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.

iii) Leads and Lags:- Within the boundaries of the terms of the trading contracts or in keeping

with prevailing commercial practices and within the existing regulations, payments to trading

partners or foreign subsidiaries, in currencies whose values are expected to appreciate or

depreciate, can be accelerated or delayed.

iv) Invoicing and Currency Clauses:- Trading companies may, sometimes, have options to

invoice their cross-border sales or purchases, in domestic currency, so that the other party

absorbs exchange rate risk. Similar choices of invoicing in third country currencies may also be

negotiated with trading partners. There are instances of invoicing in terms of currency baskets,

comprising a composite index of different national currencies that have been allotted

predetermined weights. Judiciously employed, this can help in reducing the impact of volatility

of exchange rates.

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v) Forward Currency Transactions:- This involves an agreement between two parties, a buyer

and a seller, to buy/sell a currency at a later date at a fixed price. Forward currency contracts can

be easily arranged with banks, which are ADs in foreign exchange. A forward contract has the

advantage of locking in the exchange rate at an agreed level, protecting from adverse movement

in exchange rates.

vi) Currency Futures:- This involves an agreement between two parties, a buyer and a seller, to

purchase/sell a currency at a later date at a fixed price, and that it trades on the futures exchange

and is subject to a daily settlement procedure to guarantee each party that claims against the

other party will be paid.

vii) Currency Options:- Currency options offer the holder the right, but not the obligation, to

buy or sell foreign currency at an agreed price, within a specified period of time. Generally, on

most exchanges, options are not constructed on theunderlying market, but rather convey the right

to buy or sell the futures contract.

viii) Currency Swaps:- A financial swap is a transaction in which two parties agree to an

exchange of payments over a specified time period. It is ordinarily marked by an exchange of

principals, which may be actual or notional. In a cross currency swap, the counter-parties

exchange principals in different currencies at an exchange rate that is usually the current spot

rate and reverse the exchange at a later date, usually at the same exchange rate.

ix) Money Market Hedging:- Companies that have need to raise medium term foreign currency

loans should explore the possibility of reducing currency risk by raising them in currencies in

which they have medium term exposure in terms of receivables and assets in these currencies

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Determinants of Hedging Decisions:

The management of foreign exchange risk, as has been established so far, is a fairly complicated

process. A firm, exposed to foreign exchange risk, needs to formulate a strategy to manage it,

choosing from multiple alternatives. This section explores what factors firms take into

consideration when formulating these strategies.

I. Production and Trade vs. Hedging Decisions

An important issue for multinational firms is the allocation of capital among different countries

production and sales and at the same time hedging their exposure to the varying exchange rates..

Only the revenue function and cost of production are to be assessed, and, the production and

trade decisions in multiplecountries are independent of the hedging decision. The implication of

this independence is that the presence of markets for hedging instruments greatly reduces the

complexityinvolved in a firms decision making as it can separate production and sales functions

from the finance function. The firm avoids the need to form expectations about futureexchange

rates and formulation of risk preferences which entails high information costs.

II. Cost of Hedging

Hedging can be done through the derivatives market or through money markets (foreign debt). In

either case the cost of hedging should be the difference between value received from a hedged

position and the value received if the firm did not hedge. In the presence of efficient markets, the

cost of hedging in the forward market is the difference between the future spot rate and current

forward rate plus any transactions cost associated with the forward contract. Similarly, the

expected costs of hedging in the money market are the transactions cost plus the difference

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between the interest rate differential and the expected value of the difference between the current

and future spot rates. In efficient markets, both types of hedging should produce similar results at

the same costs, because interest rates and forward and spot exchange rates are determined

simultaneously. The costs of hedging, assuming efficiency in foreign exchange markets result in

pure transaction costs.

REVIEW OF LITERATURE

Jesswein et al, (1993) in their study on use of derivatives by U.S. corporations, categorises

foreign exchange risk management products under three generations: Forward contracts

belonging to the First Generation; Futures, Options, Futures- Options, Warranties and Swaps

belonging to the Second Generation; and Range, Compound Options, Synthetic Products and

Foreign Exchange Agreements belonging to the Third Generation. The findings of the Study

showed that the use of the third generation products was generally less than that of the second-

generation products, which was, in turn, less than the use of the first generation products. The

use of these risk management products was generally not significantly related to the size of the

company, but was significantly related to the companys degree of international involvement.

Phillips (1995) in his study focused on derivative securities and derivative contracts found that

organisations of all sizes faced financial risk exposures, indicating a valuable opportunity for

using risk management tools. The treasury professionals exhibited selectivity in their use of

derivatives for risk management.

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Gczy et al. (1997) argues that currency swaps are more cost-effective for hedging foreign debt

risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is

because foreign currency debt payments are long-term and predictable, which fits the long-term

nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term

and unpredictable, in line with the short-term nature of forward contracts.

Howton and Perfect (1998) in their study examines the pattern of use of derivatives by a large

number of U.S. firms and indicated that 60% of firms used some type of derivatives contract and

only 36% of the randomly selected firms used derivatives. In both samples, over 90% of the

interest rate contracts were swaps, while futures and forward contracts comprised over 80% of

currency contract

Marshall (2000) also points out that currency swaps are better for hedging against translation

risk, while forwards are better for hedging against transaction risk. This study also provides

anecdotal evidence that pricing policy is the most popular means of

hedging economic exposures.

Viktor Popov and yann sutzmann(October 2003) 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.

Bjrn Dhring (January 2008) Domestic-currency invoicing and hedging allow internationally

active firms to reduce their exposure to exchange rate variations. This paper discusses exchange

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rate exposure in terms of transaction risk (the risk of variations of the value of committed future

cash flows), translation risk (the risk of variations of the value of assets and liabilities

denominated in foreign currency) and broader economic risk (which takes into account the

impact of exchange rate variations on competitiveness). This draws on data on the invoicing

currencies of euro-area exports and on previous empirical work on hedging, which has, however,

focussed largely on firms in the US and a small number of EU Member States.

Dr.Hiren Maniar(March 2010) This research paper attempts 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.

Carmen Bonaci, Crina Filip, Ji Strouhal, Alina Matis (September 2012) Paper offers an

accounting perspective to hedging currency risk from both a theoretical and practical

perspective. From the theoretical point of view we first position the study by considering

historical developments of accounting research literature. Furthermore, we mainly look at

currency hedging techniques being established through trade literature and practice while

developing an overview of research literature. On the other hand, there are also analyzed the use

of techniques for hedging currency risk in practice. The employed research methodology

includes literature review specific methods. The objective of this paper is to document the

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necessity of developing an adequate system of surveillance and control measures imposed

through the certainty of currency risk itself.

NEED OF THE STUDY

As there is no research available on the various hedging used by Ludhiana exporters there is a

need to know whether exporters are aware of the various hedging tools and techniques and what

factors and considerations are kept in mind while choosing a particular hedging techniques and if

they are using a particular technique then what are the reasons and if they are not then what are

the reasons.This research will help the Banks and various financial institutions in knowing the

attitude of exporters towards hedging.

OBJECTIVE

1. To know the awareness about various hedging techniques in exporters2. To know the consideration taken into account while chosing a hedging technique3. To know the reason for choosing a particular hedging technique

RESEARCH METHODOLOGY

Research Methodology is the way to systematically solve a problem. Research Methodology is

prepared to describe not only the Research procedure and method adopted for the achievement of

the objective of the project but also the logic behind the use of this methodology

RESEARCH DESIGN

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A research design is an arrangement of conditions for collection and analysis of data in a manner

that aims to combine relevance to the research purpose with economy in procedure. It constitutes

the blueprint for collection, measurement and analysis of data.Our research design is Descriptive

research design. Descriptive research answers the questions who, what, where, when and how...It

includes surveys and fact finding enquiries of different kinds. The major purpose of descriptive

research is description of the state of affairs as it exists at present.

RESEARCH INSTRUMENT

The primary data was obtained during the cource of doing research in a systematic manner with

the help of Questionnaire

SAMPLING FRAME

Sampling frame is generated from FIEO that is Federation of Indian Export Organisation who

are having information about exporters in Ludhiana

SAMPLING TECHNIQUE

Convenience Sampling which is a kind of Non Probability Sampling Technique is used

SAMPLING SIZE

Sample size is 100 exporters

POPULATION

Population refers to part of universe from which the sample for conducting the research is

selected. Universe & population can be same in some researches.The population of our research

is exporters from Ludhiana.

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SAMPLING UNIT

Sampling unit refers to smallest possible individual eligible respondent. In my research Sampling

unit is every exporter who is using any kind of hedging technique to minimize his risk.

DATA COLLECTION

For our research study the data has been collected by the primary data. For primary data

collection we have adopted Personal Interview method

DATA CONTACT METHOD

Personal Interview contact with the Respondents

DATA EVALUATION METHOD

Suitable Statistical Technique will be used for evaluation

LIMITATIONS

Since Convenience Sampling is used it may not represent the whole population. Since the scope of study is limited to Ludhiana due to shortage of manpower and

resources so findings cannot be generalised

.

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