Abstract
v SWAPS
Garman, Mark B & Steven W. Kohlhagen. "Foreign currency option values." Journal of International Money & Finance December, 1983.
This paper attempts to evaluate the various alternatives available to the Indian corporates for hedging financial risks. Hedging is a risk management technique, done to protect the foreign exchange exposures against the volatility of exchange rates, by using derivatives like Options, Futures, Forward Contracts, Swaps or by off-setting positions against the underlying asset. Managing foreign exchange risk is a fundamental component in the safe and sound management of all institutions that have exposures in foreign currencies. It involves prudently managing foreign currency positions in order to control, within set parameters, the impact of changes in exchange rates on the financial position of the corporates. The major parts of earnings of information technology come through exports in US dollars. The value of US dollar is fluctuating day by day which is, in turn, reducing the quantum of exports and profit margin of such companies. As Information Technology Industry is export oriented industry, hence the study of forex risk management in this sector is of great significance because the foreign exchange risk requires a lot of attention.
Origin and Development of IT Sector
India is pioneer in software development and favourite destination for IT-enabled services. As regards its development in India, it has come into existence by virtue of availability of trained English speaking professionals, cost competitiveness and quality telecommunications infrastructure. India has a vast market and Indian Information Technology provides potential services like IT Services, Engineering Services, IT enabled Services and Electronic Business (E-Business).
As regards IT Services, these consists of Information Services (IS), outsourcing packaged software support and installation systems integration, processing services, hardware support and installation and IT training and education. Engineering Services consist of Industrial Design, Mechanical Design, Electronic System Design, Design Validation Testing, Industrialization and Prototyping. IT enabled Services refer to the use of telecom networks or the Internet. Such services comprise of Remote Maintenance, Back Office Operations, Data Processing, Call Centres, Business Process Outsourcing, etc. E-Business implies business which is carried out on the Internet. It includes buying and selling, serving customers and collaborating with business partners.
As a matter of fact, the Indian IT sector is very lucrative because of : (i) Low wage structure; (ii) Government's Policy; (iii) Quality of work; (iv) Highly skilled human resource; (v) Establishment of Foreign Organizations in India; (vi) Cost competitiveness; (vii) Quality telecommunications infrastructure. (ix) English-speaking professionals; and (x) Quality Standards.
As regards Key Players in the IT Sector, Tata consultancy Services Ltd., Wipro Technologies Ltd., Infosys Technologies Ltd., Satyam Computer Services Ltd. are India’s Tier one companies in the Information Technology Sector. The other key players include : IBM, HCL, Patni, Polaris, Cisco, KPIT Cummins, I-Flex Solutions, Cognizant, Sapient & Mphasis. Besides, a large number of multi-national IT enterprises are also operating in India in sectors such as Integrated Chip Design, System Software, Communication Software, R&D Centers, Technology Support Sector, Captive Support Sector, Business Process Outsourcing Sector and benefiting from cost and quality advantages available in the country. These multinationals comprise of Siemens, Philips, Intel, Texas Instruments etc. (Chip Design); Siemens, Motorola, Lucent Technologies, Sony, Nortel etc. (Communication Software); Microsoft, Oracle, Sun Microsystems, HP, Compaq etc. (Systems Software); Google, Yahoo etc. (R & D Centres); Axa Business Services, Swiss Shared Services, Siemens Shared Services etc. (Business Process Outsourcing Sector); Accenture, DELL, HSBC, GE Capital, Fidelity etc.
As regards the growth of the Indian IT Sector, the Indian information technology sector is one of the sunshine sectors of the Indian economy witnessing rapid growth.The Indian IT- Business Process Outsourcing sector aims to achieve a target of US$ 60 billion in exports and US$ 73-75 billion in overall software and services revenues by 2010. India’s information and communication technology market also aims to grow 20.3 per cent annually to reach US$ 24.3 billion by 2011. The Indian IT and IT enabled Services market is targeted to grow at the rate of over 16 per cent to become a US$ 132 billion industry, significantly, the domestic market alone is targeted to become over US$ 50 billion, with an annual compound growth rate of 18.4 per cent. Simultaneously, the IT and IT enabled Services exports are targeted to more than double to US $ 78.62 billion by 2012.[1]
IT enabled Services offers services such as Knowledge Process Outsourcing (KPO), Legal Process Outsourcing (LPO), Games Process Outsourcing (GPO) etc. More and more sophisticated products are being developed in India. The domestic Business Process Outsourcing segment is growing annually at a rate of nearly 35-40 %. The revenues generated by the BPO’s are almost $ 1.18 million and the domestic market is expected to reach $ 10 billion by the end of 2011-12[2] then IT and IT enabled services will reach nearly US$ 330 million.
Concept of Forex Rates
Foreign exchange refers to the conversion of one country’s currency into another country’s currency. H.E. Evitt[3] States that foreign exchange is that section of economic science which deals with the means and methods by which rights to wealth in one country’s currency are converted into rights to wealth in terms of another country’s currency. He further observes that it involves the investigation of the method by which the currency of one country is exchanged for that of another, the cause which renders such exchange necessary, the forms which such exchange may take, and the rations or equivalent values at which such exchanges are effected. Similarly, Dr. Paul Einzig[4] remarks that Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another.
Types of Exchange Rates
In the foreign exchange market all over the world, there are two ways in which exchange rates are expressed;
Direct and Indirect Rates
As regards Direct Exchange Rate, it expresses the units of home Currency equal to one unit of foreign currency Foreign Currency remains fixed and Home Currency varies in direct rates whereas Indirect Rates refer to the exchange rate which is quoted in terms of the number of units of foreign currency equal to one unit of local currency. Home Currency remains fixed and Foreign Currency goes on changing in indirect rates.
Spot and Forward Foreign Exchange Rates
The spot rate of foreign exchange indicates the rate or price expressed in terms of home currency which is payable for the spot delivery of specified type of foreign exchange; whereas the forward rate of foreign exchange refers to the rate or price at which a transaction will take place at some specified time in future.
Types of Forex Risk
Foreign exchange exposure is categorized as (i) Transaction Exposure; (ii) Translation Exposure and (iii) Economic Exposure.
Transaction exposure arises because of denomination of a payable or receivable in a foreign currency. Translation exposure arises on the consolidation of foreign currency denominated assets and liabilities in the process of preparing consolidated accounts. It is also regarded as accounting exposure. Economic exposure arises because the present value of a stream of expected future cash flows which are denominated in the home currency or in a foreign currency may vary due to exchange fluctuations. Transaction and economic exposure are both considered as cash flow exposures.
Transaction exposure can also be considered as subset of economic exposure. It can be viewed because of fact that the present value of an uncovered foreign currency denominated receivable or payable changes as exchange rates changes. The value of an international operation can be expressed as the present value of expected future operating cash flows, which are incremental to that international activity discounted at the appropriate discount rate.
Concept of Forex Risk Management
Every company that has exposure to foreign exchange risk must prudently manage & control its exposure together with management of other risks. Foreign exchange risk implies the exposure of a company to the potential impact of movements in foreign exchange rates. The risk that is caused by adverse fluctuations in exchange rates may result in a loss to the company.
Foreign exchange risk arises mainly due to currency differences in a company’s assets & liabilities and cash flow differences. Such risk continues till the foreign exchange position is settled. This risk arises because of foreign currency cash transactions, foreign exchange trading, investments denominated in foreign currencies and investments in foreign companies. The quantum of risk is derived out by multiplying the magnitude of exchange rate changes with the size and duration of the foreign currency exposure.
Need for Forex Risk Management
Globalisation of financial markets and developments in exchange markets have resulted into complicated transnational exposure management. It is complex mainly because of (a) the increasing size and variety of exposures which companies incur as they grow globally and (b) the increasing volatility & fluctuations in exchange rates of the foreign exchange markets. Due to this complexity, a logical balanced approach is required in view of formulating company’s foreign exchange risk management programme.
Methods of Forex Risk Management
Exposure Management techniques are classified into internal and external techniques according to their basic origin. Internal techniques are mainly used as a part of company’s regulatory financial management & aims at minimizing its exposure to exchange risk. These basically aim at reducing or preventing an exposed position from arising. The external techniques are used to provide protection against the possibility that exchange losses will result from the foreign exchange risk exposure which the internal measures have not been able to eliminate. These consists of basically the contractual measures to provide protection against an exchange loss which may arise from an existing translation or exposed position.
Internal Techniques
v Netting
Netting implies offsetting exposures in one currency with exposure in the same or another currency, where exchange rates are expected to move high in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure.
v Leading and Lagging
It refers to the adjustment of intercompany credit terms, leading means a prepayment of a trade obligation and lagging means a delayed payment. It is basically intercompany technique whereas netting is purely defensive measure.
v Pricing Policy
In order to manage foreign exchange risk exposure, there are two types of pricing tactics: price variation and currency of invoicing policy. One way for companies to protect themselves against exchange risk is to increase selling prices to offset the adverse effects of exchange rate fluctuations. Selling price requires the analysis of competitive situation, customer credibility, price controls and internal delays.
v Asset and Liability Management
This technique can be used to manage balance sheet, income statement and cash flow exposures. It can also be used aggressively or defensively.
External Techniques
External techniques are used by both exporters and importers as well as by multinational companies. The costs of the external exposure management methods are fixed and predetermined. The main external exposure management techniques are forward exchange contracts, short term borrowing, discounting, government exchange risk guarantees, options, futures and swaps.
v Forward Exchange Contracts
Forward exchange contracts refer to agreements in which two parties agree upon the exchange rate at which currencies will be exchanged on future date or within future specified duration. Forward contracts reduces exchange risk element in the foreign transactions.
v Short term Borrowing
Another alternative to hedge risks in the forward market is the short-term borrowing technique. A company can borrow either dollar or some other foreign currency or the local currency. Through short term borrowing techniques, two major difficulties of the settlement dates and the continuing stream of foreign currency are easily solved.
v Discounting
This technique is used to resolve the problems of continuing foreign currency exposures and uncertain settlement dates. The discounting technique for covering receivables exposures is very similar to short term borrowing. In discounting techniques, the effective discount rate less the home currency deposit rate rather that the foreign currency borrowing rate less the home currency rate as is short term borrowing techniques, is the cost.
v Options
Options are rights & not obligations to make buy and sell decision. An option is a contract between two parties known as the buyer and the seller or writer. The buyer pays a price or premium to the seller for the right but not the obligation to buy or sell a certain amount of a specified quantity of one currency in exchange at a fixed price for a specified period of time. The right to buy is a call option and the right to sell is a put option.
v Futures
Futures are contracts to buy or sell financial instruments, for forward delivery or settlement on standardized terms and conditions. Future contacts are similar to forward contracts but are more liquid as these are traded on recognized exchanges.
v SWAPS
Swaps refer to a contract between two parties, termed as counter-parties, who exchange payments between them for an agreed period of time according to certain specified rules. It is defined as a financial transaction involving two counter-parties who agreed terms to exchange streams of payments or cash flows overtime on the basis of agreed at the beginning of the contract. Swap is like a series of forward contracts. Swaps involve a series of exchanges at specific futures dates between counter parties.
Conclusions and Suggestions
Derivatives used for mitigating risk must increase due to the increased global linkages and
volatile exchange rates. Firms must focus at development of sound risk management
system and also need to formulate their hedging strategy. Foreign exchange risk management must be conducted in the context of a comprehensive business plan. Hedging should also be done without speculation. Further, in-correct application of hedging strategies along with no trade off between uncertainties associated with exchange rate and opportunity loss, makes a hedging foreign exchange risk itself a risk.In order to reduce the cost of hedging, it is suggested that the Government of India should revise its regulations wherein corporates should be allowed directly to deal in foreign currency derivative market in place of the banks which have so far been allowed to deal in foreign exchange market. In order to avoid delay in the implementation of hedging decisions, it is suggested that the corporates should be equipped with latest methods of technical analysis together with the introduction of statistical packages for better and accurate forecasting and timely action. Rupee- Dollar futures should be introduced in Indian stock exchanges as a new product of derivatives so as to provide an another route for hedging forex risk.
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[1] Quoted from the Speech of Mr. R.K. Bhatia, High Commissioner of India, at seminar entitled "India@Futurex" in Johannesburg , South Africa
[2] I.bid.
[3] Keshkamat, V.V., "Foreign Exchange & Exchange Control", Vivek Publications Bombay
[4] I.bid.
