Foreign Exchange Exposure Management Practices of Indian Firms: An Empirical Analysis

Prof Madhu Vij

Professor Corporate Relations and Placement Advisor Faculty of Management Studies (FMS) University of Delhi, Delhi -110007 Fax:+91-11-27667183 E-mail: drmadhuvij@hotmail.com; madhuvij@hotmail.com Mobile 9810828835

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Electronic copy available at: http://ssrn.com/abstract=1331760

ABSTRACT
This study employs questionnaire survey and reports the findings of a survey of chief financial officers of Indian Companies conducted in 2008. The objective of this study is to investigate if the CFOs had a clear understanding of the difference between translation, transaction and economic exposure. In addition, the study also concentrates on the hedging policies used by firms, the key factors that determine the decision to hedge and how frequently is the

hedging policy reviewed.

Key Words: Foreign exchange, Exchange risk, Exposure, Translation exposure, Transaction exposure, Economic exposure, hedging

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Foreign Exchange Exposure Management Practices of Indian Firms: An Empirical Analysis

Theoretical Framework: Management of Foreign Exchange Risk In the light of globalization and internationalization of world markets, foreign exchange risk has become one of the most difficult and persistent problems with which financial executives must cope. Fluctuations in exchange rates have become a major source of uncertainty for multinational firms (Jorion, 1990). The present study aims to provide a perspective on managing the risk that MNCs face due to fluctuating exchange rates. Firms are exposed to foreign exchange risk if the results of their projects depend on future exchange rates and if exchange rates cannot be fully anticipated (Glaum Martin, 2000). Exchange rate risk is of fundamental concern to both investors and managers. Investors are concerned with the impact of unexpected changes in the exchange rate as it relates to portfolio values, and managers are also concerned with the exposure of the firm as it relates to profitability. (Pantzalis et al, 2001). Managing foreign exchange risk is a fundamental component in the safe and sound management of companies that have exposures in foreign currencies. In deciding what the companys objectives are in managing exposure to foreign currency, the company is in essence deciding what risks it is willing to accept in this area. Research in this area indicates that 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 company. The frequency and direction of rate changes, the extent of the foreign currency exposure and the ability of counter parties to honor their obligations to the company are significant factors in foreign exchange risk management. A study of the exposure management practices of Indian firms is both interesting and challenging for three reasons. Firstly, their exposure management practices are still evolving and are at an early stage of financial development. Secondly, management of

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exchange rate exposure is many times influenced by expectations and perceptions about the current and future course of events. Finally, not many empirical studies have been attempted on the foreign exchange exposure practices of Indian companies. Most empirical studies about foreign exchange exposure management practices, concentrate on the behavior of multinational corporations (MNCs) that are located in the U.S. and the U.K. Studies about the practices of firms located in smaller open economies are rather limited ( Oxelheim,1984; and Batten, Mellor and Wan, 1993). Therefore, this study will be important since it documents the practices of companies across different industries. In order to translate foreign currency financial statements of US based MNCs, Financial Accounting Standards Board (FASB) -8 became effective in 1976. FASB Statement - 8 formulated uniform standard for the translation into dollars of foreign currency denominated financial statements and transactions of US-based multinational companies were established. An important feature of this statement was that translation gain and losses could not be deferred and multinational corporations had to include them in current income. However, due to dissatisfaction over FASB Statement - 8, FASB Statement - 52 was adopted. According to FASB-52, MNC had to adopt the current rate method for translating foreign currency denominated assets and liabilities into dollars. For foreign currency revenues, expenses and gains/ losses, the exchange rate at the dates used on which those elements are recognized shall be used ( Kasibhatla and Eduardo, 2001). FASB 52 presents standards for foreign currency translation that are designed to (1) Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise's cash flows and equity and (2) Reflect in consolidated statements the financial results and relationships as measured in the primary currency in which each entity conducts its business (referred to as its "functional currency"). An important feature of FASB 52 was that translation gains and losses are shown in the balance sheet in a new and separate account known as the Cumulative Translation Adjustment account. The functional currency translation approach adopted in this Statement encompasses: a. Identifying the functional currency of the entity's economic environment b. Measuring all elements of the financial statements in the functional currency c. Using the current exchange rate for translation from the functional currency to the reporting currency, if they are different d. Distinguishing the economic impact of changes in exchange rates on a net investment from the impact of such changes on individual assets and liabilities that are receivable or payable in currencies other than the functional currency. The next section of the paper reviews the literature on exposure management practices of companies. It also addresses the issue of the new standard FASB 52. Section 3 presents the survey responses and analysis of the results. Section 4 describes the hedging techniques used by companies and how companies determine the decision to hedge. The last section presents a summary and implications of the study. 4

Literature Review All firms dealing in multiple currencies face a risk of unanticipated gains/ losses due to sudden changes in exchange rates. The literature on exchange rate exposure has grown rapidly more specifically after the financial crises in 1990s. These crises have made it clear that exchange rates may have significant real economy effects. There are a large number of theories of why companies manage risk, including foreign exchange risk. (Christie and Marshall, 2003) Coping with risk has become an important managerial function, especially after the increased volatility in the foreign exchange market in recent years. The magnitude of the risk involved is illustrated by the 150 million exchange loss reported by the UK food and drinks company Allied- Lyons in 1991 ( Corporate Finance Magazine, April 1991). According to the literature, there are different sources/ types of exchange rate exposure (Schafer-Pohn-Weidinger, 2005). The main types of exchange rate exposure are: 1. Translation exposure - is the exposure short-term foreign assets are exposed to due to inflation uncertainty, while domestic assets are not exposed to this exchange risk (Jorion, 1990). Shapiro defines it as the accounting based changes in consolidated financial statements caused by exchange rate changes. Translation exposure arises on the consolidation of assets, liabilities and profits denominated in foreign currency in the process of preparing consolidated accounts. 2. Transaction Exposure Eiteman et al (2001) define transaction exposure as a measure of change in the value of outstanding financial obligations which are incurred prior to a change in exchange rates but are not due to be settled until after exchange rates change. Transaction exposure arises from the possibility that the future cash flow may change as a result of exchange rate changes. Marshall(2000) finds that transaction risk is perceived by US, UK and Asian Companies to be the most important risk to manage. 3. Economic Exposure refers to the possibility of the change in the present value of the firms expected future cash flows due to unexpected change in exchange rates. It is also called operating exposure and measures the change in the present value of the firm, which results from any change in future operating cash flows caused by unexpected changes in exchange rates. Pantzalis et al (2001) defines Operating exposure as the effect of unexpected changes in the exchange rate on cash flows associated with a firms real assets and liabilities. Various empirical studies in the last few years have attempted to provide insights into the practices of risk management. These empirical studies provide managers with information on the current practices of other firms. This kind of information is valuable since it allows managers to critically assess and analyze their own strategies. Cohen/Wiseman (1997) explains which questions should be asked in this context: Companies should use this information to assess where they stand in comparison with other companies. The survey findings do not necessarily represent best practice, but they

should be used as a guide for a treasury to compare itself with other organizations and ask: Where are we similar? Where are we different? Should we be different? What should we do about it? (Martin Glaum, 2000) Survey Responses and Analysis An 11 Question survey was mailed to CFOs of 250 Indian corporations in 2008. A cover letter to the CFOs explained that the purpose of the survey was academic and that all responses would be kept anonymous and confidential. A total of 98 usable responses were received, for a response rate of 40%. The industries that the 98 companies operate in are shown in Table 1. Table 1 Respondent Companies by Industry Industry Banks FMCG IT Manufacturing Others Total No of Companies 35 13 16 25 9 98 Percent 35.7 13.3 16.3 25.5 9.2 100.0

Questions 1-3 sought information with regard to the understanding of the transaction, translation, and economic exposure. Translation exposure was understood completely by 55% of the respondents, 31% understood it substantially, with only 13% understanding it partially. As far as transaction exposure is concerned 53% of the respondents indicated that they understood it completely, 34% understood it substantially, with only 10% understanding it partially. Economic Exposure is defined as an exposure to fluctuating exchange rate which affects a companys earnings, cash flow and foreign investment. Economic exposure which depends on the specific characteristics of the company and its industry was understood completely by 44% of the respondents, substantially by 41%, and partially by 15%. No company felt that they do not understand economic exposure completely. This could probably be attributed to the fact that most of the companies while entering into any economy, first study the economy. This could also be due to the fact that companies are aware that their receivables and payables are affected by international economic factors like wars, oil and natural resources. The survey does show predictable results about a significant majority of the respondents understanding all the 3 different kinds of exposure. Questions 4-6 sought information on whether or not the firms covered themselves against transactions, translation, and economic exposures. As far as translation exposure is concerned, only 28% of the respondents covered themselves completely, 31% substantially, 33% partially, and 6% not at all. Translation exposure is not perceived to be

important as CFOs feel that it is simply a paper gain and does not directly affect cash flows. However, firms are concerned about it because of its potential impact on reported income. In the case of transaction exposure, 23% of the respondents covered themselves completely, 45% substantially, 28% partially and 3% not at all. It was felt that transaction exposure can be reduced by netting out the payments. If payments and receipts are in different currencies, transaction exposure can be minimized as unexpected exchange rate changes net out over many different transactions. With regard to economic exposure, only 25% of the respondents covered themselves completely, 42% substantially, 25% partially and 7% not at all. Economic exposure is rarely covered and most of the respondents felt that the key determinant of economic exposure is the competitive structure of the industry in which a firm operates. Question 7 asked if the firms covered themselves against all three foreign exchange exposures. Only 13% of the respondents indicated that they cover themselves completely against all 3 foreign exchange exposures while 50% indicated that they cover substantially. Surprisingly 16% of the respondents did not cover themselves against all 3 exposures. Financial risk management has become one of the important aspects in financial management for companies around the world (Bessembinder, 1991). Rawls and Smithson (1990) report that financial risk management is one of the important financial activities of firms. The importance executives attach to foreign exchange risk management is often reflected in their attitudes to foreign exchange risk and the organizational structures and procedures implemented for managing exposure. Question 8 addressed the issue of whether the firms hedged against translation and economic exposures. Only 15% indicated that they hedged against both, 44% covered substantially, 20% indicated that they hedged partially, while 20% indicated that their firms do not hedge. Question 9 sought information if the firms were presently using FASB-52. Almost 50% of companies use FASB-52 completely but significantly a large number of companies(22%) are still not using FASB-52. Of the firms responding, 17% indicated that they used FASB-52 substantially while 10% used it partially. Companies not using FASB 52 are kept aloof from the advanced hedging techniques in accordance with international standards. Basically FASB Statement No. 8 provided that cash, receivables and payables were translated at current exchange rates while fixed assets and liabilities were translated at historical rates. FASB 8 resulted in much criticism. Due to this criticism the FASB sponsored another study that resulted in FASB 52. The basic outcome of FASB 52 was that if a foreign entity's books are not kept in the functional currency, then the books must be re-measured into the functional currency prior to translation. Hence, these norms have improved accountability of companies. Question 10 asked if the firms found netting, leading and lagging relevant in todays scenario. A majority of the companies (65%) acknowledge the relevance of netting, leading and lagging techniques completely or substantially. Netting is a technique of hedging by which receivables/payables can be netted out by matching amount. It reduces the amount of exposure to be covered hence reducing the banking costs. Leading and

lagging shift the timing of exposures by leading or lagging payables or receivables. Companies in India need to understand the importance of these techniques and adapt to these risk management methods. 65% of the respondents found the techniques completely or substantially relevant in today scenario. . Translation method used by firms include current/ non current, monetary/ non-monetary, temporal and all current rate. Based on the questionnaire survey, all current rate method is the most popular amongst firms. 60% of the firms use this method. As per the all current rate method, all assets and liabilities are translated at the rate in effect on the balance sheet date and all items on the income statement are translated at an appropriate average exchange rate or at the rate prevailing when the various revenues, expenses, gains and losses were incurred (historical rate). Some of the executives interviewed were of the opinion that the all current rate method eliminates the variability of net earnings due to translation gains or losses and the relative proportions of individual balance sheet accounts remain the same (debt-to-equity ratio, for example). Hedging Techniques Another important issue the survey deals with is the hedging techniques used by the responding companies. A number of companies in the sample use multiple hedging techniques. Table 2 shows the hedging techniques used. Table 2: Hedging techniques used by the responding companies S No. 1 2 3 4 5 6 7 8 9 Hedging Techniques Short dated forward exchange contract Long dated forward exchange contract Swaps Currency options Currency Futures Money market Hedge Inter company netting Leading and Lagging Matching system Percent 48 40 30 19 6 4 3 2 1

The two most popular techniques used by companies are short dated forward exchange contract and long dated forward exchange contract. 48% of the responding companies use hedging with short dated forward exchange contract while 40% use long dated forward exchange contract. Long dated forward exchange contract could be a little less popular because some companies may regard these contracts as speculation on account of the uncertainty about currency exposure more than one year in the future. Also, the

possibility that companies with outstanding contracts may have to report exchange losses from revaluation at the financial year-end could discourage them from entering into longdated forward contracts (Ho Kim Wai, 1993). A forward foreign exchange contract is an agreement to deliver a specified amount of one currency for a specified amount of another currency at some future date (Ho Kim Wai, 1993). For example, a company with receivables in US dollars due in 6 months time can sell the US dollars 3 months forward. The depreciation of the receivable currency is hedged against by selling a currency forward. Accordingly, if the risk is that of a currency appreciation, it can hedge by buying the currency forward. The advantage of a forward contract is that it can be customized to the specific needs of the firm to obtain an exact hedge. The main disadvantage of these contracts is that they are binding to the parties involved and are not marketable. Swaps have become popular in the Indian scenario especially in the last few years. The advantage of swap is that it is a long term strategy for hedging and is generally used by companies whose planning horizon is longer. Swaps are not traded in exchanges but are rather Over-The-Counter (OTC) between two private parties and there is always a risk of default. They are the third common hedging technique used by about 30% of the companies. Swap is an agreement between two counterparties agreeing to exchange one stream of cash flows against another stream. Swaps are used to hedge certain risks such as interest rate, or currency risk. The most common type of swaps is a plain vanilla interest rate swap. It is the exchange of a fixed rate loan with a floating rate loan. The reason for this exchange is to take benefit from the interest rate differential in two markets. Some companies may have comparative advantage in fixed rate markets while others have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing from the market where they have a comparative advantage. However, this may lead to a company borrowing fixed when it wants floating, or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan, or vice versa. The other popular technique is currency options used by 19% of the companies. Worldwide, the currency options market is a fairly evolved one. In fact it is an intermediate solution, a middle path to a sophisticated options market on one hand and a plain-vanilla forwards market on the other. Basically, a currency option is an instrument or device that gives the buyer (of the option) the right but not the obligation to enter into a contract with a seller. So, the buyer has a downside protection against risk and an upside benefit from favorable movement of the underlying currency. For example Citi 9

Bank offers OTC cross currency FX option structures where the underlying currency pair could be any reserve (i.e. fully convertible) currency. The other hedging techniques used by companies are currency futures, money market hedge, inter company netting, leading and lagging and matching system. Currency futures have recently been introduced in India. A currency future allows an investor to buy or sell currency at a future date at a pre determined price. They are similar to the forward contract, are traded in an organized exchange i.e. the futures market and require a small initial outlay. Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double forecasts. Decentralized or the Centralized approach to foreign exchanges risk management Corporate treasury can be organized as a decentralized or centralized treasury function. Table 3 shows that 85% of the responding companies adopt the centralized approach to foreign exchange risk management. In a centralized treasury, the various tasks are managed by a head office team who are experts in foreign exchange risk management. MNCs are managing the currency risk with centralized treasury structure which manages regional treasuries and holds responsibilities for all currency exposures and uses mix of netting, compliance, and trading and liquidity distribution. Centralized treasury also reduces the trading and funding costs with a single accounting system and helps corporate with straight through processing because of complete back office automation. Table 3: Decentralized or Centralized Foreign Exchange Management S No 1. 2. Percent 15 85

Decentralized Centralized

Time horizon of hedging activities Companies were also asked to indicate about the time horizon of their firms hedging activities. The results in table 4 suggest that 32% of the responding companies use a time horizon of more than 6 months but less than or equal to 1 year, 26% more than 1 year but less than or equal to 5 years and 21% more than 90 days but less than or equal to 6 months. 13% of the companies do not have a fixed rule concerning the time horizon of their hedging activities. Also, none of the companies in the sample used a time horizon of greater than 5 years.

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Table 4: Time horizon used when formulating hedging policy S No. 1 2 3 4 5 6 7 Percent Less than or equal to 90 days More than 90 days but less than or equal to 6 months More than 6 months but less than or equal to 1 year More than 1 year but less than or equal to 5 years Greater than 5 years Matching of duration to the underlying instrument Not time dependent 8 21 32 26 nil nil 13

Review of Hedging Policy In order to gain deeper insights into the hedging policies of the responding companies, we asked the companies how frequently they review the hedging policy of their company. Table 5 gives the details. 54% of the companies review their hedging policy annually, 19% review it continually, 14% review it quarterly and 13% review it monthly. Table 5: Review of Hedging Policy S No. 1 2 3 4 Annually Quarterly Monthly Continually 54 14 13 19 Percent

Internal Controls in Foreign Exchange Management A high level of internal control is necessary for the execution of foreign exchange transactions in corporate treasuries. Table 6 shows the main internal controls used by the responding companies in foreign exchange management. Most of the companies in the sample use any one or a combination of the internal controls mentioned in table 6. In addition, other controls are also used by companies. Table 6: Internal controls in Foreign exchange management S. No. Internal Controls 1 Regular management reports on positions 2 Limits and guidelines laid down by the top management 3 Internal audits and controls 4 Different levels of authorization

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5 6 7

No formal controls Dealing limits given to the banks Other controls

Conclusion The estimation of exchange rate exposure is a relatively new area in international finance (Bodnar and Wong, 2000). In recent years, however, risk management has received increasing attention in both corporate practice and literature (Martin Glaum, 2000). The results of our study can be used by CFOs to assess and select a proper foreign exchange exposure management strategy for their company. The survey findings do not necessarily represent best practices, but they can be used by CFOs as a guide to manage risks and their foreign exchange hedging strategies. The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure (Shapiro, 2006). The present study provides evidence that most of the companies in the survey understand translation, transaction and economic exposure completely. Regarding, covering themselves against all three exposure, only 13% cover themselves completely while 50% cover substantially. On the issue of whether the firms hedged against translation and economic exposure, very few firms (15%) indicated that they hedged against both. 64% covered themselves substantially or partially. Only 20% firms do not hedge. This means that companies lay a great deal of emphasis on hedging their foreign exchange exposure and do realize that hedging is critical for long term survival for doing business overseas. Of the total firms surveyed, approximately 50% of the companies are following FASB52 completely. The use of FASB-52 also becomes mandatory since most companies use the all current rate method for the preparation of their balance sheet. 60% of the firms surveyed use the all current rate method for translation purposes. The high degree of usage of FASB-52 arises out of compliance with international accounting norms as well as an understanding of the shortcomings of FASB-8 wherein the true profitability is disguised by the exchange rate volatility. Companies following FASB 52 appreciate its advantages and felt that fluctuations in the reported earnings have substantially reduced after adopting FASB 52. In addition, the survey also dealt with the hedging techniques used by firms. Long dated and short dated forward exchange contracts are popular hedging techniques. Indian companies currently hedge their risk by entering into foreign currency forwards, swap and options agreements in over-the-counter market (OTC) market. An exchange traded platform for currency futures is considered to be more transparent, efficient and accessible than the OTC market. A majority of the companies prefer the centralized approach to the decentralized approach as the companies seem to believe in controlling all their treasury activities from

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