PROJECT REPORT

at

Cochin Stock Exchange

Submitted by

Surya.s
(Reg.No.1019)

In partial fulfillment of requirement for the award of

POST GRADUATE DIPLOMA IN MANAGEMENT

to

BHAVANS ROYAL INSTITUTE OF MANAGEMENT

(Approved by All India Council for Technical Education AICTE, New Delhi)
THIRUVANKULAM

KOCHI -682305

2008-2010
 CHAPTER 1
INTRODUCTION
Introduction

Derivatives are one of the most important classes of financial instruments that are central
to today’s financial markets. They offer various types of risk protection and allow innovative
investment strategies. In India the derivatives market was small and domestic just a few years
back. Since then it has grown impressively and had reached to a sizable volume, for example on
an average providing 3,500 crores of volume in the national stock exchange in daily currency
derivative trade. No other class of financial instruments has experienced as much innovation.
Product and technology innovation together with competition have fuelled the impressive growth
that has created many new jobs both at exchanges and intermediaries as well as at related service
providers.
Given the derivatives market’s global nature, users can trade round the clock and make
use of currency derivatives that offer exposure to the investor in almost any “Underlying
Currency” across all markets. The Currency derivatives market is growing at a fast pace and
providing all different investing horizons to the investors like Hedging, Speculation, Arbitrage
and investment. There are two competing segments in the currency market: the off-exchange or
over-the-counter (OTC) segment and the on-exchange segment. From a customer perspective,
OTC trading is approximately less expensive than on-exchange trading. By and large, the
currency derivatives market is safe and efficient. Risks are particularly well controlled in the
exchange segment, where central counterparties (CCPs) operate very efficiently and mitigate the
risks for all market participants.
In this respect, derivatives have to be distinguished from e.g. structured credit linked
security such as collateralized debt obligations that triggered the financial crisis in 2007.The
currency derivatives market has successfully developed under an effective regulatory regime in
India. All three prerequisites for a well-functioning market – safety, efficiency and innovation –
are fulfilled. While there is no need for structural changes in the framework under which OTC
players and exchanges operate today, improvements are possible. Particularly in the OTC
segment, increasing operating efficiency, market transparency and enhancing counterparty risk
mitigation would help the global derivatives market to function even more effectively. At the end
of the day, currency derivatives market opens up new window for the investors in India to go
beyond the stereotype equity and commodity market and enjoy the Currency market.

Statement of the problem

This study mainly covers the area of hedging. The main aim of the study is to prove how
corporate houses reduce their foreign exchange exposure and risk by using derivatives product.

Objective of the study

1. To conduct a literature review on derivatives and their use, specifically hedging.

2. To find out extent to which the loss can be reduced by applying hedging strategies.
3. To determine whether the hedger enjoys better returns from the use of hedging
instruments.
4. To identify the hedging strategies used by corporate houses.

Scope of the study

1. It helps the researcher to construct a detailed study on hedging through currency futures.
2. Provide an insight on Forex market.
3. It helps to make a general study on derivatives.
4. It helps the corporate to design the hedging strategies to avoid currency exposure.
Research Methodology

Research design- The study about "Corporate Hedging for Foreign Exchange Risk in India”
is an empirical study to compile a theoretical perspective and bring clarity in this field of study
Research approach – Desk research is attempted by reviewing the attempted by reviewing the
available literature of the study

Research instrument– Mathematical and statistical tools will be used to compute the effect of
hedging strategies and for comparing the relative benefit of a hedger and a non-hedger
 Sources of Data

The secondary data is data, which is collected and compiled previously for different
purpose. The present study depends solely on secondary sources for collecting all the required
information for the successful completion of the study. The secondary data include material
collected from:
1. Newspaper
2. Magazine
3. Internet
4. Website
5. Books
6. Journals
Research period
To study the hedging strategies of corporate houses for the period of three years starting from
2007 to 2010.

Limitation of the study

The limitations of the study were

1. The analysis was purely based on the secondary data. So, any error in the secondary data might
affect the present study also.
2. Hedging strategy is applied on historical data. So the direction of each trend in the stock
market is known before hand for the period selected. As a result, some bias may creep in
the section of the application of hedging strategy.
3. There is no organized information available on how the corporate enterprises in India are
facing this challenge
1.6 CHAPTER SCHEME

This project report is presented in 6 chapters.

i. First chapter contains introduction which includes statement of the problem, objectives of

the study, scope of the study, research methodology, limitations of the study and chapter

scheme.

ii. Second chapter consists of industry profile which contains international scenario, national

scenario and the state scenario.

iii. Third chapter gives an overview about the profile of ITC Ltd which includes the history

and growth of the company till now, future plans, financial performance of the company

and the details of HR department etc.

iv. Fourth chapter contains theoretical background and it gives an overview about the

concept of balanced score card, learning and growth and the various aspects involved.

v. Fifth chapter includes data analysis and interpretation of data collected for this study.

vi. Sixth chapter contains the findings, suggestions and conclusion of the research.
 CHAPTER II

INDUSTRY PROFILE

Foreign Exchange Market

The foreign exchange (FX) market is the largest financial market in the world. It is the
largest and most liquid financial market in the world. Globally, operations in the foreign
exchange market started in a major way after the breakdown of the Britton Woods system in
1971, which also marked the beginning of floating exchange rate regimes in several countries.
Over the years, the foreign exchange market has emerged as the largest market in the world. The
decade of the 1990s witnessed a perceptible policy shift in many emerging markets towards
reorientation of their financial markets in terms of new products and instruments, development of
institutional and market infrastructure and realignment of regulatory structure consistent with the
liberalized operational framework. The changing contours were mirrored in a rapid expansion of
foreign exchange market in terms of participants, transaction volumes, decline in transaction
costs and more efficient mechanisms of risk transfer.
The foreign exchange market runs 24 hours a day from Monday 5:00 am Australian
Eastern Standard Time (AEST), to Friday 5:00pm New York time. It is a place where global
currencies are bought and sold against one another however, unlike the commodity and stock
markets, it is not a physical market based on one building or location. Rather, it is an
organizational framework within which participants, linked by telephone and computers, buy and
sell global currencies. Actual currencies are not physically traded; instead, they are transferred
electronically from one back account to another.

The Forex market has historically been dominated by banks including central banks,
commercial banks, and investment banks. However the number of other participants is growing
rapidly and now includes large multinational corporations, global money managers, registered
dealers, international money brokers, futures and options traders, small businesses and private
speculators. The Forex market is an over-the-counter (OTC) market. This means that the size of
the "deal" and the "settlement date" are negotiable between the two counterparties in the market.
Currency prices are affected by a variety of economic and political conditions, but the most
important factors are interest rates, inflation and political stability. Any of these factors, as well
as large market orders, can cause high volatility in currency prices. However, the size and
volume of the FX market makes it impossible for any one entity to affect the market significantly
for any length of time

Global Foreign Exchange Market

The foreign exchange market is known to be the largest financial market in the world, as
measured by daily turnover. The most commonly traded, or "liquid", currencies are those from
countries with stable governments, respected central banks, and low inflation. Today, over 85%
of all daily transactions involve trading of the major currencies which include the US Dollar
(USD), Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Canadian
Dollar (CAD) and the Australian Dollar (AUD).

Forex Market Share of Countries

31%
34%

UK
USA
Switzerland
Japan
Singapore
India
Others
1%
6%
6% 17%
6%
 Over the long term the US stock market has always gone up giving stocks in the US an
upward bias when trading. As currencies are traded in pairs when the value of one currency is
falling this automatically means that the value of another currency is rising. This is an advantage
from the standpoint of there is equal opportunity for profit from both long and short trades. This
is a disadvantage from the standpoint of not having that upward bias working for you when you
are in a long trade

Global Foreign Exchange Market Turnover in the Traditional Foreign Exchange Market

3500
3000
2500
2000
1500
1000
500
0
1992 1995 1998 2001 2004 2007

Daily averages in April in billions of US dollars at April 2007 exchange

24 Hour Liquidity
 Probably the biggest advantages that traders of the forex market will cite is that the
market is by far the largest market in the world, and that main currencies can be traded actively
24 hours a day. The huge amount of volume traded in the world’s main currencies each day the
volume traded in the equities and the futures markets many times over. This combined with the
24 hour trading day gives traders the ability to determine their own trading hours instead of
having to trade within set hours as they would have to when trading stocks and/or futures. More
importantly than this however is that as the market is more liquid than the futures and equities
markets, price slippage (the difference between where you click to enter or exit a trade and
where you actually get in or out) in the forex market is normally much smaller than in the stock
and futures market.

Daily Trading Volumes($billion)

180

160

140

120

100

80

60

40

20

0
EBS Reuters CMS NYSE Nasdaq London Tokyo

Geographic Distribution

Geographic Distribution of Turnover (in percent)

40

35

30

25 UK

US
20
Japan
15 Singapore

Switzerland
10

0
1992 1998 2004 2007
Exchange Traded and Over the Counter Markets

When trading stocks or futures you normally do so via a centralized exchange such as the
New York Stock Exchange, Bombay stock exchange, or the Chicago Mercantile Exchange. In
addition to providing a centralized place where all trades are conducted, exchanges such as these
also play the key role of acting as the counterparty to all trades. What this means is that while
you may be buying for example 100 shares of Infosys stock at the same time someone else is
selling those shares, you do not buy those shares directly from the seller but instead from the
exchange. The fact that the exchange stands on the other side of all trades in exchange traded
markets is one of their key advantages as this removes counterparty risk, or the chance that the
person who you are trading with will default on their obligations relating to the trade. A second
key advantage of exchange traded markets is that as all trades flow through one central place, the
price that is quoted for a particular instrument is always the same regardless of the size or
sophistication of the person or entity making the trade.

Over the counter market

Unlike the stock market and the futures market which trade on centralized exchanges, the
spot Forex market and many debt markets trade in what’s known as the over the counter market.
What this means is that there is no centralized place where trades are made, instead the market is
made up of all the participants in the market trading among themselves .The biggest advantage to
over the counter markets is that because there is no centralized exchange and little regulation,
you have heavy competition between different providers to attract the most traders and trading
volume to their firm. This being the case transaction costs are normally lower in over the counter
markets when compared to similar products that trade on an exchange. As there is no centralized
exchange the firms that make prices in the instrument that is trading over the counter can make
whatever price they want, and the quality of execution varies from firm to firm for the same
instrument. While this is less of a problem in liquid markets such as Forex market where there
are multiple price reference sources, it can be a problem in less highly traded instruments.
 Foreign exchange market in India

Introduction

During 2003-04 the average monthly turnover in the Indian foreign exchange market
touched about 175 billion US dollars. Compare this with the monthly trading volume of about
120 billion US dollars for all cash, derivatives and debt instruments put together in the country,
and the sheer size of the foreign exchange market become evident. Since then, the foreign
exchange market activity has more than doubled with the average monthly turnover reaching 359
billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As
in the rest of the world, in India too, foreign exchange constitutes the largest financial market by
far.
Liberalization has radically changed India’s foreign exchange sector. Indeed the
liberalization process itself was sparked by a severe Balance of Payments and foreign exchange
crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe
import and foreign exchange controls and a thriving black market is being replaced with a less
regulated, “market driven” arrangement. While the rupee is still far from being “fully floating”
(many studies indicate that the effective pegging is no less marked after the reforms than before),
the nature of intervention and range of independence tolerated have both undergone significant
changes. With an overabundance of foreign exchange reserves, imports are no longer viewed
with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in
the foreign exchange markets not always to support the rupee but often to avoid an appreciation
in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of this
development s are palpable in the explosive growth in the foreign exchange market in India.

Foreign Exchange Markets in India – a brief background

The foreign exchange market in India started in earnest less than three decades ago when
in 1978 the government allowed banks to trade foreign exchange with one another. Today over
70% of the trading in foreign exchange continues to take place in the inter-bank market. The
market consists of over 90 Authorized Dealers (mostly banks) who transact currency among
themselves and come out “square” or without exposure at the end of the trading day. Trading is
regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self regulatory
association of dealers. Since 2001, clearing and settlement functions in the foreign exchange
market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles
transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions.
The liberalization process has significantly boosted the foreign exchange market in the country
by allowing both banks and corporations greater flexibility in holding and trading foreign
currencies. The growth of the foreign exchange market in the last few years has been nothing
less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in the foreign
exchange market (including swaps, forwards and forward cancellations) has more than tripled,
growing at a compounded annual rate exceeding 25%. Figure 1 shows the growth of foreign
exchange trading in India between 1999 and 2006. The inter-bank Forex trading volume has
continued to account for the dominant share (over 77%) of total trading over this period, though
there is an unmistakable downward trend in that proportion. (Part of this dominance, though,
result s from double-counting since purchase and sales is added separately, and a single inter-
bank transaction leads to a purchase as well as a sales entry.) This is in keeping with global
patterns.
 In March 2006, about half (48%) of the transactions were spot trades, while swap
transactions (essentially repurchase agreements with a one-way transaction – spot or forward –
combined with a longer- horizon forward transaction in the reverse direction) accounted for 34%
and forwards and forward cancellations made up 11% and 7% respectively. About two-thirds of
all transactions had the rupee on one side. In 2004, according to the triennial central bank survey
of foreign exchange and derivative markets conducted by the Bank for International Settlements
(BIS (2005a) the Indian Rupee featured in the 20 th position among all currencies in terms of
being on one side of all foreign transactions around the globe and its share had tripled since
1998. As a host of foreign exchange trading activity, India ranked 23 rd among all countries
covered by the BIS survey in 2007 accounting for 0.3% of the world turnover.
Turnover in Indian Foreign Exchange Market
Turnover in the foreign exchange market was 6.6 times of the size of India’s balance of
payments during 2005-06 as compared with 5.4 times in 2000-01. With the deepening of the
foreign exchange market and increased turnover, income of commercial banks through treasury
operations has increased considerably. Profit from foreign exchange transactions accounted for
more than 20 per cent of total profits of the scheduled commercial banks during 2004-05 and
2005-06

Relative Size of the Foreign Exchange Market in India

Foreign Exchange turnover segment wise

 100
90
80
70
60
50 derivatives
spot
40
30
20
10
0
2000 2001 2002 2003 2004 2005 2006 2007 2008

In the derivatives market, foreign exchange swaps account for the largest share of the
total derivatives turnover in India, followed by forwards and options. Options have remained
insignificant despite being in existence for four years. With restrictions on the issue of foreign
exchange swaps and options by corporate in India, the turnover in these segments (swap and
options) essentially reflects inter-bank transactions.
Where Does India Stand in Global Forex Market?

The daily turnover of the Global Forex market is presently estimated at US$ 3 trillion.
Presently the Indian Forex market is the 16th largest Forex market in the world in terms of daily
turnover as the BIS Triennial Survey report. As per this report the daily turnover of the Indian
Forex market is US$ 34 billion in the year 2007. Besides the OTC derivative segment of the
Indian Forex market has also increased significantly since its commencement in the year 2007.
During the year 2007-08 the daily turnover of the derivative segment in the Indian Forex market
stands at US$ 48 billion.

The growth of the Indian Forex market owes to the tremendous growth of the Indian
economy in the last few years. Today India holds a significant position in the Global economic
scenario and it is considered to be one of the emerging economies in the World. The steady
growth of the Indian economy and diversification of the industrial sectors in India has
contributed significantly to the rapid growth of the Indian Forex market.
The Forex trading history of India dates back to 1978, when Reserve Bank of India took a step
towards allowing the banks to undertake intra-day trading in Foreign exchange. It is during the
period of 1975-1992 when Reserve Bank of India, officially determined the exchange rate of
rupee according to the weighted basket of currencies with the significant business partners of
India. But it needs to be mentioned that there are too many restrictions on these banks during this
period for trading in the Forex market.

The introduction of the open market policy in the year 1991 and implementation of the
new economic policy by the Govt. of India brought a comprehensive change in the Forex market
of India. It is during the month of July 1991, that the rupee undergone a twofold downward
adjustment and this was in line with inflation differential to ensure competitiveness in exports.
Then as per the recommendation of a high level committee set up to review the Balance of
Payment position, the Liberalized Exchange Rate Management System or the LERMS was
introduced in 1992. The method of dual exchange rate mechanism that was part of the LERMS
also came into effect 1993. It is during this time that uniform exchange rate came into effect and
that started demand and supply controlled exchange rate regime in Indian. This ultimately
progressed towards the current account convertibility that was a part of the Articles of
Agreement with the International Monetary Fund.

It was the report and recommendations of the Expert Group on Foreign Exchange,
formed to judge the Forex market in India that actually helped to widen the Forex trading
practices in the country. As per the recommendations of the expert committee, Reserve bank of
India and the Government took so many significant steps that ultimately gave freedom to the
banks in many ways. Apart from the banks corporate bodies were also given certain relaxation
that also played an instrumental role in spread of Forex trading in India.

It is during the year 2008 that Indian Forex market has seen a great advancement that
took the Indian Forex trading at par with the global Forex markets. It is the introduction of future
derivative segment in Forex trading through the largest stock exchange in country – National
Stock Exchange. This step not only increased the Indian Forex market volume too many folds
also gave the individual and retail investor a chance to trade at the Forex market, that was till this
time remained a forte of the banks and large corporate.
 Total traded value-all exchanges(Rs crore)
200000

180000

160000

140000

120000

100000

80000

60000

40000

20000

0
9

09

9
08

08

09

.9

9
.0
b.
t.0

v.0

c.0

r.0

l.0
ar
g.

p.

n.

n.
ay
Fe

Ju
Oc

Ap
M
No

De
Au

Ju
Se

Ja

Traded volumes on all exchanges for USD-INR pair (data: SEBI)

Indian Forex market got yet another boost recently when the SEBI and Reserve Bank of
India permitted the trade of derivative contract at the leading stock exchanges NSE and MCX for
three new currency pairs. In its recent circulars Reserve Bank of India accepting the proposal of
SEBI, permitted the trade of INRGBP (Indian Rupee and Great Britain Pound), INREUR (Indian
Rupee and Euro) and INRYEN (Indian Rupee and Japanese Yen). This was in addition with the
existing pair of currencies that is US$ and INR. From inclusion of these three currency pairs in
the Indian Forex circuit the Indian Forex scene is expected to boost even further as these are
some of the most widely traded currency pairs in the world.

Foreign exchange regulatory regimes in India

Soon after independence, a complex web of controls were imposed for all external
transactions through a legislation i.e. Foreign Exchange Regulation Act (FERA), 1947. These
were put into more rigorous framework of controls through FERA, 1973. Severe restrictions on
current account transactions had continued till mid-1990‟s when relaxations were made in the
operations of FERA, 1973. The control framework was essentially transaction based in terms of
which all transaction in foreign exchange including those between residents and non residents
were prohibited, unless specifically permitted. A sequence of events started in the subsequent
years generally followed by the recommendations made by different committees such as the high
level committee on Balance of Payments under chairman Dr. C. Rangarajan, 1993. In 1993,
exchange rate of rupee was made market determined. In 1994 India accepted article VIII of the
Articles of Agreement of the International Monetary Fund in August 1994 and adopted current
account convertibility. In June 2000 a legal framework, with implementation of FEMA, has also
has also being put into effect to ensure convertibility on the current account. This consistent
approach has lent credibility to the liberalization process of both current and capital account
transactions. As evident from various economic indicators, the liberalization process has been
underway for some time created a more competitive environment for Indian Industry vis-a-vis
what existed earlier. Consequently the Indian companies have upgraded their technology and
expanded to more efficient scales of production and refocused their activities to areas of
competence. Increasingly, Indian companies are looking to become global players. Reform
measures is external sectors, including dismantling of exchange control have been a contributor
to this development.

Players in the Forex Market

Diverse a commodity market, where all participants have access to the same price levels,
the Forex market is separated into levels of access. At the peak is the interbank industry, which is
made up of the most prominent investment funds banking firms. Inside the interbank
marketplace, gaps, which are the deviation between the bidding and ask cost, are razor sharp and
normally unavailable, and not known to participants outside the inner circle. As you go down the
degrees of access, the difference between the bidding and ask costs extends. This is due to mass.
If a swing trader can guarantee immense amounts of dealings for huge amounts, they can require
a more minor difference between the bidding and ask price, which is named to as a better
spreading. The top tier interbank industry accounts for 53% of all transactions. When that there
are usually more minor investment banks, followed by heavy multinational corporations (which
want to hedge risk and pay employees in diverse countries), big hedge funds, and potentially a
few of the retail Forex market makers. Major Pension funds, insurance policy companies, mutual
funds, and other institutional investors have wagered an increasingly significant role in financial
markets in general, and in FX markets in particular, since the early 2000s.
Central Banks
National primal banks play a please note role in the foreign exchange marketplaces. They
seek to check the revenue supply, inflation, and/or interest rates and often have prescribed or
unofficial target values for their currencies. They can use their oftentimes substantial foreign
exchange reserves to stabilize the marketplace. The strength of primal banking institute
stabilizing hypothesis is in question because primal banking firms don't go bankrupt if they make
huge losses, like more traders would, and there are no convincing grounds to believe that they do
make a profits dealing. Key banking institutes do not universally accomplish their objectives,
however. The merged resources of the industry can easily sweep over whatever central banking
concern. Some scenarios of this nature were seen in the 1992/93 ERM collapse, George Soros
bet on bank of England, and in more recent times in Southeast Asia.
Banking Institutions
The interbank market caters for each the majority of commercial turnover and large
numbers of speculative dealing each day. A prominent bank may swap billions of dollars every
day. Some of this swapping is undertaken on behalf of customers, but great deal is conducted by
proprietary desks, swapping for the banking firms own account. 51 Until lately, foreign exchange
agents did heavy amounts of business, helping interbank dealing and coupling anonymous
counterparts for small scale fees. Today, however, great deal of this business has moved on to
more efficient electronic systems, such as Bloomberg, EBS, Reuters Dealing 3000, the Chicago
Mercantile Exchange and Trade Book(R). The professional squawk box lets dealers hear in on
ongoing interbank dealing and is heard in almost all dealing rooms, however turnover is
perceptibly littler than just two or three years ago.
Investment Funds Management Firms
Investing management firms (who occasionally manage vast accounts on behalf of clients
such as pension funds and endowments) utilize the foreign exchange industry to facilitate
dealings in foreign securities. For instance, an investment funds manager with an worldwide
equity portfolio will require to choose and deal foreign currencies in the area market in order to
compensate for purchases of alien stocks. Because the Forex trading transactions are secondary
to the de facto investing decision, they are not seen as speculative or calculated at profit
maximization. Some investing management houses also have more speculative specialist
currency overlay operations, which manage client’s currency exposures with the aim of
generating profits as well as limiting risk. Whilst the figure of this type of specialist firms is quite
microscopic, many have a big value of assets under management (AUM), and hence can generate
immense trades.
Commercial Corporations
An important side of this marketplace comes from the financial activities of corporations
seeking extraneous exchange to pay for goods or services. Commercial corporations much
business deal fairly pocket size amounts likened to those of banks or speculators, and their trades
frequently have little short term impact on market merits. However, business deal flows can be
an please note ingredient in the semi permanent direction of a currency’s exchange rate. A few
transnational corporations can have an unpredictable impact when very enormous positions
could be reported due to exposures that want to be not widely known by more marketplace
players.
Retail Forex Brokers
Retail foreign currency exchange agents or industry makers address a minute divide of
the sum volume of the alien exchange marketplace. Based on data from CNN, one retail
professional estimates retail volume at $2550 billion every day, which is around 2% of the whole
industry

CHAPTER -III
COMPANY PROFILE

Origin of Indian Stock Market

The origin of the stock market in India goes back to the end of the eighteenth century
when long-term negotiable securities were first issued. However, for all practical purposes, the
real beginning occurred in the middle of the nineteenth century after the enactment of the
companies Act in 1850, which introduced the features of limited liability and generated investor
interest in corporate securities. An important early event in the development of the stock market
in India was the formation of the native share and stock brokers 'Association at Bombay in
1875, the precursor of the present day Bombay Stock Exchange. This was followed by the
formation of associations/exchanges in Ahmadabad (1894), Calcutta (1908), and Madras (1937).
In addition, a large number of ephemeral exchanges emerged mainly in buoyant periods to
recede into oblivion during depressing times subsequently.
Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life.
Without a stock exchange, the saving of the community- the sinews of economic progress and
productive efficiency- would remain underutilized. The task of mobilization and allocation of
savings could be attempted in the old days by a much less specialized institution than the stock
exchanges. But as business and industry expanded and the economy assumed more complex
nature, the need for 'permanent finance' arose. Entrepreneurs needed money for long term
whereas investors demanded liquidity – the facility to convert their investment into cash at any
given time. The answer was a ready market for investments and this was how the stock exchange
came into being. Stock exchange means anybody of individuals, whether incorporated or not,
constituted for the purpose of regulating or controlling the business of buying, selling or dealing
in securities. These securities include:
1. Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like
nature in or of any incorporated company or other body corporate;
2. Government securities; and
3. Rights or interest in securities.
The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd
(NSE) are the two primary exchanges in India. In addition, there are 22 Regional Stock
Exchanges. However, the BSE and NSE have established themselves as the two leading
exchanges and account for about 80 per cent of the equity volume traded in India. The NSE and
BSE are equal in size in terms of daily traded volume. The average daily turnover at the
exchanges has increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further
to Rs 2,273 crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a
total market capitalization of around Rs 9, 21,500 crore. The BSE has over 6000 stocks listed
and has a market capitalization of around Rs 9, 68,000 crore. Most key stocks are traded on both
the exchanges and hence the investor could buy them on either exchange. Both exchanges have a
different settlement cycle, which allows investors to shift their positions on the bourses. The
primary index of BSE is BSE Sensex comprising 30 stocks. NSE has the S&P NSE 50 Index
(Nifty) which consists of fifty stocks. The BSE Sensex is the older and more widely followed
index. Both these indices are calculated on the basis of market capitalization and contain the
heavily traded shares from key sectors. The markets are closed on Saturdays and Sundays.
Both the
exchanges have switched over from the open outcry trading system to a fully automated
computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT (National
Exchange Automated Trading) System. It facilitates more efficient processing, automatic order
matching, faster execution of trades and transparency; the scrip's traded on the BSE have been
classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares represent those, which
are in the carry forward system (Badla). The 'F' group represents the debt market (fixed income
securities) segment. The 'Z' group scrip's are the blacklisted companies. The 'C' group covers the
odd lot securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key regulator
governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual Funds, FIIs
and other participants in Indian secondary and primary market is the Securities and Exchange
Board of India (SEBI) Ltd.

Brief History of Stock Exchanges

Do you know that the world's foremost marketplace New York Stock Exchange (NYSE),
started its trading under a tree (now known as 68 Wall Street) over 200 years ago? Similarly,
India's premier stock exchange Bombay Stock Exchange (BSE) can also trace back its origin to
as far as 125 years when it started as a voluntary non-profit making association. News on the
stock market appears in different media every day. You hear about it any time it
reaches a new high or a new low, and you also hear about it daily in statements like 'The BSE
Sensitive Index rose 5% today'. Obviously, stocks and stock markets are important. Stocks of
public limited companies are bought and sold at a stock exchange. But what really are stock
exchanges? Known also as the stock market or bourse, a stock exchange is an organized
marketplace for securities (like stocks, bonds, options) featured by the centralization of supply
and demand for the transaction of orders by member brokers, for institutional and individual
investors. The exchange makes buying and selling easy. For example, you don't have to actually
go to a stock exchange, say, BSE - you can contact a broker, who does business with the BSE,
and he or she will buy or sell your stock on your behalf.

Market Basics
Electronic trading
Electronic trading eliminates the need for physical trading floors. Brokers can trade from
their offices, using fully automated screen-based processes. Their workstations are connected to
a Stock Exchange's central computer via satellite using Very Small Aperture Terminus (VSATs).
The orders placed by brokers reach the Exchange's central computer and are matched
electronically.
Exchanges in India
The Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE) are the
country's two leading Exchanges. There are 20 other regional Exchanges, connected via the
Inter- Connected Stock Exchange (ICSE). The BSE and NSE allow nationwide trading via their
VSAT systems.
Index
An Index is a comprehensive measure of market trends, intended for investors who are
concerned with general stock market price movements. An Index comprises stocks that have
large liquidity and market capitalization. Each stock is given a weight age in the Index equivalent
to its market capitalization. At the NSE, the capitalization of NIFTY (fifty selected stocks) is
taken as a base capitalization, with the value set at 1000. Similarly, BSE Sensitive Index or
Sensex comprises 30 selected stocks. The Index value compares the day's market capitalization
vis-a-vis base capitalization and indicates how prices in general have moved over a period of
time.
Execute an order
Select a broker of your choice and enter into a broker-client agreement and fill in the
client registration form. Place your order with your broker preferably in writing. Get a trade
confirmation slip on the day the trade is executed and ask for the contract note at the end of the
trade date. Need a broker As per SEBI (Securities and Exchange Board of India.) regulations,
only registered members can operate in the stock market. One can trade by executing a deal only
through a registered broker of a recognized Stock Exchange or through a SEBI-registered sub-
broker
Stock & Exchange Board of India
Regulation of business in the stock exchanges
Under the SEBI Act, 1992, the SEBI has been empowered to conduct inspection of stock
exchanges. The SEBI has been inspecting the stock exchanges once every year since 1995-96.
During these inspections, a review of the market operations, organizational structure and
administrative control of the exchange is made to ascertain whether:
1. The exchange provides a fair, equitable and growing market to investors
2. The exchange's organization, systems and practices are in accordance with the Securities
Contracts (Regulation) Act (SC(R) Act), 1956 and rules framed there under
3. The exchange has implemented the directions, guidelines and instructions issued by the
SEBI from time to time
4. The exchange has complied with the conditions, if any, imposed on it at the time of
renewal/ grant of its recognition under section 4 of the SC(R) Act, 1956.
During the year 1997-98, inspection of stock exchanges was carried out with a special focus on
the measures taken by the stock exchanges for investor's protection. Stock exchanges were,
through inspection reports, advised to effectively follow-up and redress the investors' complaints
against members/listed companies. The stock exchanges were also advised to expedite the
disposal of arbitration cases within four months from the date of filing. During the earlier years'
inspections, common deficiencies observed in the functioning of the exchanges were delays in
post trading settlement, frequent clubbing of settlements, delay in conducting auctions,
inadequate monitoring of payment of margins by brokers, non-adherence to Capital Adequacy
Norms etc. It was observed during the inspections conducted in 1997-98 that there has been
considerable improvement in most of the areas, especially in trading, settlement, collection of
margins etc

COCHIN STOCK EXCHANGE LTD.

Introduction
 COCHIN STOCK EXCHANGE LTD. is one of the premier Stock Exchanges in India,
established in the year 1978.  The exchange had a humble beginning with just 5 companies listed in 1978
-79, and had only 14 members. Today the Exchange has more than 508 members and 240 listed
companies. In 1980 the Exchange computerized its offices. In order to keep pace with the changing
scenario in the capital market, CSE took various steps including trading in dematerialized shares. CSE
introduced the facility for computerized trading - "Cochin Online Trading (COLT)" on March 17, 1997.
CSE was one of the promoters of the "Interconnected Stock Exchange of India (ISE)". The objective was
to consolidate the small, fragmented and less liquid markets into a national level integrated liquid market.
With the enforcement of efficient margin system and surveillance, CSE has successfully prevented
defaults. Introduction of fast track system made CSE the stock exchange with the shortest settlement
cycle in the country at that time. By the dawn of the new century, the regional exchanges faced a serious
challenge from the NSE & BSE. To face this challenge CSE promoted a 100% subsidiary called the
"Cochin Stock Brokers Ltd. (CSBL)" and started trading in the National Stock Exchange (NSE) and
Bombay Stock Exchange (BSE).

CSBL is the first subsidiary of a stock exchange to get membership in both NSE & BSE.
CSBL also became a depository participant in the Central Depository Services Ltd. The CSE has
been playing a vital role in the economic development of the country in general, and Kerala in
particular and striving hard to achieve the following goals:

1. Providing investors with high level of liquidity whereby the cost and time involved in
the entry into and exit from the market are minimized.

2. Bringing in high tech solutions and make all operations absolutely transparent.

3. Building infrastructure for capital market by turning CSE into a financial super market.

4. Serve the investors of the region.

5. Professional stock broking and investment management.

6. Imparting Capital Market knowledge to all intermediaries on a continuous basis.

The Cochin Stock Exchange is directly under the control and supervision of Securities &
Exchange Board of India (the SEBI), and is today a demutualized entity in accordance with the
Cochin Stock Exchange  (Demutualization)  Scheme,  2005  approved  and  notified  by SEBI on
29th of August 2005. Demutualization essentially means de-linking and separation of ownership
and trading rights and restructuring the Board in accordance with the provisions of the
scheme. The Exchange has been demutualised and the notification thereof published in the
Gazette.    

Management of Cochin Stock Exchange Ltd

The policy decisions of the CSE are taken by the Board of Directors. The Board  is
constituted with 12 members of whom less than one-fourth  are elected from amongst the trading
member of CSE, another one fourth are  Public Interest Directors selected by SEBI from the
panel submitted by the Exchange and the remaining are Shareholder Directors. The Board
appoints the Executive Director who functions as an ex-officio member of the Board and takes
charge of the administration of the Exchange.

Management - Board of Directors

The Exchange is professionally managed, under the overall direction of the Board of

Directors.   The Board consists of eminent   professionals from fields such as judiciary,
administration and management, who are known as Public Interest Directors. The Public Interest
Directors constitute one fourth of the total strength of the Board .The representation of brokers of
the Exchange is limited to one fourth of the total strength of the Board .The remaining are
representatives of shareholders without trading rights, called the Shareholder Directors

Board of Directors

Designatio
Sl.No. Name & Address Contact nos. Email id
n
1. Shri T.N.T Nayar(IRS Public Res.0484-2318362 tnt42@rediffmail.com
Retd) Interest.
Director Mob.9447064246
Retd. Chief
Commissioner of Official
Income Tax and -9388959820
Member, Central
Administrative  
 Tribunal.  
Shri.A.S
Narayanamoorthy
 Off. 2312960,
Chartered Accountant Public
2316538 
2 Interest priceco@vsnl.com
Mob.9847004207   
  Director
Res. 2319367
 
Shri.C.J.Mathew
Res.2317240        
Member(Rtd.), Postal Public
Mob. 9447370661
3 Services Board, India Interest chakmat@satyam.net.in
Director
 
 
Shri Robins Jacob Share
4 Holder Mob.9447465885 robinsjac@gmail.com
  Director
Shri M.Vijayakumar Share
Res. 0487-2382331 mittathullilvkumar@yahoo.co.i
5 Holder
Mob.9895700905 n
  Director
Shri Varghese
Share Off.2391123  
Menachery
6 Holder Res.0484-3224471 ttvcochin2005@rediffmail.com
Director Mob.9388688471
 
Res. 2424875          
Shri. Varghese Mathew
Member Off. 2390856     
7 varghesefincon@yahoo.co.in
Director Cubicle 2402557  
 
Mob. 93492 53814
Shri Abraham P.Korah Res.2331391
Member
8 Off.3042392 abrahamkorah@hotmail.com
Director
  Mob.9846040094
jacobgeorgek@gmail.com
Res.2665634           
Shri K.Jacob George
Member Off. 2665454,    
9 kvsons@gmail.com
Director 2665457
 
Mob.9388830345
kvsons@vsnl.com
Shri P.C. Cyriac,  IAS
Shareholde 2310492
10  
r Director Mob.9447305842
 
11 Shri V A Vijayan Shareholde 2306864  
Menon r Director
 Retired ROC
Executive
12 Shri. V Srinivasan Off. 3048525 ed@cochinstockexchange.com
Director

Previous Presidents

Mr. P. S. Joseph :: 1984-89

Mr. K. K. Thomas :: 1989-91
Mrs. Omana Abraham :: 1991-92
Mr. K. K. Thomas :: 1992-94
Mr. Augustin Kolenchery :: 1994-96
Mr. P. Oommen Isen :: 1996-98
Mr. N. Ninan Varkey :: 1998-99
Mr. Chacko J. Kallivayalil :: 1999-00
Mr. Johny J. Kannampilly :: 2000-01
Mr. K.V.Thomas :: 2001-02
Mr. Justice K.John Mathew :: 2002-07
Mr. T.N.T.Nayar :: 2007-08
Mr. P.C.Cyriac :: 2008-
ORGANIZATION STRUCTURE
Legal department

Guided by the Officer-Legal, the Legal Department is primarily responsible for advising
the management of the merits and demerits of legal issues involving the Exchange. The
department consistently monitors the compliance parameters in terms of the Companies Act,
SEBI Act, Securities Contracts Regulation Act and other related statutes. Listing Guidelines and
related criteria stipulated by SEBI, and the rules, regulations, directives and circulars issued by
SEBI with regard to trading in the Capital Market are consistently scrutinized and necessary
directions are given to the concerned departments to ensure strict and continued compliance.
Relevant developments are brought to the notice of the members and the investing public.
Officer-Legal is the Compliance Officer as per the provisions of SEBI regulations and also
functions as Secretary to the Board of Directors. Other major activities undertaken by the
department relate to Investor Grievance Service, Arbitration and Resolution of issues pertaining
to declared defaulters.

 
Systems Department

The Systems Department is  the heart of the various operations of CSE. The department
provides the necessary technical support for screen based trading and the computerized
functioning of all the other departments.
The activities of the department include: -
1. Developments of software needed for the functions of the exchange.
2. Maintenance of Multex software, which enables online trading with NSE and BSE.
3. Maintenance of an effective network of computers for the smooth functioning of
the CSE.
4. Providing the necessary services to the Settlement and Surveillance Departments.
5. The support for maintenance of depository participants’ accounts with the CSBL DP.
The major back office system software used are NESS and BOSS respectively for NSE
and  BSE trades calculations. This software is developed in-house by the software professionals
at the Exchange and are used to maintain the entire records of all the trades that occur each day.
 It also does all the required calculations for deductions and also generates reports require by the
brokers and their clients. The trading software used in CSBL is Multex, developed by CMC. The
advantage of using Multex is that both BSE and NSE scrip can be traded using this facility.
CSBL has provided trading facility in equities through Multex to a large number of their clients
over the Wide Area  Network. Currently, the clients are connected by  VPN, ISDN, Dial-Up,
Vsat etc.
Membership Department

The Membership Department screens applications from prospective members to ensure

that they are eligible to be members of the Exchange as per provisions of the Securities Contracts
Regulation Act. It is also verified whether they are ‘Fit and Proper’ persons eligible to be
members as per the SEBI (Criteria for Fit and Proper persons) Regulation 2004. The eligible
applications are processed and forwarded to SEBI for the purpose of obtaining registration with
SEBI. The department continuously follows up the status of the applications with SEBI and
provides necessary data if any required by SEBI. The members are informed of their fee liability
as and when information in this regard is obtained from SEBI. The Membership Department
also assists SEBI by ensuring proper delivery of notices and letters issued by SEBI to the
concerned members. The changes in status and constitution of the Brokers are sent for approval
to the Governing Board of the Exchange and thereafter to SEBI and Members are given
necessary directions wherever required. Change in address and contact information are updated
in the Finance and Accounting System and SEBI intimated.

Listing Department

The Listing Department guides prospective companies desirous of being listed on the
Exchange by providing the knowledge base and information on the statutory requirements that
have to be complied with. The major functions undertaken by the department include post-listing
monitoring and compliance with the listing agreement, monitoring the listing agreements and
reviewing the provisions of listing agreement from time to time with specific reference to SEBI
Regulations/Circulars that are in force. The department also ensures diligence in scrutinizing
listing applications and adhering to the Listing Norms.

Compliance Monitoring is carried out with specific emphasis on the following clauses in the
Listing Agreement.

1. Clauses 15/16 - Short/non intimation of BC/RD

2. Clause 19 – Intimation of Board Meeting including advance notice wherever required

 3. Clause 20- Outcome of Board Meeting

4. Clause 24 – In-principle approvals

5. Clause 31 – Annual Reports

6. Clause 32 – Name Change, Cash Flow, Consolidated Financial Statement, Related Party
Disclosures etc.

7. Clause 35 – Quarterly submission of Shareholding Pattern.

8. Clause 36 – Material Price sensitive Information

9. Clause 40 - Continuous Listing requirements

10. Clause 41 – Financial Results and Limited Review Reports

11. Clause 47 – Appointment of Compliance Officer

The department also performs the processing of the documents submitted by companies
on new listings/additional listings and provides them with the listing approval/trading permission
and also ensures that listing fee/processing fee is paid at the stipulated time.

Settlement Department

Settlement Department is a key department of the Exchange, dealing with cash and
securities. It assists the brokers in settling the matters related to their pay-in and payout, recovery
of dues and settling issues related to bad deliveries. This department is headed by a Deputy
Manager assisted by two Senior Officers who take care of the operations involved in the
settlement activities in CSE.  The Exchange follows the T+2 settlement system.

 
Marketing Department

The Marketing Department interacts with the brokers of the exchange trading both within
the state and outside and collects their opinions and suggestions. These are brought to the notice
of the Committee constituted for the purpose and decisions of the committee are placed for
approval of the Governing Board of the Exchange .The efforts are aimed at improving the quality
and efficiency of the service offered. In addition, the department conducts extensive surveys and
campaigns in remote areas and where necessary organizes awareness programmes about capital
markets. Experts with sufficient experience in the trade brief the participants and address their
queries. Talk shows and interviews are conducted on television channels, clippings are displayed
in theatres all with a view to increase public awareness and motivate their interest in the Capital
Markets .The marketing wing also coordinates the off campus programmes of the CSE Institute
and organizes regular classes at authorized centres after verifying the availability of suitable
infrastructure and facilities.

Surveillance Department

The Exchange has set up the Surveillance Department to keep a close watch on price
movements of scrip and to detect market abuse like price rigging, monitor abnormal prices and
volumes which are not consistent with normal trading pattern etc. The main objective of the
department is to ensure a free and fair market, to avoid manipulations and to manage risks. The
surveillance function at the exchange has assumed greater importance in the last few years. SEBI
has directed the Exchange to set up a separate surveillance department with staff exclusively
assigned for this function.

The Surveillance Department

1. Keeps a close watch on the price movement of scrip.

2. Detects market manipulations like price rigging.
3. Monitors abnormal changes in prices and volumes which are not consistent with
normal trading pattern.
4. Monitors the member brokers’ positions to ensure that defaults do not occur.
 
The department conducts in-depth investigation based on preliminary enquiries made into
trading of the scrip as also at the instance of SEBI. . Conducting investigations involves the
following stages: -.
1. Identification of scrip based on the alerts thrown by the online system and offline
reports.
2. Identification of Members from whom the client details have to be called for .
3. Preparation of company profile including Corporate News and Financial results.
4. Compilation of client details.

5. Preparation of reports. In case irregularities are found, necessary action is

initiated.

 
Finance Department

The Finance Department controls the financial transactions of the Exchange and is the
life line of the organization. The department is headed by a Finance Officer.
 
The activities of the department include
 
i. Fund Management
ii. Interaction with bankers
iii. Maintaining general accounts of the Exchange
iv. Preparation of various financial statements.
v. Maintaining payrolls and cash register.
vi. Coordinating accounting transactions of different branches and
departments.
vii. Taxation
viii. Budgeting and Expense research.
 ix. Maintenance of internal control system.
x. Liaison with external and internal auditors
xi. Annual Report Generation

CHAPTER -IV
LITERATURE REVIEW

1. Sivakumar Anuradha and Sarkar Runa (corporate hedging for foreign exchange risk of India.

This paper evaluates the various alternatives available to Indian firms for hedging
foreign exchange exposure. 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. The paper concludes by pointing out that the onus is on Reserve
Bank of India, the apex bank of the country, and its Working Group on Rupee Futures to realize
the need for rupee futures in India and the convertibility of the rupee. Risk management
techniques vary with the kind of exposure and the term of firm faces. Accounting exposure, also
called translation exposure, results from the need to restate foreign subsidiaries’ financial
statements into the parent’s 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. Transaction Exposure is a form of short term economic exposure
due to fixed price contracting in an atmosphere of exchange-rate volatility.
http://www.iitk.ac.in/infocell/announce/convention/papers/Marketing,%20Finance%20and%20International%20Strategy-
07-Anuradha%20Sivakumar%20Runa%20Sarkar.pdf

2.Yi-Chein Chiang (Foreign Exchange Exposures, Financial and Operational

Hedge Strategies of Taiwan Firms)
This study examines financial and operational hedge strategies of foreign exchange exposures
Simultaneously. Empirical findings show that the use of operational hedge strategies does not
help reduce foreign exchange exposures for Taiwan firms. Also, the use of foreign currency
derivatives (FCD) is an effective hedging strategy in a one-month horizon, but it is less effective
when the horizon lengthens. In addition, the use of foreign currency-denominated debts (FDD)
always increases foreign exchange exposures.
.c http://www enterforpbbefr.rutgers.edu/2007/Papers/039-ForeignExchangeExposure_YCCHJL.pdf

Martin Glaum (Foreign Exchange Risk Management in German Non-Financial

Corporations: An Empirical Analysis

The paper reports the results of an empirical study into the foreign exchange
risk management of large German non-financial corporations. Of the 154 firms that were
addressed, a total of 74 took part in the study. The managers of these firms were asked about the
measurement of exchange risk, about their management strategies, and about organizational
issues. The results can be summarized as follows. The majority of the firms are concerned about
managing their transaction exposure. Most firms adopted a selective hedging strategy based on
exchange rate forecasts. Only a small minority of firms does not hedge foreign exchange risk at
all, and only few companies hedge their transaction exposure completely. Looking in more detail
at the management of the firms' exposure to the US-dollar, we found that only 16% of the firms
were fully hedged. The majority of firms had realized hedge ratios between 50 and 99%. The
study found a number of interesting discrepancies between the positions of the academic
literature and corporate practice. For instance, numerous firms are concerned about their
accounting exposure and some firms are actively managing it. The exposure concept favored by
the academic literature, that is, economic exposure, is of little importance in practice. Further the
paper found that almost half of the firms an age their exchange positions on the basis of the
micro hedge approach. In other words, they forego the possibility to establish the firm's net
exposure by balancing out cash outflows and inflows first. The most interesting finding from an
academic point of view, however, is the widespread use of exchange rate forecasts and of
exchange risk management strategies based on forecasts (selective hedging). By adopting such
strategies, the managers indicate that they do not believe that the foreign exchange markets are
information efficient and they are able to beat the market with their own forecasts. The academic
literature, on the other hand, emphasizes that it is very difficult indeed to make systematically
successful exchange rate forecasts

http://www.uni-giessen.de/~g21142/limteam/ma/workingpaper/forex.pdf

Gleason, Sang Kim & Mathur (The Operational and Financial Hedging Strategies
of U.S.High Technology Firms
This paper examines the operational hedging strategies of U.S. high technology firms and how
this hedging is related to financial hedging. It establishes that derivatives users are larger and are
more R&D intensive than non-derivative users. The operational hedging and financial hedging
are complementary. Firms that are geographically diversified have more foreign exchange
exposure. However, firms that use financial hedging are able to significantly lower their
exchange rate exposure. Also, financial hedging adds value for high technology firms, while
operational hedging does not. High technology firms in the U.S. make substantial investments in
intangible assets. These firms seek to exploit their unique assets by expanding globally, which
increases the volatility of their cash flows and the risk of financial distress. Thus, high
technology firms view hedging as a viable strategy for managing risks. These firms undertake
some combination of operational and financial hedging to manage risk. There are four distinct
measures of operational hedging: the number of foreign countries in which a firm operates, the
number of broad regions where a firm operates, and two dispersion measures based on the
Hirshman-Herfindal concentration index.
http://www.fma.org/Chicago/Papers/techhedge.pdf
 Corporate Hedging for Foreign Exchange Risk in India

Introduction
Hedging is a way for companies to eliminate foreign exchange risk while doing business
with other countries that involves financial transactions. When companies do business across
borders, they deal in foreign currencies. 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. Corporate 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. 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.
Companies must exchange foreign currencies for their home currencies when dealing with
receivables, and payables respectively. This exchange of one currency for the other happens at
the current exchange rate between the two countries. Foreign exchange risk arises when the
exchange rate fluctuates unfavorably before the currency is actually exchanged. Hedging in
Forex is a way out for companies to minimize or eliminate foreign exchange risk. Hedging in
Forex trading can be defined as holding of two or more positions at a time with an objective to
offset the losses in the first position by gaining from the other. With time and experience Forex
traders have developed hedging techniques that not only protect them from incurring and
offsetting losses but also making profits from foreign exchange.

Introduction

Exchange-Rate Risk and Globalization

Exchange rate volatility is one of the most difficult and unrelenting problems in the era of
globalization. Firms with foreign transactions and obligations may face substantial losses due to
adverse movements in exchange rates. Firms are exposed to the adverse movement of exchange
rates because of three broad reasons. First, all foreign financial transactions involving cash
payments must often be denominated in the creditor’s domestic currency. As the exchange rates
fluctuate between the time of contract and the date of payment, there is the possibility of losses
because the amount of money that has to be available for conversion from the debtor’s to
creditor’s currency at the payment date is larger than it was expected on the contract. Second, the
exposure arises because of the size of the foreign transactions. Finally, the length between the
date of contract and the date of payment is also the reason for firms’ exposure to foreign
exchange rate risk.
The Dimensions of Foreign Exchange Exposures
Beside the financial impacts of cash losses and increased debt obligations, the adverse
effects of foreign exchange have several dimensions for firms with foreign operations. For the
purpose of financial reporting, the foreign operational units must often translate items in the
financial statement at the common exchange rate that may differ from the rate at which the
transaction items prevail. As a result, the parent company will experience exchange gains or
losses which, in turn, influences the firm’s performance from the perspectives of investors,
banks, analysts, and other external users who rely merely on consolidated financial statements.
The adverse effect of exchange rate movements for firms with foreign operations has yet another
dimension.
A depreciation of domestic exchange rate of the overseas operational units may not only
change the value of assets and liabilities that are translated in the currency of the parent company
but also increase the competitiveness of exportable products of the operational units. Thus, the
reported decrease in the assets and liabilities at the parent company do not reflect the true value
of the revenue and expense streams of the operational units since any advantage from a
depreciation may offset the lower value of assets and liabilities from translation. Hence, an
appropriate measure of the adverse effect of exchange rate movements is the expected cash flows
of the operational units. Although the first and the second dimensions of the adverse
consequences of exchange rate movements appear contradictory, it may actually have the same
effects on the parent company and the overseas operational units.
For example, the decreased value of retained earnings when it is translated at the
currency of the parent company may also be experienced by the foreign operating firms. This is
because the real economic environment of the operating firms remains unknown Regardless of
whether the domestic economic environment where the operational units conducting business
improve or deteriorate the obvious effects of exchange rate movements on cash flows of both
overseas operating firms and parent company is inevitable. The variability of input costs and a
decrease in the products’ competitive position may contribute to an increase in variability of the
firm’s expected cash flows. The persistent variability of cash flows can cause further severe
direct and indirect problems including, liquidity, bankruptcy and financial, spoiling investment
decisions and the firm’s ability to raise capital, and the perception of stakeholders, regulators,
and society in general of inadequate corporate governance.
Meaning of Risk
Risk means condition or choices that have certain consequences of loss or danger. In
probability and statistics, financial management, and investment management, risk is used to
describe the likelihood of variability in outcomes around expected value, which is often
measured by the extent of the dispersion around the mean or average value of the underlying
variables. Thus, the term risk, which is used here, refers to the situations where outcomes are
uncertain that may lead to the losses.
Foreign Exchange Risk: One Type of Business Risk
Risk can be broadly classified into two groups business and financial. Business risk is
associated with the operating environment such as technological changes, marketing, etc.
Financial risk includes foreign exchange rates, interest rate, and commodity prices. A more
comprehensive classification has been presented by Harrington. In this classification, the
business risk is divided into three types, price, credit, and pure. Price risk refers to uncertainty of
cash flows owing to changes in output and input prices. Credit risk occurs mostly in financial
institutions because loans are the primary products. Since there is a probability of default by the
borrower, firms engaging in this business face credit risk. Non-financial firms are also vulnerable
to this risk due to credit selling. The difference between financial and non-financial firms is the
magnitude of the risk. Finally, pure risk refers to risk arising from three sources. The first source
is risk of reduction in value of business assets on account of physical damage, theft and
expropriation.
The second source is risk resulting from legal liability from harm to customers, suppliers,
shareholders, and other parties. Finally, there is risk that may force a firm to pay benefits to
injured workers which it is not covered by the workers' compensation. Foreign exchange rate risk
is only one source of price risk. This arises from fluctuations of input prices as a result of
exchange rate movements. This type of risk occurs due to firms' activity to obtain inputs from
foreign countries. The reasons for obtaining inputs from foreign markets are often dictated b y
several considerations, including price, quality, and availability. Under similar considerations,
firms expand their operation by selling products in foreign countries. Since the sales price is
affected by exchange rate changes, firms are exposed to foreign exchange rate risk.
Foreign Exchange Rate Risk and Exposure
The word risk is often used interchangeably with exposure. Although these words have a
close relationship, the meaning is different. The risk is usually concerned with the probability of
an unexpected outcome, while exposure is concerned with the magnitude of the possibility of
loss. The definition of foreign exchange risk differs to foreign exchange exposure. Foreign
exchange risk can be defined as "related to the variability of domestic-currency values of Assets,
liabilities, or operating incomes due to unanticipated changes in exchange rates, whereas foreign
exchange exposure is “what is at risk". Foreign exchange risk arises as a result of uncertainty
about the future spot exchange rate. It is a result of uncertainty about the future spot exchange
rate (due to the variability of exchange rates), the domestic value of assets, liabilities, operating
incomes, profit, rates of return, and expected cash flows that are stated in foreign currency are
uncertain. Exposure can exist on assets, liabilities, and operating incomes. Exposure exists on
foreign assets when the real domestic currency value of foreign assets rises and when the foreign
currency appreciates, and vice versa. This relationship can be simplified with the following
regression equation:
(A/L) = ß S
Where, A and L are changes in the real domestic currency value of foreign assets or
liabilities, S is changes in exchange rates, and ß is the slope of the equation as well as a measure
of exposure. The larger the value of ß the more sensitive the value of the assets towards
exchange rate changes, and therefore, the larger the exposure.
The Importance of Foreign Exchange Exposure Management
Foreign Exchange Exposure Management and the Value of Firm
From literature it evident that a sufficient condition for managing foreign exchange
exposures is that it increases the expected value of the firm. The value of the firm is the present
value of the projected cash flows; that is, cash flows that have been discounted at a certain rate
reflecting both the degree of risk in the business and the financing generated from many sources
used by the firm there are three ways o f increasing firm value by implementing exposure
management:
(I) Reduction in tax
(ii) The reduction of the expected cost of financial distress
(iii) Improving investment decisions and increasing the ability to raise capital.
The Reduction in Taxes and Exposure Management
With respect to increasing the expected the net cash flows, it is important to notice that it
is implicitly concerned with the reduction of the out flows. One way to increase the net cash
flows is by reducing the amount of tax in the pre-tax income. Exposure management can reduce
the expected pre-tax income if a firm effective tax schedule is ‘convex’, that is, the amount of tax
should be paid increase as the pre-tax income rises (progressive tax rate). The more convex the
corporate tax schedule, the more benefit from exposure management can be gained. The reason
for this is that exposure management can presumably smooth out the pre-tax income. Since the
amount of pre-tax cash flows moves in the mean, the amount of tax to be paid is less than that of
pre-tax with variability.
Exposure Management and Expected Cost of Financial Distress
Besides the reduction in taxes, the value of a firm can also be increased by reducing the
expected costs of financial distress. Financial distress is a situation where firms are close to
bankruptcy even though they may never actually go bankrupt. Firms can be categorized as in
financial distress when their income is not sufficient to cover all fixed claims. The probability of
financial distress is determined by two factors. The first is the firm’s ability to pay fixed claims.
Another factor is firm’s income volatility. The second factor should be considered as a
determinant of probability of financial distress because the more volatile firms' income the
higher the probability of default. If financial distress leads to bankruptcy, there will be many
expenses that should be paid. And there must be some dialogue between the management of the
bankrupt firm and the creditors. There are also legal expenses to be paid, such as, court costs and
advisory fees. The expected costs of financial distress arise from three sources. First, costs
arising from the legal and administrative expenses of bankruptcy including court costs and
advisory fees (direct costs). Second, costs arise from conflicts between debt holders and equity
holders (indirect costs). Finally, costs arising from non-financial stakeholders, such as customers,
employees, suppliers, and the community in which firms operate (indirect cost). Exposure
management could reduce the variability of expected future cash flows while the stability of cash
flows can reduce the probability of financial distress. Therefore, foreign exchange exposure
management increases the value of the firm by decreasing the problems associated with financial
distress.
Exposure Management and Investment Decisions
In order to address the effect of exposure management as a financial policy towards
investment decisions, it may be useful to look back to the central argument of the Modigliani-
Miller theorem in which they argue that financing decisions, choosing between debt and equity,
have no implications for investment. In the following description, the role of currency
management on maintaining the stability of the firm’s cash flows will explain how a financing
decision will improve investment decisions and increase debt capacity. For this purpose, the
cause of investment problems is explored, particularly those arising from conflict between debt
holders and equity holders. Basically, the problem arises because of self-interest towards claims
between them. On the one hand, bond holders have fixed claims so that they have to bears most
of the firm’s risk. On the other hand, equity holders have claims based on a certain percentage of
firm’s cash flows. The real cause of the problem between them is the perception by debt holders
that equity holders tend to dominate decisions in the firms. Therefore, managers of most firms
will take action on behalf of the equity holders, thereby, maximizing the shareholders benefits. It
can also be said that there is a possibility of the managers ignoring the interest of debt holders.
The conflict between debt holders and equity holders can usually be found in highly leveraged
firms, that is, those with a larger portion of debt than equity to finance the investment. Myers has
recognized this problem widely known as ‘under investment’. The conflict between debt and
equity holders occurs when the firm has a plan to finance a new investment with more debt.
Certainly, this situation does not bring benefits within the perspective of current debt holders
because financing investment using more debt will be more risky. As a result, the debt holders
tend to limit the firm’s borrowing in the future or the existing bondholders will ask higher rate as
compensation to bearing a higher risk. Due to this limitation, the firm has difficulty in financing
the new investment with more debt. Consequently, although there is a project that has positive
NPV, the equity holders will not take the investment particularly if the value of the firm assets is
low because the bondholders will receive the benefit if the positive NPV project is taken. This
problem can be eased by the implementation of exposure management. The currency exposure
management can be implemented when the cost of external sources of funds are more expensive
that of internal. If a firm does not manage exposures, there might be some variability in their
cash flows. According to the authors, there will be two implications resulting from such
variability. First, there will be variability in the amount of money raised internally. Second, there
will be variability in the amount of investment. The investment and financing plan will be
disturbed by a variability of cash flows. Therefore, maintaining the stability of cash flows in
currency management is a logical argument because firms that have difficulty in financing
investment using external sources of funds will rely on their internal sources.
Empirical Evidence of Exposure Management on the Financing Decision
The benefit of exposure management on the planning process of investment is a
commonly held in finance literature. However, there have been disputes among researchers.
Some researchers have argued that there is no relationship between the implementation of
exposure management and the degree of leverage in a firm’s capital structure. Others conclude
that there is a relationship which can avoid conflicts between debt and equity holders. Normally,
firms with higher risk (low rated) tend to issue short-term debt, and then swap to pay a fix rate
for floating rate incomes. The under investment problem can be reduced because all investment
gains go to shareholders. On the other hand, shareholders cannot choose risky projects because
this action will increase the risk premium of the outstanding short-term debt. There is a negative
correlation between the degree of leverage measured by debt-to-equity ratio, in the capital
structure and hedging. Hedging does not have an effect on the conflict between debt holders and
equity holders raised from the degree of leverage. The reason for this inconsistency with the
benefit of hedging to reduce underinvestment is because firms that have a bigger leverage
usually also have smaller investment options, then hedge less since there are no sufficient funds
for hedging. There are three possible causes of losing market share. Book-to-market-ratio is the
ratio between book value of equity (BV) and its market value (MV). This ratio shows share
prices relative to book value. Firms with high MV/BV have lo w share price relative to boo k
value. These firms tend to have lower profitability and are susceptible to financial distress (more
detail in Fama and French (1995). Therefore, MV/BV can be used as a proxy variable of firms
with higher growth in their investment opportunity. First, it is caused by competitor reaction
(‘competitor driven’). Firms that is financially stronger may take advantage of the condition by
aggressive advertising or pricing their products to drive out the susceptible competitors. The
second cause is called ‘manager-driven’, that is, managers may downsize the firms to achieve
efficiency by for instance, selling unproductive assets. Third, customers may be reluctant to do
business with distressed firms (‘customer-driven’). When R&D is considered, the authors also
found that customers would be more hesitant to deal with the firms that spent more on R&D.
This is due to a customer perception that a high R&D expenditure indicates that those firms are
specialized in the products. Consequently, highly leveraged firms with high R&D expenditure
will be more susceptible to bankruptcy.
Kinds of Foreign Exchange Exposure
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 parent’s 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 firm’s 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 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 firm’s 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 firm’s value and the independent variable is the exchange rate.
Necessity of managing foreign exchange risk
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 analyzing the historical sequence of
exchange rates.(Soenen,1979). However, when the efficient markets theory is applied to the
foreign exchange market under floating exchange rates there is some evidence to suggest that the
present prices properly reflect all available information. This implies that exchange rates react to
new information in an immediate and unbiased fashion, so that no one party can make a profit by
this information and in any case, information on direction of the rates arrives randomly so
exchange rates also fluctuate randomly. It implies that foreign exchange risk management cannot
be done away with by employing resources to predict exchange rate changes.
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 firm’s 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 states that exchange
rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory
suggests that exchange rate changes will be offset by 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. Also, exchange rate-linked changes in factors like inflation and
interest rates take time to adjust and in the meanwhile firms stand to lose out on adverse
movements in the exchange rates. The existence of different kinds of market imperfections, such
as incomplete financial markets, positive transaction and information costs, probability of
financial distress, and agency costs and restrictions on free trade make foreign exchange
management an appropriate concern for corporate management. It has also been argued that a
hedged firm, being less risky can secure debt more easily and this enjoy a tax advantage (interest
is excluded from tax while dividends are taxed). This would negate the Modigliani-Miller
proposition as shareholders cannot duplicate such tax advantages. The MM argument that
shareholders can hedge on their own is also not valid on account of high transaction costs and
lack of knowledge about financial manipulations on the part of shareholders. They find a
statistically significant association between the absolute value of the exposures and the (absolute
value) of the percentage use of foreign currency derivatives and prove that the use of derivatives
in fact reduce exposure

.
Hedging Strategies/ Instruments
A derivative is a financial contract whose value is derived from the value of some other
financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or
even an index of prices. The main role of derivatives is that they reallocate risk among financial
market participants, help to make financial markets more complete. This section outlines the
hedging strategies using derivatives with foreign exchange being the only risk assumed.
1. Forwards:
A forward is a made-to-measure agreement between two parties to buy/sell a specified
amount of a currency at a specified rate on a particular date in the future. The depreciation of the
receivable currency is hedged against by selling a currency forward. If the risk is that of a
currency appreciation (if the firm has to buy that currency in future say for import), it can hedge
by buying the currency forward. E.g if RIL wants to buy crude oil in US dollars six months
hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed exchange
rate for INR-USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time.
In this example the downside is an appreciation of Dollar which is protected by a fixed forward
contract. The main advantage of a forward is that it can be tailored to the specific needs of the
firm and an exact hedge can be obtained. On the downside, these contracts are not marketable,
they can’t be sold to another party when they are no longer required and are binding.
2. Futures
A futures contract is similar to the forward contract but is more liquid because it is traded
in an organized exchange i.e. the futures market. 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 coincidence. Futures
require a small initial outlay (a proportion of the value of the future) with which significant
amounts of money can be gained or lost with the actual forwards price fluctuations. This
provides a sort of leverage. The previous example for a forward contract for RIL applies here
also just that RIL will have to go to a USD futures exchange to purchase standardized dollar
futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As
mentioned earlier, the tailor ability of the futures contract is limited i.e. only standard
denominations of money can be bought instead of the exact amounts that are bought in forward
contracts.

3. Options
 A currency Option is a contract giving the right, not the obligation, to buy or sell a
specific quantity of one foreign currency in exchange for another at a fixed price; called the
Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of
exchange rate changes and limits the losses of open currency positions. Options are particularly
suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call
Options are used if the risk is an upward trend in price (of the currency), while Put Options are
used if the risk is a downward trend. Again taking the example of RIL which needs to purchase
crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar
rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there
are two scenarios. If the exchange rate movement is favorable i.e the dollar depreciates, then RIL
can buy them at the spot rate as they have become cheaper. In the other case, if the dollar
appreciates compared to today’s spot rate, RIL can exercise the option to purchase it at the
agreed strike price. In either case RIL benefits by paying the lower price to purchase the dollar
4. Swaps
A swap is a foreign currency contract whereby the buyer and seller exchange equal initial
principal amounts of two different currencies at the spot rate. The buyer and seller exchange
fixed or floating rate interest payments in their respective swapped currencies over the term of
the contract. At maturity, the principal amount is effectively re-swapped at a predetermined
exchange rate so that the parties end up with their original currencies. The advantages of swaps
are that firms with limited appetite for exchange rate risk may move to a partially or completely
hedged position through the mechanism of foreign currency swaps, while leaving the underlying
borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms to hedge
the floating interest rate risk. Consider an export oriented company that has entered into a swap
for a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company pays US
6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July,
till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest
for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures.
Foreign Debt
Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the
International Fischer Effect relationship. This is demonstrated with the example of an exporter
who has to receive a fixed amount of dollars in a few months from present. The exporter stands
to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge
this, he could take a loan in the foreign currency for the same time period and convert the same
into domestic currency at the current exchange rate. The theory assures that the gain realized by
investing the proceeds from the loan would match the interest rate payment (in the foreign
currency) for the loan.
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 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. The three main elements of these transaction costs are
brokerage or service fees charged by dealers, information costs such as subscription to Reuter
reports and news channels and administrative costs of exposure management.
Factors affecting the decision to hedge foreign currency risk
Research in the area of determinants of hedging separates the decision of a firm to hedge
from that of how much to hedge. There is conclusive evidence to suggest that firms with larger
size, R&D expenditure and exposure to exchange rates through foreign sales and foreign trade
are more likely to use derivatives. First, the following section describes the factors that affect the
decision to hedge and then the factors affecting the degree of hedging are considered.
1. Firm size
Firm size acts as a proxy for the cost of hedging or economies of scale. Risk
management involves fixed costs of setting up of computer systems and training/hiring of
personnel in foreign exchange management. Moreover, large firms might be considered as more
creditworthy counterparties for forward or swap transactions, thus further reducing their cost of
hedging. The book value of assets is used as a measure of firm size.
 2. Leverage
According to the risk management literature, firms with high leverage have greater incentive
to engage in hedging because doing so reduces the probability, and thus the expected cost of
financial distress. Highly levered firms avoid foreign debt as a means to hedge and use
derivatives. A Liquidity and profitability: Firms with highly liquid assets or high profitability
have less incentive to engage in hedging because they are exposed to a lower probability of
financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by current
liabilities). Profitability is measured as EBIT divided by book assets.
3. Sales growth
Sales growth is a factor determining decision to hedge as opportunities are more likely to be
affected by the underinvestment problem. For these firms, hedging will reduce the probability of
having to rely on external financing, which is costly for information asymmetry reasons, and thus
enable them to enjoy uninterrupted high growth. The measure of sales growth is obtained using
the 3-year geometric average of yearly sales growth rates. As regards the degree of hedging
conclude that the sole determinants of the degree of hedging are exposure factors (foreign sales
and trade). In other words, given that a firm decides to hedge, the decision of how much to hedge
is affected solely by its exposure to foreign currency movements. This discussion highlights how
risk management systems have to be altered according to characteristics of the firm, hedging
costs, nature of operations, tax considerations, regulatory requirements etc. The next section
discusses these issues in the Indian context and regulatory environment.
The Corporate Hedging Process
The Hedging Decision
The issue of whether or not to hedge risk continues to baffle many corporations. At the
heart of the confusion are misconceptions about risk, concerns about the cost of hedging, and
fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools
and strategies compounds this confusion. Corporate risk managers also face the difficult
challenge of getting hedging tools (i.e., derivatives) approved by the company's board of
directors. The purpose of this newsletter is to clarify both some of the basic misconceptions
surrounding the issue of risk as well as the tools and strategies used to manage it. "Derivations"
is part of our commitment to work with you to create financial solutions.

The Challenge

An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to
transform unacceptable risks into an acceptable form. The key challenge for the corporate risk
manager is to determine the risks the company is willing to bear and the ones it wishes to
transform by hedging. The goal of any hedging program should be to help the corporation
achieve the optimal risk profile that balances the benefits of protection against The Costs Of
Hedging. 

Step 1: Identify the Risks

 Before management can begin to make any decisions about hedging, it must first identify
all of the risks to which the corporation is exposed. These risks will generally fall into two
categories: operating risk and financial risk. For most non-financial organizations, operating risk
is the risk associated with manufacturing and marketing activities. A computer manufacturer, for
example, is exposed to the operating risk that a competitor will introduce a technologically
superior product which takes market share away from its leading model. In general, operating
risks cannot be hedged because they are not traded. 

The second type of risk, financial risk, is the risk a corporation faces due to its exposure
to market factors such as interest rates, foreign exchange rates and commodity and stock prices.
Financial risks, for the most part, can be hedged due to the existence of large, efficient markets
through which these risks can be transferred.  In determining which risks to hedge, the risk
manager needs to distinguish between the risks the company is paid to take and the ones it is not.
Most companies will find they are rewarded for taking risks associated with their primary
business activities such as product development, manufacturing and marketing. For example, a
computer manufacturer will be rewarded (i.e., its stock price will appreciate) if it develops a
technologically superior product or for implementing a successful marketing strategy. 

Most corporations, however, will find they are not rewarded for taking risks which are
not central to their basic business (i.e., interest rate, exchange rate, and commodity price risk).
The computer manufacturer in the previous example is unlikely to see its stock price appreciate
just because it made a successful bet on the dollar/yen exchange rate. Another critical factor to
consider when determining which risks to hedge is the materiality of the potential loss that might
occur if the exposure is not hedged. As noted previously, a corporation's optimal risk profile
balances the benefits of protection against the costs of hedging. Unless the potential loss is
material (i.e., large enough to severely impact the corporation's earnings) the benefits of hedging
may not outweigh the costs, and the corporation may be better off not hedging.

Step 2: Distinguish Between Hedging and Speculating

One reason corporate risk managers are sometimes reluctant to hedge is because they associate
the use of hedging tools with speculation. They believe hedging with derivatives introduces
additional risk. In reality, the opposite is true. A properly constructed hedge always lowers risk.
It is by choosing not to hedge that managers regularly expose their companies to additional
risks. 

Financial risks - regardless of whether or not they are managed - exist in every business.
The manager who opts not to hedge is betting that the markets will either remain static or move
in his favor. For example, a U.S. computer manufacturer with French franc receivables that
decides to not hedge its exposure to the French franc is speculating that the value of the French
franc relative to the U.S. dollar will either remain stable or appreciate. In the process, the
manufacturer is leaving itself exposed to the risk that the French franc will depreciate relative to
the U.S. dollar and hurt the company's revenues. 

A reason some managers choose not to hedge, thereby exposing their companies to
additional risk, is that not hedging often goes unnoticed by the company's board of directors.
Conversely, hedging strategies designed to reduce risk often receive a great deal of scrutiny.
Corporate risk managers who wish to use hedging techniques to improve their company's risk
profile must educate their board of directors about the risks the company is naturally exposed to
when it does not hedge. 

Step 3: Evaluate the Costs of Hedging In Light of the Costs of Not Hedging

The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly,
some hedging strategies do cost money. But consider the alternative. To accurately evaluate the
cost of hedging, the risk manager must consider it in light of the implicit cost of not hedging. In
most cases, this implicit cost is the potential loss the company stands to suffer if market factors,
such as interest rates or exchange rates, move in an adverse direction. In such cases the cost of
hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative
to the potential loss. 

In other cases, derivative transactions are substitutes for implementing a financing

strategy using a traditional method. For example, a corporation may combine a floating-rate bank
borrowing with a floating-to-fixed-rate swap as an alternative to issuing fixed-rate debt.
Similarly, a manufacturer may combine the spot purchase of a commodity with a floating-to-
fixed swap instead of buying the commodity and storing it. In most cases where derivative
strategies are used as substitutes for traditional transactions, it is because they are cheaper.
Derivatives tend to be cheaper because of the lower transaction costs that exist in highly liquid
forward and options markets. 

Step 4: Use the Right Measuring Stick to Evaluate Hedge Performance

Another reason for not hedging often cited by corporate risk managers is the fear of
reporting a loss on a derivative transaction. This fear reflects widespread confusion over the
proper benchmark to use in evaluating the performance of a hedge. The key to properly
evaluating the performance of all derivative transactions, including hedges, lies in establishing
appropriate goals at the onset.  As derivative transactions are substitutes for traditional
transactions. A fixed-rate swap, for example, is a substitute for the issuance of a fixed-rate bond.
Regardless of market conditions, the swap's cash flows will mirror the bonds. Thus, any money
lost on the swap would have been lost if the corporation had issued a bond instead. Only if the
swap's performance is evaluated in light of management's original objective (i.e., to duplicate the
cash flows of the bond) will it become clear whether or not the swap was successful. 

Step 5: Don't Base Your Hedge Program on Your Market View

Many corporate risk managers attempt to construct hedges on the basis of their outlook
for interest rates, exchange rates or some other market factor. However, the best hedging
decisions are made when risk managers acknowledge that market movements are unpredictable.
A hedge should always seek to minimize risk. It should not represent a gamble on the direction
of market prices. 

Step 6: Understand Your Hedging Tools

A final factor that deters many corporate risk managers from hedging is a lack of
familiarity with derivative products. Some managers view derivatives as instruments that are too
complex to understand. The fact is that most derivative solutions are constructed from two basic
instruments: forwards and options, which comprise the following basic building blocks: 

a. Options
 b. Swaps        
c. Futures      
d. Puts
e. Calls  
f. Forwards 

Step 7: Establish a System of Controls

As is true of all other financial activities, a hedging program requires a system of internal
policies, procedures and controls to ensure that it is used properly. The system, often
documented in a hedging policy, establishes, among other things, the names of the managers
who are authorized to enter into hedges; the managers who must approve trades; and the
managers who must receive trade confirmations. The hedging policy may also define the
purposes for which hedges can and cannot be used. For example, it might state that the
corporation uses hedges to reduce risk, but it does not enter into hedges for trading purposes. It
may also set limits on the notional value of hedges that may be outstanding at any one time. A
clearly defined hedging policy helps to ensure that top management and the company's board of
directors is aware of the hedging activities used by the corporation's risk managers and that all
risks are properly accounted for and managed

A well-designed hedging program reduces both risks and costs. Hedging frees up
resources and allows management to focus on the aspects of the business in which it has a
competitive advantage by minimizing the risks that are not central to the basic business.
Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing
earnings