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Sr. No



Types of Hedging


Hedging Strategies for Garment Exporters

Pg. No

2a. Overview of the Indian Textile Industry

2b. Currency Fluctuations & Risks Associated
2c. Risk Management Alternatives
2d. Case of the Garment Exporters
2e. Hedging Strategies
2f. Conclusions & Suggestions

Factors For Rise In NPAs



Problems Due To NPAs



Management of NPAs








Hedging is often considered an advanced investing strategy, but the
principles of hedging are fairly simple. With the popularity - and accompanying
criticism - of hedge funds, the practice of hedging is becoming more widespread.
Despite this, it is still not widely understood.
Although it sounds like your neighbor's hobby who's obsessed with his
topiary garden full of tall bushes shaped like giraffes and dinosaurs, hedging is a
practice every investor should know about. There is no arguing that portfolio
protection is often just as important as portfolio appreciation. Like your neighbor's
obsession, however, hedging is talked about more than it is explained, making it
seem as though it belongs only to the most esoteric financial realms. Well, even if
you are a beginner, you can learn what hedging is, how it works and what hedging
techniques investors and companies use to protect themselves.

What Is Hedging?
The best way to understand hedging is to think of it as insurance. When
people decide to hedge, they are insuring themselves against a negative event. This
doesn't prevent a negative event from happening, but if it does happen and you're
properly hedged, the impact of the event is reduced. So, hedging occurs almost
everywhere, and we see it everyday. For example, if you buy house insurance, you
are hedging yourself against fires, break-ins or other unforeseen disasters.
Portfolio managers, individual investors and corporations use hedging
techniques to reduce their exposure to various risks. In financial markets, however,
hedging becomes more complicated than simply paying an insurance company a
fee every year. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In
other words, investors hedge one investment by making another.
Technically, to hedge you would invest in two securities with negative
correlations. Of course, nothing in this world is free, so you still have to pay for
this type of insurance in one form or another.

Although some of us may fantasize about a world where profit potentials are
limitless but also risk free, hedging can't help us escape the hard reality of the riskreturn tradeoff. A reduction in risk will always mean a reduction in potential
profits. So, hedging, for the most part, is a technique not by which you will make
money but by which you can reduce potential loss. If the investment you are
hedging against makes money, you will have typically reduced the profit that you
could have made, and if the investment loses money, your hedge, if successful, will
reduce that loss.

How Do Investors Hedge?

Hedging techniques generally involve the use of complicated financial
instruments known as derivatives, the two most common of which are options and
futures. We're not going to get into the nitty-gritty of describing how these
instruments work, but for now just keep in mind that with these instruments you
can develop trading strategies where a loss in one investment is offset by a gain in
a derivative.
Let's see how this works with an example. Say you own shares of Cory's
Tequila Corporation (Ticker: CTC). Although you believe in this company for the
long run, you are a little worried about some short-term losses in the tequila
industry. To protect yourself from a fall in CTC you can buy a put option (a
derivative) on the company, which gives you the right to sell CTC at a specific
price (strike price). This strategy is known as a married put. If your stock price
tumbles below the strike price, these losses will be offset by gains in the put
option. (For more information, see this article on married puts or this options
basics tutorial.)
The other classic hedging example involves a company that depends on a
certain commodity. Let's say Cory's Tequila Corporation is worried about the
volatility in the price of agave, the plant used to make tequila. The company would
be in deep trouble if the price of agave were to skyrocket, which would severelyeat
into profit margins. To protect (hedge) against the uncertainty of agave prices, CTC
can enter into a futures contract (or its less regulated cousin, the forward contract),

which allows the company to buy the agave at a specific price at a set date in the
future. Now CTC can budget without worrying about the fluctuating commodity.
If the agave skyrockets above that price specified by the futures contract, the
hedge will have paid off because CTC will save money by paying the lower price.
However, if the price goes down, CTC is still obligated to pay the price in the
contract and actually would have been better off not hedging.
Keep in mind that because there are so many different types of options and
futures contracts an investor can hedge against nearly anything, whether a stock,
commodity price, interest rate and currency - investors can even hedge against the

The Downside
Every hedge has a cost, so before you decide to use hedging, you must ask
yourself if the benefits received from it justify the expense. Remember, the goal of
hedging isn't to make money but to protect from losses. The cost of the hedge whether it is the cost of an option or lost profits from being on the wrong side of a
futures contract - cannot be avoided. This is the price you have to pay to avoid
We've been comparing hedging versus insurance, but we should emphasize
that insurance is far more precise than hedging. With insurance, you are completely
compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a
perfect science and things can go wrong. Although risk managers are always
aiming for the perfect hedge, it is difficult to achieve in practice.

What Hedging Means to You

The majority of investors will never trade a derivative contract in their life.
In fact most buy-and-hold investors ignore short-term fluctuation altogether. For

these investors there is little point in engaging in hedging because they let their
investments grow with the overall market.
Even if you never hedge for your own portfolio you should understand how
it works because many big companies and investment funds will hedge in some
form. Oil companies, for example, might hedge against the price of oil while an
international mutual fund might hedge against fluctuations in foreign exchange
rates. An understanding of hedging will help you to comprehend and analyze these


Agricultural commodity price hedging

A typical hedger might be a commercial farmer. The market values of wheat
and other crops fluctuate constantly as supply and demand for them vary, with
occasional large moves in either direction. Based on current prices and forecast
levels at harvest time, the farmer might decide that planting wheat is a good idea
one season, but the price of wheat might change over time. Once the farmer plants
wheat, he is committed to it for an entire growing season. If the actual price of
wheat rises greatly between planting and harvest, the farmer stands to make a lot of
unexpected money, but if the actual price drops by harvest time, he is going to lose
the invested money.
If at planting time the farmer sells a number of wheat futures contracts
equivalent to his anticipated crop size, he effectively locks in the price of wheat at
that time: the contract is an agreement to deliver a certain number of bushels of
wheat to a specified place on a certain date in the future for a certain fixed price.
The farmer has hedged his exposure to wheat prices; he no longer cares whether
the current price rises or falls, because he is guaranteed a price by the contract. He
no longer needs to worry about being ruined by a low wheat price at harvest time,
but he also gives up the chance at making extra money from a high wheat price at
harvest times. However, in the case of a farmer, it must be noted that the hedge
introduces another kind of risk. If the farmer has contracted to sell all his expected
crop but then has a "bad year" (i.e. a year with lower-than-expected yields) such
that his farm is not able to produce the committed quantity, he may have to
purchase replacement crop at a disadvantageous price to fulfill his futures contract.
For the farmer, this can be especially problematic if the low yields are widespread
such that the price of the commodity is substantially higher than anticipated when
the crop was planted.

Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the
next month, due to the company's new and efficient method of producing widgets.
He wants to buy Company A shares to profit from their expected price increase, as
he believes that shares are currently underpriced. But Company A is part of a
highly volatile widget industry. So there is a risk of a future event that affects stock
prices across the whole industry, including the stock of Company A along with all
other companies.
Since the trader is interested in the specific company, rather than the entire
industry, he wants to hedge out the industry-related risk by short selling an equal
value of shares from Company A's direct, yet weaker competitor, Company B.
The first day the trader's portfolio is:
Long 1,000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each
The trader has sold short the same value of shares (the value, number of shares
price, is $1000 in both cases).
If the trader was able to short sell an asset whose price had a mathematically
defined relation with Company A's stock price (for example a put option on
Company A shares), the trade might be essentially riskless. In this case, the risk
would be limited to the put option's premium.
On the second day, a favorable news story about the widgets industry is published
and the value of all widgets stock goes up. Company A, however, because it is a
stronger company, increases by 10%, while Company B increases by just 5%:
Long 1,000 shares of Company A at $1.10 each: $100 gain
Short 500 shares of Company B at $2.10 each: $50 loss (in a short position,
the investor loses money when the price goes up)

The trader might regret the hedge on day two, since it reduced the profits on the
Company A position. But on the third day, an unfavorable news story is published
about the health effects of widgets, and all widgets stocks crash: 50% is wiped off
the value of the widgets industry in the course of a few hours. Nevertheless, since
Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Day 1: $1,000
Day 2: $1,100
Day 3: $550 => ($1,000 $550) = $450 loss
Value of short position (Company B):
Day 1: $1,000
Day 2: $1,050
Day 3: $525 => ($1,000 $525) = $475 profit
Without the hedge, the trader would have lost $450 (or $900 if the trader took the
$1,000 he has used in short selling Company B's shares to buy Company A's shares
as well). But the hedge the short sale of Company B net a profit of $25 during a
dramatic market collapse.

Hedging employee stock options

Employee stock options (ESOs) are securities issued by the company mainly
to its own executives and employees. These securities are more volatile than
stocks. An efficient way to lower the ESO risk is to sell exchange traded calls and,
to a lesser degree,[clarification needed] to buy puts. Companies discourage hedging the
ESOs but there is no prohibition against it.

Hedging fuel consumption

Airlines use futures contracts and derivatives to hedge their exposure to the
price of jet fuel. They know that they must purchase jet fuel for as long as they
want to stay in business, and fuel prices are notoriously volatile. By using crude oil
futures contracts to hedge their fuel requirements (and engaging in similar but
more complex derivatives transactions), Southwest Airlines was able to save a
large amount of money when buying fuel as compared to rival airlines when fuel
prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina.

Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such
as the married put. A natural hedge is an investment that reduces the undesired risk
by matching cash flows (i.e. revenues and expenses). For example, an exporter to
the United States faces a risk of changes in the value of the U.S. dollar and chooses
to open a production facility in that market to match its expected sales revenue to
its cost structure.
Another example is a company that opens a subsidiary in another country
and borrows in the foreign currency to finance its operations, even though the
foreign interest rate may be more expensive than in its home country: by matching
the debt payments to expected revenues in the foreign currency, the parent
company has reduced its foreign currency exposure. Similarly, an oil producer may
expect to receive its revenues in U.S. dollars, but faces costs in a different
currency; it would be applying a natural hedge if it agreed to, for example, pay
bonuses to employees in U.S. dollars.
One common means of hedging against risk is the purchase of insurance to
protect against financial loss due to accidental property damage or loss, personal
injury, or loss of life.


Indian textile industry is one of the leading textile industries in the world.
The industry has gone through a robust transformation post the liberalization of the
economy in 1991 which gave the much needed thrust to this industry. Indian textile
industry largely depends on the manufacturing and exports. Textile exports
contribute a major portion of Indias exports.

Facts & Figure

Earns 27% to Indias total foreign exchange.

Contributes 14% to Indias total industrial production.
Contributes 3% to Indias GDP.
Largest employment generator for India estimated to be approximately 35
million people

Segments of Indian Textile Industry

Cotton Textiles
Silk Textiles
Woolen Textiles
Readymade Garments
Hand-crafted Textiles
Jute & Coir


Current Scenario

India Exports FY 2011-12

Readymade Garments

2% 2%

Cotton Textile


Manmade Textile


Silk & Handloom
Wool & Woolen Textiles




Indian Textile Exports


US$ Billions








Technical Textile Segment

This is a very critical contributor to the India textile industry. The working
committee for the11th 5 year plan has estimated its market size to be US$ 10.6
Billion in 2011-12 without any regulatory framework and US$ 15.16 Billion with
regulatory framework. The scheme for growth& development of technical textiles
aims to promote indigenous manufacture of technical textile to leverage global
opportunities and cater to the domestic demand. Further the government is set to
launch US$ 44.21 Million mission for promotion of technical textiles while the
finance ministry has cleared up setting up of 4 new research centres for the
industry, which include products like mosquito and fishing nets, shoe laces and
medical gloves. The global technical industry is estimated at US$ 127 billion and
the same in India is pegged at US$11 Billion.

Major Players in the Indian Textile Industry

Welspun India Ltd
Vardhman Group Alok Industries Ltd
Raymond Ltd Arvind Mills Ltd

Bombay Dyeing & Manufacturing Company Ltd

Garden Silk Mills Ltd
Mafatlal Industries Ltd
Aditya Birla Nuvo
ITC Lifestyle
Reliance Industries Limited

Government Initiatives & Regulatory Framework

The GOI has implemented various export promotion policies for the textile
Industry in the union budget 2011-12 and the foreign trade policy 2009-14. This
also includes various incentives under focus market scheme and focus product

Below is a gist of various schemes by the GOI for promotion of this industry:

FDI: 100% FDI allowed in textiles under the automatic route thereby
promoting the development of the industry and capital inflow in the country.
Welfare Schemes: 161.10 million weavers and ancillary workers offered
health insurance & life insurance under the handloom weavers
comprehensive welfare scheme and 7.33 lacs artisans provided health
coverage under the Rajiv Gandhi Shilpi Swasthya Bima Yojna.
E-marketing: The central cottage industries corporation of India (CCIC) and
the handicrafts &handlooms export council of India (HHEC) have developed
various e-marketing platforms to simplify marketing issues.
Skill development: The integrated skill development scheme offers training
assistance to the workers for enhancement of skills. All 3 sub sectors of the
textile industry viz. Textiles & Apparels, Handicrafts and Jute & Sericulture.


Credit linkages: As per the credit guarantee program, over 25000 artisan
credit cards have been supplied to various artisans and 16.50 million
additional applications for issuing up credit cards are under consideration.
Financial package for waiver of overdues: The GOI has announced a
package of US $ 604.56 Million to waive off overdue loans in the handloom
Other regulations: Government has also levied regulations to prohibit child
labour. Also government has brought in regulations for better wages and
compensation to workers who develop respiratory diseases due to paint
pigments used for dying of the fabrics and yarns.
Textile Parks: The GOI has approved 40 new textile parks to be set up and
this would be executed over a period of 36 months. Thereby leveraging
further employment in this industry.
Recent developments: Along with the increasing export figures in the Indian
apparel sector in the country, Bangladesh is planning to set up two special
economic zones for attracting Indian companies in view of the duty free
trade between the two countries. The 2 SEZs are expected to come up on
100-acres plot of land in Kishoreganj & Chattak in Bangladesh. Italian
luxury major Canali has entered into a 51:49 joint venture with Genesis
luxury fashion which currently has distribution rights of Canali-branded
products in India. The company will now sell Canali branded products in
India exclusively.

Policy & Regulatory Framework

The ministry of textiles which is responsible for policy formulation,
planning, development, export promotion and trade regulation in the textile sector.
Various policies viz. National Textile Policy 2000, Technology mission on Cotton
(TMC) 2000, National Jute policy 2005, Jute Technology Mission (JTM) 2006,
Mega cluster schemes laid its emphasis and focus on:

Technological upgrades
Enhancement of productivity
Quality consciousness & Strengthening of raw material base
Product diversification, Increase in exports and innovative marketing
Financing arrangements
Increasing employment opportunities
Integrated human resource development

Investments & Opportunities

Investments: The industry attracted FDI worth US $ 934.04 million
between April 2000 and January 2011. FDI in the textile industry stood at USD
129 Million in FY11.
Opportunities: The potential size of the Indian Textiles Industry is expected
to reach US $ 220billion by 2020.Private sector participation in Silk production,
demand for technical textiles, growth in the retail sector, establishment of Centres
of excellence for research & technical training etc. have boosted the opportunities
in the textile industry.

Typical Value Chain of the Textile Industry



Risk In General
Risk is defined as the potential that a chosen action or activity will lead to a
loss or an undesirable outcome. To simplify, it is a potential loss or less than
expected returns. It is the chance that an investments actual return will be different

than expected or required. Different versions of risk are usually measured

calculating the standard deviation of the historical returns or average returns of a
specific investment. A high standard deviation indicates a high degree of risk.
A fundamental idea in finance is the relationship between risk and return.
The greater the amount of risk that an investor is willing to take on, the greater the
potential return. The reason for this is that investors need to be compensated for
taking on additional risk. This is why increasing number of companies are
allocating large amount of time and money in developing risk management
strategies to help manage risks associated with business and investment dealings.
Risk management is a process of identification, analysis and either acceptance or
mitigation of uncertainty associated in decision making. Simply put, risk
management is basically a 2 step process determination of risks associated with
an investment or a decision and handling those risks in a way best suited to the
investment or decision objectives. However, a broad framework with risk
management is as given below:


Risk and return go hand in hand. While the level of risk increases with
increasing expectations in the returns required, there are certain risks which are
associated with current level of business and the concern is not necessarily about
the increase in the return or a potential loss but to safeguard or be sure of the
current business situation. One such risk associated with the international business
is the risk associated with the currency fluctuations. Such risks usually affect the
business in various ways and impact the costs/revenue/expenditure and eventually
performance of any company/ organization involved with international business.

Currency Fluctuations

Rupee vs. USD


Rupee vs. Euro

Source: Midmarket rates as per Xe.com

Above graphs are clear indications of the currency fluctuations in past 12
months which would have its impact not only on the countrys BOP and trade
performance but also on competitiveness and profitability of the firms/ companies
involved in international business. USA and Europe being the major export
markets for the Indian textile industry and the industry itself being a major
contributor to the countrys exports, there is growing significance for currency risk
management in this industry. While large size exporting companies have dedicated
risk management team, small exporters also have initiated the same to mitigate the
risks associated with currency fluctuations.

Risks associated with Currency Fluctuations

Although exchange rates cannot be forecasted with perfect accuracy, firms
can at least measure their exposure to exchange rate fluctuations. Technically
speaking, there are 3 kinds of risks associated with currency fluctuations which can

affect a firms value:

i. Translation Exposure
ii. Transaction Exposure
iii. Operational Exposure

A Taiwanese company has the following USD exposures:
i. Owns a factory in Texas worth US$5 million.
ii. Agreement to buy goods worth US$2 million.
iii. Biggest competitor is a US company.
What happens if the dollar appreciates?
i. NT$ value of US factory goes down (translation exposure).


NT$ cost of buying goods goes down (transaction exposure).

Global competitiveness of Taiwanese company decreases (operating

Translation Exposure:
The exposure of an MNCs consolidated financial statements to exchange
rate fluctuations is known as translation exposure. In particular, subsidiary earnings
translated into the reporting currency on the consolidated income statement are
subject to changing exchange rates. From a cash flow perspective: The translation
of financial statements for consolidated reporting purposes does not by itself affect
an MNCs cash flows. However, a weak spot rate today may result in a weak
exchange rate forecast (and hence a weak expected cash flow) for the point in the
future when subsidiary earnings are to be remitted. From a stock price perspective:
Since an MNCs translation exposure affects its consolidated earnings and many
investors tend to use earnings when valuing firms, the MNCs valuation maybe
affected. An MNCs degree of translation exposure is dependent on: The
proportion of its business conducted by foreign subsidiaries, the locations of its
foreign subsidiaries, and the accounting methods that it uses.

Transaction Exposure:
The degree to which the value of future cash transactions can be affected by
exchange rate fluctuations is referred to as transaction exposure. Transaction
exposure measures changes in the value of outstanding financial obligations
incurred prior to a change in exchange rates but not due to be settled until after the
exchange rates change. Thus, this type of exposure deals with changes in cash
flows that result from existing contractual obligations.
Transaction exposure arises from:
i. Purchasing or selling on credit goods or services whose prices are stated in
foreign currencies.
ii. Borrowing or lending funds when repayment is to be made in a foreign


Being a party to an unperformed foreign exchange forward contract.

Otherwise acquiring assets or incurring liabilities denominated in foreign

Transaction exposure is usually measured by estimating the net cash inflows or

outflows in each currency, and then the potential impact of the exposure to those
currencies. Various methods like the standard deviation, correlation coefficients or
the value-at-risk methods are used for assessing the transaction exposure.

Operational Exposure:
Operating exposure, also called economic exposure, competitive exposure,
and even strategic exposure on occasion, measures any change in the present value
of a firm resulting from changes in future operating cash flows caused by an
unexpected change in exchange rates.
Measuring the operating exposure of a firm requires forecasting and
analyzing all the firms future individual transaction exposures together with the
future exposures of all the firms competitors and potential competitors worldwide.
Operating exposure is far more important for the long-run health of a business than
changes caused by transaction or accounting exposure. Operating exposure is
inevitably subjective, because it depends on estimates of future cash flow changes
over an arbitrary time horizon. Planning for operating exposure is a total
management responsibility because it depends on the interaction of strategies in
finance, marketing, purchasing, and production.
An expected change in foreign exchange rates is not included in the
definition of operating exposure, because both management and investors should
have factored this information into their evaluation of anticipated operating results
and market value. From an investors perspective, if the foreign exchange market is
efficient, information about expected changes in exchange rates should be reflected
in a firms market value. Only unexpected changes in exchange rates, or an
inefficient foreign exchange market, should cause market value to change.

Operating exposure is usually measured using audit/ scenarios analysis or

statistical approach and is managed through various means like pass through the
costs to customers, use of marketing strategies and use of production management.
Financial hedging techniques may also be used.
Day to day currency risk management is mostly related to the transaction
exposure or risk involved on account of currency fluctuation.
An effective tool of currency risk management to mitigate/ manage the
transaction exposure is HEDGING.



Risk Management
There are various kinds of risks which a company has to encounter. We must
remember that foreign currency risk management is only a small part of the
companys overall risk management process.
Below figure illustrates various risks as a part of a corporate risk
management process:

Risk Management has to be taken seriously and a modern risk management

program is sustained over a period of time with these objectives:
i. Raising the awareness level of key risks in the business (risk exposure
ii. Proactively mitigating significant risks so as not to exceed senior
managements defined worst case (risk tolerance level)
iii. Incorporating risk management into capital allocation decisions (riskadjusted returns)
iv. Strong controls and meaningful reporting to senior management
v. Hedging should stabilize earnings and modify the risk profile of a company.


Given below figures to illustrate the above:

Objectives of Risk Management

Hedging to stabilize cash flows


The major aim of currency risk management via Hedging tools is to

determine the appropriate mismatch or imbalance between maturing foreign assets
and liabilities given certain basic information such as current & expected exchange
rates, interest rates (both locally & abroad)and the risk return profile acceptable to
a companys management.
Hedging is the taking of a position, either acquiring a cash flow or an asset
or a contract (including a forward contract) that will rise (fall) in value to offset a
fall (rise) in value of an existing position.
Hedging, therefore, protects the owner of the existing asset from loss (but it
also eliminates any gain resulting from changes in exchange rates on the value of
the exposure).Hedging is an effective tool for currency risk management and helps
reduce the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk.


Whether this reduction of variability in cash flows then sufficient reason for
currency risk management is a continuing debate in financial management and
corporate finance and there are several schools of thought to the same.
Opponents of currency hedging commonly make the following arguments:
i. Stockholders are much more capable of diversifying currency risk than the
management of the firm.
ii. Currency risk management does not add value to the firm and it incurs costs.
iii. Hedging might benefit corporate management more than shareholders.
Proponents of currency hedging cite:
i. Reduction in risk in future cash flows improves the planning capability of
the firm.
ii. Reduction of risk in future cash flows reduces the likelihood that the firms
cash flows will fall below a necessary minimum (the point of financial
iii. Management has a comparative advantage over the individual shareholder in
knowing the actual currency risk of the firm.
iv. Individuals and corporations do not have same access to hedging instruments
or same cost.
Hedging of currency in it-self is a process and undergoes a step by step

approach in its successful implementation. A typical hedging process can be

illustrated in the figure below:

As mentioned earlier, day to day currency risk management is mostly related

to the transaction exposure or risk involved on account of currency fluctuation.
Transaction exposure can be managed by contractual, operating and financial
i. Contractual Hedges include - Forward, Future, Options and Money Market
ii. Operating and Financial Hedges include - Risk-Sharing Agreements, Leads
and Lags in Payment Terms, Swaps and Other Strategies

Contractual Hedges:
Forward contracts:
A forward contract is an agreement between a firm and a commercial bank
to exchange a specified amount of a currency at a specified exchange rate (called
the forward rate) on a specified date in the future.

There are two types of forward contracts: Deliverable and non-deliverable

forwards (NDF). A derivable forward will be exchanged into the spot currency at
the expiry of the forward. An NDF is handy when you need to hedge currency
exposures from countries that have foreign exchange control where access to the
local forward markets are restricted to domestic companies only. A NDF, unlike the
deliverable contracts, only settles the difference between the onshore official fixing
and the NDF rates at contract maturity date. Customer either pays to the Bank or
receives from the Bank the difference depending on the onshore official fixing at
contract maturity. The customer could then buy/sell the same currency in the
onshore market to fulfill the physical currency requirement. Effectively, the
customer is buying/selling the onshore currency at the offshore NDF contract rate.
Future contracts:
Currency futures contracts specify a standard volume of a particular
currency to be exchanged on a specific settlement date. They are used by MNCs to
hedge their currency positions, and by speculators who hope to capitalize on their
expectations of exchange rate movements.
The contracts can be traded by firms or individuals through brokers on the
trading floor of an exchange (e.g. Chicago Mercantile Exchange), automated
trading systems (e.g. GLOBEX), or the over-the-counter market.
Brokers who fulfill orders to buy or sell futures contracts typically charge a
commission. Enforced by potential arbitrage activities, the prices of currency
futures are closely related to their corresponding forward rates and spot rates.
Currency futures contracts are guaranteed by the exchange clearinghouse,
which in turn minimizes its own credit risk by imposing margin requirements on
those market participants who take a position.
MNCs may purchase currency futures to hedge their foreign currency
payables, or sell currency futures to hedge their receivables.
Currency Options:
Currency options provide the right to purchase or sell currencies at specified
prices. They are classified as calls or puts. Standardized options are traded on
exchanges through brokers. Customized options offered by brokerage firms and
commercial banks are traded in the over-the-counter market.

A currency call option grants the holder the right to buy a specific currency at a
specific price (called the exercise or strike price) within a specific period of time.
A call option is
in the money if exchange rate > strike price,
at the money if exchange rate = strike price,
out of the money if exchange rate < strike price.
Firms may purchase currency call options to hedge payables, project bidding, or
target bidding.
A currency put option grants the holder the right to sell a specific currency at a
specific price (the strike price) within a specific period of time.
A put option is
in the money if exchange rate < strike price,
at the money if exchange rate = strike price,
out of the money if exchange rate > strike price.

Options are handy to

i. Hedge against adverse exchange rates movement but you do not want to
miss the potential gain if the future currency movement is in your favor.
ii. Have the right to deal but not the obligation to deal. Options are combined
into structures that give specific payoff profiles and exposures.


Money Market Hedge:

This is taking a money market position to hedge future receivables/payables.
This usually is done in following steps:
i. borrow foreign currency to be received
ii. convert to domestic currency
iii. invest for future use
Operational Hedges:

Risk shifting & risk sharing

Leading & Lagging - Leading (accelerate timing of depreciating currency)
and Lagging (delay timing of appreciating currency)
Exposure Netting


Currency Diversification
Use of marketing strategies
Use of product management
Transferring the risk to the buyers



About the company: Mahalaxmi Textiles is a textile manufacturer established in
1985 &exporter based out of Worli, Mumbai. The company is into the export of all
kinds of garmentsmajorly to USA and Europe markets and has a turnover of INR
100 crores.
Their vision: To become world leaders in innovation & consolidation with a
potential toproduce and market quality oriented customer products.
Their mission: To endure our brands with integrity and solidity by consistently
manufacturing &supplying our branded consumer products through well organized
business channel across theglobe.
Core products: Mens & Womens fashion wear
Core competencies:
Developing new items as per specifications of overseas buyers
Use of latest technology and manufacturing techniques
Strong focus on quality and 20 years of experience in exports market
OEM suppliers to international brands
This company has been into exports for over 20 years and their major
markets have been USA and Europe. Their typical sales include the merchandise
meant for fashion industry and the value chain cycle time from production to
consumption is approximately 8 to 12 months. Hence in June 2012 they would
manufacture merchandise meant for the expected fashion trend & demand for
winter 2013.


An illustrative interpretation of the cycle time in the typical value chain shared
earlier could be as below:



Current Hedging Strategy
Mahalaxmi group have been into the exports business for the past 20 years
and are working with their bankers (Citibank) for as many years. This has enabled
them to enjoy high bargaining power over their bankers with respect to interest
rates/ exchange rates and other services.
The company follows a typical 4 step hedging process as illustrated below:

Identifying Exposures:
With the growing currency fluctuations in US dollars and Euro, and the
company being 100% export oriented, the complete business revenue of the
company is exposed to currency fluctuations risk. While the rupee has been stable
against Euro, it has been volatile against the US dollar although recent trends have
seen rupee depreciating against the same.


Formulate Hedging Strategy:

Mahalaxmi group works on a cost plus model and all its procurement and
manufacturing costs are in INR. At the time of executing a contract in foreign
currency i.e. an export, the costs in INR are converted to the denomination of
foreign currency to arrive at expected costs of that contract in foreign currency and
includes finance cost for 6 months considering the payment cycle. Margin is then
added over this cost in foreign currency to arrive at selling price. To cover the risks
hence Mahalaxmi group signs a forward contract with their bank and the future
rate available to them is Rs. 1.20 higher than the spot rate on the date of executing
such a contract for a period of 12 months. Hence if the spot rate is Rs. 53 against 1
US $, the forward rate would be Rs. 54.20 thereby improving the price realization
of the exporter at the time of maturity.
Execute Hedging Strategy:
Mahalaxmi group regularly signs forward contracts with their bankers for a
period of 12 months.
Monitor performance & adjust:
Mahalaxmi group regularly keeps pace with overseas market. However since
they use forward contracts only to hedge against the currency risks, there is little
need for adjustments in the hedging strategies.

Impact of hedging strategies on business

Mahalaxmi group uses hedging strategies with an objective of risk managing
and not with the profit objective. A forward contract thus impacts their business as
per the following illustration
Forward Contract
1$ = Rs. 53.00

USD/INR as on
delivery date
1$ = Rs. 56.00
1$ = Rs. 56.00

Fx P/L for unhedged

+ Rs. 3.00
- Rs. 3.00

Fx P/L for hedged


As seen above, a hedged exporter will not earn any profit or incur any loss
on account of a forex fluctuation. However, there could be gain (on account of a
forward contract) in the price realization since the company follows a cost plus
model with current INR costs as the base cost to arrive at selling price for a
particular contract. This is however a notional gain.

Considering an export order for 1000 shirts @USD 10 each and spot rate assumed
at Rs.53.00
Payment terms are 90 days
US $
Selling price per piece
Total Selling Price
Cost price per piece
Total Cost price
Total cost price in $
Expected Gross Margin in $
Keeping the cost price constant at Rs. 42,400 and selling price at 54.20 on date of
Price realization in INR
Cost in INR being constant
Actual Gross Margin in INR
Actual Gross Margin in $
Change in Gross Margin in $
Change in Gross Margin in %



A forward Contract booked by an Exporter seeks to protect his profitability
from his business operations (Export of Shirts in the present example).
As long as the Forward Contract is not cancelled, and the contracted export
takes place as per the agreed timeline, the Exporter does not make any gains/losses
on account of the fluctuations in the foreign currency versus INR (if exports
invoiced in foreign currency).
If a Forward Contract (Exports) is cancelled, there could be a gain for the
Exporter, if the foreign currency (vs INR) price depreciates as on date of
cancellation as compared to the spot rate on date of booking the contract.
If a Forward Contract (Exports) is cancelled, there could a loss to the
Exporter, if the foreign currency (vs INR) price appreciates as on date of
cancellation as compared to the spot rate on date of booking the contract.

Suggestions Final word of advice:


Financial hedging: In the light of the current trend in currency fluctuations,

the exporter can use put option in combination with forward contracts to
increase profitability in the event that rupee depreciates beyond the forward
contract rate of 1.20 premium over spot rate (as per their current contract
with the bankers). However if rupee appreciates then the exporter could
incur loss arising out of insufficient cover under a forward contract (as
partial amounts will be hedged using a put option).


Dealing with bankers: Due to Mahalaxmis long relationship with the

Citibank on one hand its stands benefitted but at the same time risks
complacency an thereby risk of getting exploited by Citibank. So before

Mahalaxmi hedges its funds it is advisable that they survey the market at
least intermittently if not regularly.

Money market hedge: The exporter may also get into money market hedge
and borrow foreign currency to be received, convert to domestic currency
and invest for future use. This would however invite risks in case if rupee


Operation hedging: Considering the current trend of fluctuations and steep

appreciation of rupee against US dollar (relatively higher compared to its
valuation against EURO), the company can get into risk shifting and
increase proportion of exports to USA compared to Europe. Also risks
related to euro zone should support this move if adequate business is
available in US markets and if the company has a competitive advantage.

It is however imperative for Mahalaxmi textiles to stay updated with the

fluctuation trends, market exposure and internal factors to implement an overall
risk management process.