For Indian firms, foreign exchange exposure arises mainly on account of imports, exports and foreign currency borrowings. To cope with such exposures, the following devices are commonly employed:
1. Forward market hedge
2. Financial swaps
Forward market Hedge:
In a forward market hedge, a net liability (asset) position is covered by an asset (liability) in the forward market. To illustrate the mechanism of the forward market hedge, consider the case of an Indian firm which has a liability of $100,000 payable in 60 days to an American supplier on account of credit purchases. The firm may employ the following steps to cover its liability position:
Step 1: Enter into a forward contract to purchase $100,000 in 60 days from a foreign exchange dealer. The 60 day forward contract rate is, say, Rs 48.00 per dollar.
Step 2 : On the sixtieth day, pay the dealer Rs 4,800,000 ($100,000 x Rs 48.00).
By using such a mechanism, the Indian firm can eliminate the exchange risk of dollars because of its assets position in the forward dollars.
To cover a net asset position in the foreign currency, a reverse process has to be followed. To illustrate this process, consider an Indian firm which is expecting a payment of $100,000 due in 60 days, on account of credit sale, from an American customer. The firm can take the following steps to cover its asset position.
Step 1: Enter into a forward contract with a foreign exchange dealer to sell $100,000 in 60 days. The 60 day forward rate is, say, Rs 47.80.
Step 2: On the sixtieth day, collect $100,000 from the American customer, deliver the same to the dealer and collect Rs 4,780,000.
The forward market hedge is a relatively simple and convenient arrangement. It merely involves getting a forward quotation from a foreign exchange dealer and advising him to do the needful. Of course, the dealer will charge a commission for the transaction.
A financial swap basically involves an exchange of one set of financial flows for another. Widely used internationally, financial swaps have in recent years attracted the attention of firms in India. The two most important financial swaps are the interest rate swap and the currency swap.
Interest rate Swap: An interest rate swap is a transaction involving an exchange of one stream of interest obligations for another. Typically, it results in an exchange of fixed rate interest payments for floating rate interest payments. Occasionally, it involves an exchange of one stream of floating rate interest payments for another.
The principal features of an interest rate swap are:
1. It effectively translates a floating rate borrowing into a fixed rate borrowing and vice versa. The net interest differential is paid or received as the case may be.
2. There is no exchange of principal repayment obligations
3. It is structured as a separate contract distinct from the underlying loan agreement.
4. It is applicable to new as well as existing borrowings.
5. It is treated as an off-the-balance sheet transaction.
An interesting Indian example of an interest rate swap is the one entered into by Maruti Udyog Limited (MUL) ON March 16, 1984, MUL took a syndicated foreign currency loan of US $75 million. The terms of the loan agreement specified that MUL would draw $30 million by March 16, 1985, $40 million by March 16, 1986, and $50 million by March 16, 1987. The loan was repayable from March 1988 through March 1991. The rate of interest on the loan was stipulated to be 3 / 8 per cent over LIBOR till March 1988 and half per cent over LIBOR thereafter. Concerned about the dollar LIBOR fluctuations, MUL in consultations with the government, the Reserve Bank of India, and the State Bank of India, decided to go in for an interest rate swap. On July 30, MUL entered into a transaction with the Bank of America interest rate swap. Under this deal, Bank of America agreed to pay Bank of Tokyo an interest of 3/8 per cent over LIBOR on $ 20 million while MUL agree to pay a fixed rate of interest of 10.5 per cent to Bank of America.
Currency Swap: In a currency swap, both the principal and interest in one currency are swapped or principal and interest in another currency. On maturity, the principal amounts are swapped back. Thus, a currency swap involves: (1) an exchange of principal amounts today, (2) and exchange of interest payments during the period of the loans, and (3) a re-exchange of principal amounts at the time of maturity.