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Exposure Management Strategy


Welcome friends once again to our course on International Business. So, in the last
lecture we discussed about Foreign Exchange Exposure. So, the types of exposure the
three types basically we discussed, the first is the Translation exposure where we talked
about that it does not have actual any impact, but it is only to reflect on the books of
accounts because nothing is liquidated, nothing is sold or purchased there. Second we
talked about the Transaction exposure where there is a difference between the cost you
know the receivables or the payable due to the change in the exchange rate in a short
term period maybe 1 month.
So, suppose let us say we have sold something and we are we are about to receive some
payment and in between the exchange rate change changes. So, we will get less or more
due to the exchange rate change, right. The third we said is the Economic or Operating
exposure which is a long term view and this has a larger impact on when you know when
it is connected with the pricing of the product, change in the price of the products or it is
the company’s location changes. So, it has a long-term view basically and we understood
that economic exposure also has an effect on the cash you know operating cash flow
right of any company.
So, today we will talk about the Exposure Management Strategy, right. So, how does a
company who we all have understood for example an Indian company if we have
understood that there is a change in the, the currency value, so the exporter and importers
would feel the pain right. Either they will be in a gain, so they will be happy or there will
be in a loss, they will be in a pain right. So, we have understood also how it affects,
correct. So, it becomes very important for all the firms and especially the firms who are
in a large number of countries, they are operating in a large number of countries to take
care of this exposure management and control it. So, that as you saw in the case of BMW
a company, the company was doing everything fine, but because they were not able to
understand and properly control the exposure management, they could not do it. They
were making a loss of 2.4 billion Euro’s in between 2005 and 9.
So, this should not be happening to any company. So, today we will discuss we will start
with the Exposure Management Strategy.
(Refer Slide Time: 02:47)
So, what it says is to protect assets adequately against risks from translation transaction
and economic exposure of exchange rate fluctuations management must do something,
right. So, they have to do the following. So, what they have to do? The first point is
define and measure the exposure. So, first you have to define the exposure and measure
it. That means how much of exposure is there right, what is the magnitude of the
exposure, how much exposed we are. That means how much of transactions are we
doing with a particular currency.
Let us say are we doing too much of trading with a particular country and with a
particular currency, then we are more exposed to that particular currency. So, any
volatility in that will have a major effect on our profitability. Similarly organize and
implement a reporting system. A proper reporting system is required that monitors the
exposure and exchange rate movements, ok. The third is adopt a policy assigning
responsibility for minimizing or hedging. So, these two are connected. So, you have to
monitor the exposure and also try to minimize or hedge the exposure. Hedging means to
reduce right control it, formulate strategies for hedging.
So, what are the different strategies? Are we said one of the strategies which BMW had
adopted was to get into different countries and produce there, so that they and they
would buy the products source, the products in the from the local market. So, they have a
long good supply chain establishment and thus they can hedge their exposure, ok.
(Refer Slide Time: 04:30)
Define and measure exposure. So, MNEs Multinationals must see all three types of
exposure, right. To develop a viable hedging strategy a multinational enterprise must
forecast the degree of exposure in major currency in which it operates. So, it is not that
simple. It is a very complicated task that you need to forecast. How much of business we
are going to do with which country, right and what is the currency of that country and
what is going to be the change in the currency of that particular country in the maybe
future in the coming 10 months or 12 months or 1-3 years whatever it is during the time
duration.
So that also has to be kept in mind; because suppose you are trying to do business with
let us say today with Iran. Let us say an Iran is in with a fight with US. So, the Iran’s
Iran’s Iran’s political condition is going to change and because of the change, there has
to be an impact on its currency also. So, now that impact on its currency because of this
suppose the currency depreciates, now what is the going to be the impact on an Indian
trader who is going to let us say trade with an Iranian trader right. So, because of this fall
in the value of the currency there is it going to make a big impact or a negative impact?
If yes, then we need to maybe have some different strategies for that. A key aspect of
measuring exposure is forecasting the exchange rates.
So, you need to forecast the exchange rate on you cannot exactly forecast, but you at
least get a guess [FL]. What should be the way? We can whether it will fall, it will go up,
what is the climatic condition, what is the ecological condition, what is the political
condition, so what changes are happening in that country. So, accordingly we can decide
that ok.
(Refer Slide Time: 06:14)
The third thing it says is create a proper reporting system. Reporting system has used
both central control. That means where the country where the company resides for
example we talked about BMW in Germany, right and input from the foreign operations.
For example, they had operations in China, India right and they were expanding in
Russia also.
So, this helps in protecting against risk ok. Substantial participation from foreign
operation must be combined with effective central control. This is what we are talking of
the first point. You see this example Dell computer has developed a system whereby
hedging strategies are developed jointly by the financial management at corporate
headquarters and local management at its Brazilian production facility.
So, Dell has adopted this strategy that they would have a joint you know collaborative
effort, so that they can hedge the risk.
(Refer Slide Time: 07:12)
Now finally formulate the right hedging strategies. Once a company has identified its
level of exposure and determine which exposure is critical, so which exposure is critical
for them, it can accordingly hedge is position by adopting operational and financial
strategies. So, the law, the supply chain, the local suppliers, the buying and you know
amount of purchase how much which you are purchasing from the local suppliers and all
this and the financial strategies like the pricing of the products and all these things.
With cost benefit implications as well as operational implications; obviously it will have
an operational and cost benefit application because if you are buying it from uh from
different suppliers and the suppliers where they are and what is the quality of the
suppliers, all these things will matter to the entire production system.
The safest position is a balanced position in which exposed assets equal expose
liabilities. So, so it says the safest portion is a balanced position, ok.
(Refer Slide Time: 08:08)
Now currency or foreign exchange hedging. So, I am not going deep, but let us
understand what is it is. Hedging refers to the avoidance of foreign exchange risk,
hedging refers to the avoidance of foreign exchange risk because spot rates vary
overtime. So, you know what are spot rates, right. So, we have discussed spot rates are
the rates at the current at the present moment, ok. So, it provides a mechanism to guard
against losses as arising from fluctuations in the exchange rates.
So, hedging helps you protects you from fluctuations in that exchange rates. The
investors, traders, businesses and other market participants use forex hedges. It is meant
to protect from losses not to make a profit. It is not exactly to make a profit, but it to
protect from losses, right. It allows hedging to manage and minimize their exposure to
any adverse exchange rate movement. Risk and reward are often professional to one
another, thus reducing risk means in fact reducing profits right. So, when you are not
exposed, so obviously you are if the meaning of this is very important to understand.
So, higher risk in business we say higher risk is sometimes higher profits, but also it can
be higher losses also so, but when there is a reduction in risk losses also maybe reduced,
but profit is also reduced, right. There is no doubt about it, but then we are more
bothered about protecting (Refer Time: 09:41) from the losses.
(Refer Slide Time: 09:45)
Let us see this example. An Indian exporter has made export worth 1000 dollars, right.
The current spot exchange rate is 1 dollar is 60 rupees, right. So, how much will we get
60000? So, 60 into 1000 dollars at the said date suppose after 3 months. So, after 3
months, he will receive it how much? He will receive rupees 60000, but the rupee
appreciates to 50. Now this is interesting when we say appreciates, that means what the
rupee has become stronger and the dollar correspondingly has become weaker in front of
us.
So, today earlier what you are buying with 60 rupees 1 dollar, today you can buy with 50
rupees 1, right. So, he gets now because of the appreciation what will he do, he will get
only 50000 rupees. So, you see the exporter as an exporter if you think when you are
exporting, so if the rupee appreciates, will you like it? No, you will never like as an you
know exporter that the rupee should appreciate. You will feel that the rupee should rather
depreciate, right.
So, had it depreciated to let us say 70 rupees. So, 1 dollar is equal to 70 rupees. Suppose
it would have happen now how much this guy would have got? Maybe 70000 rupees,
right. So, loss of rupees 10000 due to appreciation. Now he can hedge his position by
signing a contract with some financial institution after payment of the hedge premium by
paying a premium. So, they can make a contract. So, as you do in case of a life insurance
that something if goes wrong, the company will insure me right. The exporter can take an
option. So, this is a repeat an option to sell 1000 dollar at 1 dollar is equal to rupees 60
for the particular future date say 3 months and he pays the premium for it.
So, in any case if something happens at least he will get rupees 60 rupees 60, but as I
said had this depreciated, then what would have happened? Maybe there was a case. Just
imagine now he has by he has paid a premium. So, that premium is some value and also
he is getting 60000 at the end of 3 months, but suppose let us say and the premium is
whatever the premium charge you have to minus it. So, the actually something less than
60000. Now the other hand in instead of appreciating had the rupee depreciated. So, now
the rupee has depreciated to let us say 70.
Now, what you would have got? He would have got 70000 rupees and the premium also
would have been saved because he did not had to pay the premium, but so this is an if
you look at the difference now it is more than 10000 and not 60 minus 70 because it is 70
minus 60 minus the premium. So, it is a higher value. So, this is what you would have
gained, but the question is we are not looking at only profits, we have to protect
ourselves from the risk right and the risk can be that it can go too much, it can appreciate
much higher right.
So, this is all what we discussed about the foreign exchange market. You can go in deep
for a reading about these things from in the course of International Finance or
somewhere because in International Business I am not going to go deep into that, right. It
is a part of the International Finance which you if you want you can cover up through
some other books and materials, right.
(Refer Slide Time: 13:13)
So, now coming to the next. So, we will talk about Foreign Exchange Regulation Act
and Foreign Exchange Management Act. So, this foreign exchange, the government in
every country has its own regulations, right. In India also we had earlier called the FERA
and FEMA.
(Refer Slide Time: 13:33)
So, FERA was earlier there and which was later on changed to FEMA. So, what was this
FERA act? It was the 19th act of 1973 with 81 sections and came in 1974, 1st January
1974. It was introduced at a time when foreign exchange reserves of the country were
low. So, we had very less foreign reserves, right. The main objective of FERA was to
regulate control and to ensure proper utilization of the foreign exchange, so as to
promote the economic development of the country.
So, the government wanted to interfere and tried to regulate and protect the foreign
currency, did not want you know too much of any mishandling or misutilization. So, that
we because already we are running short of foreign reserves right, but it was a Draconian
law where violation was a criminal offense. So, if anybody did something wrong, so they
were it was a criminal offense.
There was a very popular case I do not know the if anybody you know about it you can
check it ITC KL Chugh. There was a gentleman called KL Chugh who was arrested
before of because of FERA violation. So, there was a demand for substantial
modification in FERA because of the economic liberalization because we were opening
up the market was opening and improving foreign exchange reserve positions. Our
foreign exchange reserve positions also was improving which led to a new act called
Foreign Exchange Management Act.
(Refer Slide Time: 15:02)
So, we will see. So, FERA moved on to become FEMA right. FEMA came on 2000,
June right with 49 sections. The earlier one was 81, right if you see and in 74. So, this
after 16 almost years FEMA came FEMA is applicable to all parts of India and all, also
applicable to all the branches, offices and agencies outside India owned or controlled by
a person who is resident of India. So, you all come under FEMA when you suppose you
are resident of India you have offices in different countries that also comes under FEMA
act, ok.
So, what is the objective to facilitate external trade in payments ok? Obviously it is to
controlling the foreign exchange. So, trade in payments promote the orderly development
and maintenance of foreign exchange market and consolidate and amend the law related
to foreign exchange market in India.
So, these were the basic objectives of the FEMA. So, in nutshell if you want to
understand FEMA wanted to be less you know draconian. It had it was more liberal,
slightly liberal than the FERA and it, but the intention was the same to facilitate trade
and to make a proper, maintain the foreign exchange market right. So, what are the
regulations and management of foreign exchange let us see.
(Refer Slide Time: 16:21)
So, dealing in foreign exchange as per the act as per this FEMA act no person shall deal
or in or transfer any foreign exchange or security to any person not being an authorized
person, right. Now let us see what does it mean? Make any payment to or for the credit
of any person resident outside India in any manner, so you are not allowed, right.
Receive otherwise through an authorized person any payment by order on behalf of any
person resident outside India in any manner.
So, these were the conditions right enter into, so no person right entry into any financial
transactions in India as consideration for in association with acquisition or creation or
transfer of a right to acquire any asset outside India by any person.
(Refer Slide Time: 17:22)
So, this is what the FEMA was said, right. The regulation now who is this authorized
person? So, here you have seen authorized person, right. So, this word being used time
and again authorized person means an authorized dealer, money changer, offshore
banking unit or any person for the time being authorized under subsection 1 of section 10
to deal in foreign exchange or foreign securities.
So, the government has given permission to few people. So, they are the authorized
people who these foreign these are the ones who deal in foreign exchange or in foreign
securities as an authorized dealer, money changer or off shore banking unit in any other
manner as it deems fit.
Comply with such general or specific directions or orders of the Reserve Bank of India,
RBI right. FEMA covers three different type of categories and deals differently with
them. These are one person in person, then person resident outside India, person resident
in india.
(Refer Slide Time: 18:23)
Let us see what they are. So, what is the definition of? As per FEMA person for the
purpose of provisions a person shall include an individual Hindu Undivided family, a
company, a firm, an association of persons or a body of individuals whether incorporated
or not, every artificial judicial person not falling within any other proceedings sub
clauses and any agency office or branch owned or controlled by such person right.
Person resident outside India, a person resident outside India means a person who is not
resident in India, but he is a Indian right.
(Refer Slide Time: 19:00)
A person resident in India a person who has been residing in India for more than 182
days, right in the last financial year. So, this is the definition. This means if a person has
to be assessed as to whether he is person resident in India for any offense committed in
August 2001, then he should be residing in India for more than 182 days during April
2000 to March 2001.
So, this is what the definition says, right. Any person or body corporate registered or
incorporated in India right or an office, branch or agency in India owned or controlled by
a person resident outside India right or an office branch or agency outside India owned or
controlled by a person resident in India. So, these are the conditions which FEMA has
made right. So, now you have understood if you have to go it slowly to understand it and
you know what it exactly means right. Now Administration of the Act, now this FEMA
Act.
(Refer Slide Time: 20:00)
So, the rules regulations and norms pertaining to many sections are laid down by the RBI
in consultation with the central government. Now what does it want? The act requires the
central government to appoint adjudicating authorities for holding enquiries related to the
contravention of the act. So, if there is any problem, so to hold enquires one or more
special directors to hear appeals against the order of the adjudicating authorities.
The central government right shall have to establish an appellate tribunal for foreign
exchange to hear these appeals against the order of the adjudicating authorities and the
special directors, ok. The central government also has to establish a director of
enforcement with a director and such officers or class of officers as it thinks fit for taking
up the investigation. So, basically the RBI along with the central government tries to
keep a control and I am sure that nobody violates this and if they violate, what would be
the kind of punishment or kind of you know penalty on them, right.
(Refer Slide Time: 21:17)
What is the power of the central government? For the purposes of this act, the central
government may from time to time give to the RBI such general or special directions as
it thinks fit and the RBI shall in the discharge of its functions under this act comply with
any such directions, right. Two golden principles in FEMA are mentioned below. All
current account transactions are permitted unless otherwise prohibited, all current
account transactions are permitted unless it is prohibited, all capital account transactions
are prohibited unless they are permitted.
(Refer Slide Time: 21:59)
So, these are the two golden rules of the FEMA. Now current account transactions what
does it say? Any person may sell or draw foreign exchange to or from an authorized
person. If such sale or drawal is a withdrawal is a current account transaction, right. The
central government may in public interest and in consultation with the RBI impose such
reasonable restrictions for current account transactions as may be required from time to
time.
So, basically these are all theories theoretical things which you have to read again and
again to understand and try to understand what exactly how the RBI is trying to control it
basically along with the help of the central bank, central government right.
The definition is inclusive and any expenditure which is not a capital account transaction
will be current account transaction. It includes payments due in connection with foreign
trade, other current, businesses services and short term banking and credit facilities,
right. Payments due as interest on loan and net as net income from investments,
remittances for living expenses from whoever are staying abroad or expenses in
connection with foreign travel education and medical care.
(Refer Slide Time: 23:19)
So, these are all coming under the current account transactions under capital account. If
you see it means a transaction which alters the assets or liabilities. So, capital account
right including contingent liabilities outside India of persons residing in India or assets or
liabilities in India of persons resident outside India. And these can include things like
change in assets transfer or issue of security borrowing or lending, export import of or
holding of currency or currency notes and giving guarantee.
So, this come under the capital account transaction. So, this is all prohibited until and
unless you take permission, but in capital account here in current account these are all
permitted until and unless somebody for some reason is prohibited for some reason is
prohibited, ok. So, these are the as per the golden rules you have understood, right.
(Refer Slide Time: 24:09)
Exporter of goods and services, every exporter of good shall furnish to the bank. Now
this is very important. To the Reserve Bank or to any such other authority a declaration
in such form and in such manner maybe specified containing true and correct material
particulars including the amount representing the full export value or if the full export
value of the good is not ascertainable at the time of export, the value which the exporter
having regard to the prevailing market condition expects to receive should be clearly
mentioned.
Furnish to the Reserve Bank such information as may be required by the RBI for the
purpose of ensuring the realization of the export proceeds by such exporter. Every
exporter of services shall furnish to the RBI, a declaration in such form as may be
specified containing the true and correct material particulars in relation to payment for
such services. So, these are the for the export of goods and services.
(Refer Slide Time: 25:12)
Now, what is the power of the RBI in this case. The RBI may at, any time cause an
inspection to be made by any officer of the Reserve Bank specially authorized in writing
by the Reserve Bank in this on this behalf of the business of any authorized person as
may appear to it to be necessary for the purpose of verifying the correctness of any
statement information and particulars furnished to the Reserve Bank. So if you have
done something, the RBI will set up or you know under the you know have an officer to
inspect it to verify the correctness of the different statements and information.
Obtain any information or particulars which authorized person has failed. This also
happened this had happened with the case Vijay Mallya, right. Securing compliance with
the provisions of this act or of any rules regulations, directions or orders made thereunder
sorry there under. So, this is a the gap has to be given. So, these are the powers the RBI
has - the power to make check, control and inspect. So, if something is wrong they can
take action against it right. So, what are the penalties?
(Refer Slide Time: 26:30)
So, under FEMA the penalty could be up to thrice the sum involved where amount is
quantifiable. So, if you let us say is 100 rupees say the penalty could be up to 300.
If the amount is not quantifiable, penalty up to rupees 2 lacs can be imposed,. If
contravention is of continuing every day further penalty up to rupees 5000 per day
during which the contravention continues can be imposed. Now as per the Section14 if a
person fails to make full payment of the penalty imposed within a period of 90 days, he
shall be liable to civil imprisonment, but earlier it was very different. In fact if somebody
violated the FERA, he was immediately getting under criminal offense. Further in
addition to the penalty, any currency, security or other money or property involved in the
contravention may also be seized.
(Refer Slide Time: 27:33)
So, FEMA gives these are the penalties. So, this is one case we will discuss and I will
wind up here.
So, this is a case study on FEMA right. So, this happened with PriceWaterhouse
Coopers, PWC. You must have all heard. So, what happened FEMA imposed a fine of
rupees 230.4 crore on the audit firm PriceWaterhouse Coopers, right for alleged
violations of various provisions of FEMA right. So, as per as you have read now you can
go back and also check. So, PwC had violated. So, the rules of FEMA and because of
this the enforcement director had you know they had penalized it. According to the
agency the investigation against PwC and its functionaries commenced on the basis of
specific input stating. The company had allegedly received huge foreign investments
from abroad.
So, what had happened? The as per the investigation they found that PwC had received
huge foreign investments from abroad in the guise of grant. So, in the name of grant they
had received huge foreign funds. Now what did they do with these funds? During the
course of investigation it was revealed that PwC had received this much value equivalent
to rupees 229 Indian crore Indian rupees as purported brands right from Price
Waterhouse Coopers Services, right. So, from one of their own maybe related agencies
the funds so received as grants have been utilized. Now this is interesting for various
business purposes including acquisition of other Indian companies and paying noncompete
fee and accordingly a complaint was filed said the agency.
So, what PwC was had done with this money was actually falling beside the purview of
the rules as FEMAs guidelines, right. So, the adjudicating authority during the course of
the education had held the company guilty of violation of section 10 6, 6 2, 6 3 and 9 b
of FEMA; for receiving investments in the guise of purported grants. So, in the guise of
grants because grants are generally relaxed. So, in non-permitted sector without the
approval of government or RBI and imposed penalty of rupees 230 crore finally and
other penalties and office bearers of the company including past and present chairman
and directors.
So, you can understand, but had it been a case of FERA, it would have been much
stringent and very difficult, but this was a very popular case. There are many cases. You
can go and check on the internet also and this is one popular case which happened with
Price Waterhouse Coopers and the FEMA of you know they penalized they had they
imposed penalty and once they found guilty, they had to pay back this 230 crores back.
So, this is what happened.
So, FEMA is basically nothing, but like you know the SEBI looks after the you know the
Stock Exchange or the anything related to the Stock Exchange, the FEMA you know this
act looks for anything related to the Foreign Exchange right. So, whenever there is a
foreign exchange mismanagement or deliberate intentional you know mismanagement or
something, so their investigation is done and the parties who are involved in it they may
be penalized for it. So, this is all what we have for the Foreign Exchange Market and
how to you can protect yourself from the foreign exchange exposure.
So, we have discussed today what is FERA and what is FEMA we have discussed.
Whatever we have discussed you can go further, you can read more and maybe may have
improve your clarity you can learn more, but this is a basic understanding what you have
got from my lecture, right. So, this is what we have for the day.
Thank you very much.