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43 International Journal of Applied Business and Economic Research

Management of Forex Risk Exposure: A Study of SMEsand Unlisted Non-Financial Firms in India

Kiran Mehta1, Renuka Sharma2 and C.A. Aman Chugh3

1,2 Associate Professor (Finance), Chitkara Business School3 Managing Partner at Market Connected Advisor LLP and Research Scholar, Chitkara University

Abstract: The factors affecting the force of Currency Risk or Forex Risk are macro in nature but directly/indirectlyaffect the financial position of a company. Hence it is imperative for the companies having any kind of Forex riskexposure to manage such risk carefully. The present study is destined to investigate the awareness level of SMEs inIndia regarding Forex Risk by taking a sample of 68 SMEs having exposure to Forex risk and data for the same hasbeen collected through a structure questionnaire. The findings of the study have clearly indicated that greater part ofthe sampled manufacturing units have Forex risk exposure in US Dollar and maximum of these manufacturing unitsdo not have a mechanism to measure the Forex risk exposure. A large variety of hedging instruments prevailing inIndian financial market system to hedge the Forex risk are available for hedging, but the small and medium enterprisesprefer to use only currency derivative contracts available on Over-the-Counter only that too in the form of forwardcontracts. These enterprises are not using complex and more risky hedging instruments like cash flow matching, assetliability management, futures, swaps, options structured derivatives or hybrid derivatives. Steps need to be taken atinstitutional level to make other instruments as part of mainstream of risk and hedging strategies of SMEs. Succinctly,it can be stated that there is lack of awareness in SMEs regarding mechanism to measure Forex risk and Forex riskmanagement strategies.

Keywords: Forex risk, hedging, SMEs, OTC Forwards.

JEL: G31, L26, M10

INTRODUCTION AND BACKGROUND

The impact of globalization is not limited to large corporations. The small and medium enterprises are alsocontributing significantly in global world. The types of risks Small and Medium Enterprises (SME) are exposedto, are similar to what a multinational organization is facing but not in the same quantum. Broadly we classify thetypes of risks into five categories mentioned hereunder. But a company having exposure to world markets in theform of import or export is exposed to currency risk directly than its domestic counterparts.

The present study is focused towards the Currency Risk or Forex Risk of Small and Medium Enterprises(SMEs). The factors affecting the force of Currency Risk or Forex Risk are macro in nature but have direct

Kiran Mehta, Renuka Sharma and C.A. Aman Chugh

International Journal of Applied Business and Economic Research 44

impact on the receivables and payables of a company in international business and ultimately affect the financialposition of the company. Therefore it is mandatory for the companies having any kind of Forex risk exposure tomanage such risk circumspectly. A company can be affected by currency risk or Forex risk directly or indirectly.When a company is exporting or importing in foreign currencies, any foreign debts or investments or a companyhas foreign branches or subsidiaries then it is directly exposed to foreign risk. But under some situations, thecompanies get exposed to Forex risk if the cost structure of their competitor is affected by Forex rate or the priceof product, in which they are dealing, is affect by Forex rate then there is an indirect exposure of Forex risk tosuch companies. Sometimes the Forex risk/currency risk is directly noticeable while in other cases it is difficultto notice and the impact of risk is noticed at a later stage. Conventionally the Forex risk can be categorized inthree categories mentioned hereunder.

Political Risk

CommercialRisk

Product Risk

Financial Risk

International BusinessRisk

Current/ForexRisk

Currency Risk

Transaction Exposure

Economic Exposure

Translation Exposure

Transaction exposure can be defined as the sensitivity of realized domestic currency values of the company’scontractual cash flows denominated in foreign currencies to unexpected Exchange rate changes. The economicexposure is also called as operating exposure. It measures any variation in the present value of a companyconsequential to fluctuations in future operating cash flows caused by unanticipated changes in currency exchangerates. Translation exposure is also called as accounting exposure. It impacts the consolidated financial statements.It is the potential or risk for an increase or decrease in the parent’s net worth and reported net income caused bya movement in exchange rates since the last translation. In other words, it can be said that while the transactionexposure is concerned with cash flows and influences the items set out in the profit and loss account, translationexposure is concerned with values and mostly affects the items set out in the balance sheet.

The movement in exchange rate is of great concern for the enterprises involved in some export-importtransactions. The exporters and importers have a traditional mindset that the central bank of country (RBI) willalways intervene to appreciate the value of rupee and there is not much to worry about exchange rate fluctuation



and stability of value of rupee in terms of other prominent currencies of the world. Such kind of perception forexchange rate of rupee, these exporters and importers are found involved in conservative hedging strategies byjust entering into forward contracts (FC) through authorized dealers (AD) in order to cut the unwanted cost onhedging the Forex Risk. Many researchers in the past have pointed out the growth and significance of OTCderivative market in India. One such study by Arora and Rathinam (2010) indicated that the Indian OTC derivativesmarkets, unlike many other jurisdictions, are well regulated. Contracts where one party to the contract is an RBIregulated entity are considered legally valid in India. A good reporting system and a post-trade clearing andsettlement system, through a centralized counter party, has ensured high-quality surveillance of the systemicrisks in the Indian OTC market. From amongst the various OTC derivatives markets permitted in India, interestrateswaps and foreign currency forwards are the two prominent markets. Indian OTC derivatives markets willgrow fast once again after the present financial crisis (2008) is over.

For small traders and hedgers OTC derivative market is of more convenience as the products availableon OTC are customized therefore the small investors need not to bother while entering into a standardizedcontract which is available in the form of Exchange Traded Contracts (ETCs). But large companies preferexchange traded contracts (ETCs) as the size of Forex risk exposure is huge. The hedging instruments availableto manage forex risk exposure include, options, futures, forwards, OTC forwards, OTC futures, swaps andsome other structured and dynamic products. But the evidences available regarding use of hedging instrumentshave shown that forwards and futures are the most preferred instruments for managing Forex Risk. But theawareness level and risk measurement criteria of a small and medium enterprise are not similar to what alarge company follows. Several studies have been conducted in various countries indicating difference inawareness level of small and large companies for various Forex risk hedging instruments. But there is a lackof empirical research on hedging behaviors of small and medium sized enterprises (SMEs) relative to largefirms, specifically in India. So the present study has focused to obtain similar evidences in Indian context. Butbefore developing a framework of research design, it is important to study the evidences obtained in the paststudies in related areas too.

REVIEW OF LITERATURE

The following section has mentioned evidences from past research regarding forex risk exposure and managementby firms across the world.

Collier and Davis (1985) documented that majority of UK multi nationals had a centralized group ofcurrency risk management and a framework of formal exposure management policies. The active managementof currency translation risk associated with centralized control while, on the other hand, the decision to closeoutseems to be linked to some extent with a less centralized structure.

Batten, Mellor and Wan (1993) conducted industry-wide on foreign exchange risk management practiceand product usage of large Australian-based firms. Results are discussed from an empirical field study ofseventy-two firms operating in Australia. The physical products included spot, forwards, forward forwardsand short and long-term physical swaps. Jeswein et. al. (1995) studied the use of derivatives by US corporationsand categorised foreign exchange risk management products in three generations. Forward contracts fit in tofirst generation; future, options, future-options, warranties and swaps belong to second generations and foreignexchange agreements belong to third generation. The study concluded that first generation was in maximumdemand followed by second and third generation products. The study further concluded that the use of thisrisk management tool was not significantly related to the size of the company but it was related to theinternational involvement of the company. A study by Goetz & Hu (1996) argued that currency swaps aremore cost-effective for hedging foreign debt risk and forward contracts are further cost-effective for hedgingforeign operations risk. Further, He and Ng (1998) conducted a study on foreign risk exposure of 171 Japanesemultinationals and it was identified that 25% of the sampled firms experienced noteworthy Foreign Exchange



exposure. The authors have also looked at the relationship between Forex exposures and studied the variablesthat were tacit to reflect derivatives usage. It was evidenced that firms that were opting some mechanism topredict and hedging strategy were less exposed to Forex risk in comparison to their counterparts. Also, Bodnaret. al. (1998) conducted a survey on large companies and documented that majority of the companies werenot using derivative instruments effectively to hedge their risk rather they were considering other operationalapproaches to manage their risk exposures.

In a study based on Indian companies by Yadav and Jain (2000), a sample of 44 companies was taken andthese companies were exposed to Forex risk due to international operations. The findings of the study indicatedthat 30 percent of the companies hedge their exposure and some steps are taken by all companies to managetheir international business. Pramborg (2004) made a comparison of hedging practices of Swedish and Koreannon-financial firms. It was identified that companies in both the countries were hedging currency risk for differentobjectives. Korean firms mostly focused on reducing fluctuations in cash flows, while Swedish firms morecommonly emphasized reducing fluctuations of accounting numbers. Saito and Schiozer (2005) confirmed theevidences of using derivatives by Brazilian non-financial firms, using a sample of 74 companies. Even thebanking industry has been found unable to manage their risk properly despite having a complete panel of treasurersand finance experts for this purpose. Nedzvedskas and Aniûnas (2007) identified that among various componentsof market risk exposure, currency risk is the major component affecting the overall risk profile of the company.Their study documented that the Lithuanian commercial banks were not managing their currency risk in anappropriate manner. The limits set by their Central Bank was quite liberal before the adoption of Basel II norms.The authors of the paper suggested an effective model for commercial banks in Lithuania to manage currencyrisk.

Dash et. al.(2008) made a comparison of performance of different Forex risk management strategies forshort term Forex cash flows. The results of the study indicated the currency options strategy yielded the highestmean returns in all sample periods for outflows irrespective of variation in exchange rates while forwards strategywas found better one in case of inflows. In another study by Sivakumar and Starker (2008) various companiesfrom different sectors were studied and it was concluded that forwards and currency options were the mostpreferred instruments of hedging used by sampled Indian companies for short term and swaps were preferred bythese companies during long term.

Jain, Yadav and Rastogi (2009) examined risk management of different companies and concluded thatabout two-fifths of the firms were risk averse but did not hedge their full exposure. A majority of the firms werefollowing cost-center approach towards risk management. Ownership has been observed as a significantdeterminant of firms’ strategy towards risk management. While a majority of foreign controlled firms and privatesector business group firms were characterized as partial hedgers, the majority of the public sector firms belongedto the category of negligible hedgers. The study concluded that the adoption of risk management techniques isstill in infancy. In another study by Schiozer and Saito (2009) stated the determinants of currency risk managementin non-financial firms in Argentina, Brazil, Chile, and Mexico. The findings of their study clearly indicated thatthe firm size is directly related to the decision of firm to use derivative for hedging. In a more recent study byBodnar et. at. (2013) indicated that lack of financial literacy of Italian firm had an effect on the decision to usecurrency and interest rate derivatives to manage these two types of risks, i.e. currency risk and interest rate risk.Dash et. al (2013) documented that currency options are a better tool to hedge forex risk affecting cash flows ofthe business. In order to hedge currency risk in cash inflows, out-of-the-money currency put options can resultin best results and in order to hedge currency risk in cash outflows, out-of-the-money currency call options canresult in better results. The study concluded that a company not hedging its currency risk is always riskier thanits counterparts.

Further, Hrubošová, at el. (2013) conducted a study on hedging foreign exchange risk, mostly in small andmiddle enterprises. It was documented that many companies were facing Forex risk under difficult time of



financial crisis. The study concluded that the trend of CZK/EUR in 2012 gives opportunity for using financialderivates such as forwards, currency options and swaps to protect assets and liabilities against higher exchangerate volatility. Vu (2015) studied hedging practice of Vietnamese exporting small and medium sized enterprises(SMEs) and provided a better understanding of the choice of forex risk treatment by SMEs in an emergingeconomy. Exporting SMEs gained more experience of dealing with foreign exchange (forex) risk, when exportintensity increased. These firms were exposed to high levels of forex exposure, perceived higher forex risk,allocated more resources associated with forex risk management, and increased the use of hedging techniques,especially external hedging techniques. Vietnamese exporting SMEs were inert when dealing with forex risksand vacillated over allocation of resources linked with forex risk management. The firms lacked a purposefulstrategy for forex risk management.

The study of literature gives a clear indication that only large corporations (India and other countries) areactive in making comprehensive strategies to manage their foreign exchange risk exposure while small andmedium enterprises are not much aware about all the hedging instruments therefore limit to traditional ways ofhedging only. Considering this fact in mind, the present study has focused on understanding the awareness levelof small and medium enterprises regarding Forex risk measurement and hedging instruments.

OBJECTIVES OF STUDY

The present study is destined to achieve following two objectives.

1. To identify the awareness level of SMEs in India regarding Forex Risk

2. To comprehend the Forex Risk Management methods of SMEs in India

RESEARCH METHODOLOGY

The current study is descriptive in nature and based on primary data. A sample of 68 small and medium unlistedmanufacturing concerns was approached to collect the desired information. The instrument used to collect theinformation was a structured questionnaire with close-ended questions. All sample units were contacted inperson or through telephone and an interview was conducted on the basis of structured questionnaire. The SMEshaving exposure to Forex risk were asked questions related to their awareness level regarding Forex risk andhow the Forex risk exposure is managed by them. In the following section one by one we will discuss aboutthese questions.

Table 1-4 explains the demographic features of SMEs approached for current study. As mentioned inbelow tables, majority of the sample units have employees less than 80 having annual turnover less than Rs.25 cr. The foreign currency risk exposure of majority of SMEs is found more than 30% of their annualturnover. And this foreign currency risk exposure is generally found in US Dollar followed by SingaporeDollar.

Table 1Number of Employees Working in SMEs

No. of Employees No. of SMEs No. of SMEs (%)

Less than 10 2 2.94

10-30 15 22.06

30-50 19 27.94

50-80 22 32.35

Above 80 10 14.71



Table 2Annual Turnover of SMEs

Annual Turnover No. of SMEs No. of SMEs (%)

Less than 5 Crore 16 23.535-10 crore 9 13.24

10-15 crore 5 7.3515-20 crore 4 5.8820-25 crore 6 8.8225-30 crore 0 0.0030-35 crore 4 5.8835-40 crore 2 2.9440-45 crore 2 2.9445-50 crore 4 5.88

Above 50 crore 6 8.82Above 100 crore 10 14.71

Table 3Percentage of Total Turnover of SMEs in Foreign Currency

Total Turnover No. of SMEs No. of SMEs (%)

Less than 10% 10 14.7110-20% 9 13.2420-30% 12 17.6530-40% 9 13.2440-50% 6 8.8250-60% 10 14.7160-70% 4 5.8870-80% 8 11.7680-90% 0 0.00

90-100% (In case you are a 0 0.00100% export based firm/company)

Table 4Currency in which the SMEs are Exposed to Forex Risk

Currency No. of SMEs No. of SMEs (%)

U.S. Dollar 66 97.06European EURO 26 38.24Swiss Franc 6 8.82UK Pound Sterling 2 2.94Japanese Yen 0 0.00Canadian Dollar 6 8.82Australian Dollar 0 0.00Chinese Yuan 12 17.65HongKong Dollar 18 26.47Singapore Dollar 30 44.12Kuwaiti Dinar 8 11.76Any other 0 0.00

*Many of the SMEs in present study are having forex risk exposure in more than once currency, therefore the total response is morethan 68.



RESULTS AND DISCUSSION

The following section discusses the findings of the study. The results of descriptive statistics indicated that 21percent of the total sample units even do not measure their currency risk exposure. And it is Board of Directors ofthese SMEs who identify the Forex risk exposure in their manufacturing concern. And the finance department ofthe manufacturing concern ensures that the Forex Risk Exposure policy is properly implemented in the organization.

As discussed in the introduction section, there are various hedging instruments available for Forex riskmanagement. These instruments are both, i.e., OTC products and ETC products. The findings obtained in thiscontext are attention-grabbing. Majority of manufacturing concerns are using their fixed hedging style. HedgingForex risk through forwards contracts is the priority of small and medium enterprises. The small and mediumenterprises take a forward contract as they get exposure to Forex risk. And in some cases Future contracts arealso considered for the hedging foreign currency risk but majority of the SMEs prefer to use OTC availableforward contract for this purpose. Rest all available hedging instruments are rarely used by these enterprises. Inthe following tables all this have been depicted.

Figure 3:

Who implements the Forex Risk Management Policy ?

No.

of S

ME

s

35

0

510

15

20

25

30

FinanceDepartment

Head

AnyOther

FrontOfficeTeam

Treasurer

No. of SMEs, 0

Figure 1:

No. of SMEs Measuring theForex Risk Exposure

No

Who defines the Forex Risk Exposure ?

Yes

CFO20%

Company’sManagement

Team 0%

Other0%

Figure 2:



Table 5What kind of instruments or techniques is your firm/company using for hedging?

Often Sometimes Never

Cash Flow Matching 0% 16% 84%

Asset Liability Management 0% 13% 88%

Futures 23% 33% 43%

Forwards 65% 32% 3%

Options 26% 17% 57%

Swaps 3% 18% 79%

OTC Forwards 68% 27% 6%

OTC Options 23% 20% 57%

Structured Derivatives 10% 13% 77%

Hybrid Products 0% 3% 97%

Others 0% 0% 100%

When these entrepreneurs were asked about the reason for not using other hedging instruments then it wasfound that rest other instruments are either too complex, risky and sometimes do not meet the desired conditionsmeeting their risk appetite. The hedging is generally done for 3-12 months. These SMEs do not have a practiceof doing 100 percent hedging of their Forex risk exposure. Either partial hedging is done or dynamic hedging isdone by manufacturing concerns.

Table 6If you answered never, then which of the following is (are) the reason(s) for this?

Too Complex 42 61.76

Not Allowed 24 35.29

Causing Accounting Problems 8 11.76

Not having the desired features 54 79.41

Not liquid enough 30 44.12

Too Risky 44 64.71

Other 0 0.00

Table 7For Each Instrument, what is the average maturity?

0-90 91-180 180-360 360-days Over 3 Notdays days days to 3 years years used

Futures 1 13 5 0 0 11

Forwards 1 16 17 0 0 1

Options 0 4 9 0 0 17

Swaps 0 0 1 0 6 22

OTC Forwards 1 13 15 0 0 1

OTC Options 0 5 8 0 0 16

Structured Derivatives 0 1 5 0 0 19

Hybrid Debts 0 0 0 0 0 26

Others 0 0 0 0 0 8



Table 8How do you use these Instruments?

Partial Hedge Full Hedge Dynamic Hedge

Futures 41.20% 5.90% 52.90%

Forwards 25.80% 0% 74.20%

Options 0% 12.50% 87.50%

Swaps 9.10% 0% 90.90%

OTC Forwards 20% 0% 80%

OTC Options 0% 0% 100%

Structured Derivatives 0% 0% 100%

Hybrid Debts 0% 0% 100%

What is the average periodthe company is hedging itsforeign exchange rate risk?

The average period ofhedging by these small andmedium enterprises is 90days or 180 days.

No.

of S

ME

s

40

0

10

20

30

90days

Over 3years

3years

360days

180days

Average time Period of Hedging

What percentage of theexchange rate exposure isthe company hedging?

The manufacturing concernsdo not have a habit ofhedging 100 percent of theirForex risk exposure.Majority of them are hedgingless than 60 percent of theirForex risk.

No.

of S

ME

s

30

0

5

10

15

20

25

0–20%

80–100%

60–80%

40–60%

20–40%

% of Total Forex Risk Hedged by SME



The next important outcome of the findings is that these Small and Medium Enterprises are not using anytechnical and logically designed Forex Risk ManagementModel which can help them to predict exchange rate,interest rate or inflation rate. On this parameter, the approach of SMEs is found quite different from hedgingstyle of big corporate houses where treasurers used to forecast various rates to develop any Forex risk managementpolicy.

Table 9Do you use any forecasting model

to predict evolution of

Yes No

Exchange Rates 17.60% 82.40%

Interest Rates 17.60% 82.40%

Inflation 17.60% 82.40%

How often do you readjustthe hedge or measure Forexrisk?

Not all the SMEs arereadjusting their hedgingposition very frequently. TheSMEs in the study usemonthly readjustment oftheir hedging position.

No.

of S

ME

s

60

010

2030

4050

Dai

ly

Yea

rly

Sem

i Anl

.

Qua

rter

ly

Mon

thly

Wee

kly

Frequency of Hedging Risk

What is the main purposeof exchange rate exposuremeasurement?

Majority of the SMEs do riskexposure management tohedge their risk or as anoverall risk managementstrategy.

No.

of S

ME

s

70

0

2030405060

Hed

ging

Oth

ers

Ris

k M

gt

Spec

ulat

ion

Frequency of Hedging Risk

10

Figure 4:



Adding to this, the SMEs have also indicated that in order to take better decisions related to investment inForex risk management instruments, they focus more on providing training to people taking such decisions andretaining them in the organization instead of more focusing on historical data analysis and increasing access toadvance technology.

CONCLUSION AND SUGGESTIONS

Forex risk management is a multistage process which has various important steps stating from the identificationof the foreign risk exposure and then monitoring & quantification of such risk on weekly or monthly basis toensure the objective of the forex risk management of a firm.

The findings of the study have clearly indicated that greater part of the manufacturing units ofpresent studyhave Forex risk exposure in US Dollar and maximum of these manufacturing units do not have a mechanism tomeasure the Forex risk exposure. The decision related to Forex risk management is taken by their BOD and incommon, finance department implements the Forex policy. There is a large variety of hedging instrumentsprevailing in Indian financial market system to hedge the Forex risk. But the small and medium enterprises(SMEs) prefer to use only currency derivative contracts available on Over-the-Counter only that too in the formof forward contracts. None of the enterprises said that they are using other instruments like cash flow matching,asset liability management, futures, swaps, options structured derivatives or hybrid derivatives. When asked therationale for not using other hedging instruments then these enterprises said that they find other instrumentseither too complex or too risky to use. The average period of hedging by these small and medium enterprises is90 days or 180 days.One more interesting fact came to notice that these enterprises are using hedging instrumentsfor partial hedging only and none of these enterprises were using full hedging of Forex risk exposure. Not all theSMEs are readjusting their hedging position frequently.It was also shared by these enterprises that they are nothaving a separate treasury structure like large firms to hedge the currency risk. Moreover they are also notplanning to establish such structure in near future too.

Further, the market regulators need to focus on bringing awareness regarding other instruments for hedgingcurrency risk among the SMEs. Currently the currency derivative market is shallow for many instruments, otherthan forward contracts. Hence, steps need to be taken at institutional level to make other instruments as part ofmainstream of risk and hedging strategies of small and medium enterprises.

Succinctly, it can be stated that there is lack of awareness in small and medium enterprises regardingmechanism to measure Forex risk and Forex risk management strategies. Hence further research is required toincrease awareness and suggest a hedging strategy to stand before Forex risk exposure for these small andmedium enterprises. And such hedging strategies must indicate the benefit of using blend of various instrumentsof hedging Forex risk rather than focusing only on the traditional style of hedging through OTC forwards andfuture contracts.

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Yadav S.S. and Jain P.K. (2000), Corporate practices of risk management in international business operations in India.South AsianJournal of Management (SAJM), 7(1-2), 1-14.

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