Foreign exchange risk management and equ

Foreign Exchange Rate Sensitivity, FX Equity Exposure and Stock Price: A Case of Bajaj Auto Limited.. Himanshu Joshi hereby certify that this manuscript titled “Foreign Exchange Rate Sen

Foreign Exchange Rate Sensitivity, FX Equity Exposure and Stock Price:

A Case of Bajaj Auto Limited

Dr Himanshu Joshi Assistant Professor FORE School of Management B-18, Qutub Institutional Area New Delhi-110016 Contact No 011-41242449, 9999731056 (M) Email: himanshu@fsm.ac.in, himjoshin@gmail.com

I, Dr Himanshu Joshi hereby certify that this manuscript titled “Foreign Exchange Rate Sensitivity, FX Equity Exposure and Stock Price: A Case of Bajaj Auto Limited.” is my original work, and that the material is not published, copyrighted, accepted or under review elsewhere I

also assign all the copyright relating to the article to “Abhigyan” – Management Journal of

Foundation for Organisational Research and Education

Foreign Exchange Rate Sensitivity, FX Equity Exposure and Stock Price:

A Case of Bajaj Auto Limited

Abstract

Future foreign exchange rates are uncertain, which creates financial risk for firms that conduct international business Fluctuating foreign exchange rates may adversely affect a firm‟s revenues streams, cost structure, operating cash flows, net cash flows and even its equity prices These foreign exchange exposures can be managed through operational as well as financial hedging Present paper is an attempt to measure various FX exposures like FX Operating Exposure, FX Net Cash Flow Exposure, and FX Equity Exposure for an Indian exporter Bajaj Auto limited (BAL), and to study the hedging measures undertaken by the company BAL is ranked as the world's fourth largest two- and three- wheeler manufacturer The study has also estimated an empirical FX equity exposure by regressing time series of BAL‟s stock returns against percentage changes in the spot FX price of US dollar with a time lag of 10, 20, 40, 60 and 90 days Results indicate that stock market takes around 20 days to recognize FX equity exposure of BAL

Key Words: FX Operating Exposure, FX Equity Exposure, Range Forward contracts, Currency Swaps, Foreign Currency Debt

1 Introduction

Until the 1970s, the foreign exchange market was small and specialized The market changed fundamentally when the post-war Bretton Woods system broke down Under the Bretton Woods system, the U.S dollar was convertible to gold and other currencies were convertible to U.S dollar at fixed exchange rates In 1971, the U.S suspended the convertibility of the dollar to gold, and by 1973 the U.S and the other nations had accepted floating exchange market The last four decades (1970s -2010) has brought about tremendous growth in international capital and product flows In the process, the market for foreign exchange has grown into the world‟s largest financial market Apart from the magnitude of the overall market for currency instruments, the operations of firms create significant exposures to shifting exchange rates, forcing managers to understand the dynamics of exchange rates and measuring and hedging foreign exchange exposure of their firms Volatile foreign exchange rates may adversely affect a firm‟s revenues streams, cost structure, operating cash flows, net cash flows and even its equity prices Firms which are engaged in exports of products from one currency zone to other currency zone(s), their revenues are exposed to foreign exchange value fluctuations of importing countries with respect

to their home currency This type of exposure is called FX revenue exposure

Firms which are engaged in imports of raw materials and other products from other currency zone(s), their costs are exposed to foreign exchange value fluctuations of exporting countries with respect to their home currency This is known as FX cost exposure There are many firms in market which conduct their businesses at multiple locations, their sourcing, manufacturing, assembly and sales locations are in different currency zones It is more appropriate to measure exposure of their operating cash flows, and net cash flows to various currencies, known as FX operating exposure and FX Net cash flow (NCF) exposure respectively

Prices of equity shares are determined significantly by a firm‟s operating cash flows and net cash flows Thus, for the firms whose operating cash flows and net cash flows are exposed to foreign exchange fluctuations, their equity stock prices also tend to show volatility with respect

to foreign exchange fluctuations This type of exposure is known as FX equity exposure Financial as well as strategic policy of a firm is based on the objective of maximizing shareholder‟s wealth, thus hedging a particular risk faced by a firm make sense only, if this leads

to an increase in the current value of the firm According to the modern finance theory, value of the firm is the sum of its future expected cash flows, discounted at an appropriate capitalization rate Thus, hedging can increase the value of a firm either by increasing the expected cash flows

or by decreasing the rate at which these cash flows are discounted Modigliani –Miller theorem suggests that the managers of a firm cannot increase its value by undertaking financial transactions that the shareholders can make themselves In our context, the financial policy that

we wish to evaluate is the firm‟s decision to hedge its exposure to exchange rates Thus, applying Modigliani-Miller proposition to the firm‟s hedging decision we see that the firm‟s decision to hedge its exposure to exchange rates will not affect its value if shareholders could have achieved the same risk reduction through a transaction in the exchange market Specifically if spot and forward markets are perfect, then investors can undo at no cost the foreign currency positions that the firm managers take on The world that we live in, however, is not a perfect one Given the existence of market imperfections like convex tax schedules, cost of financial distress, and agency costs, hedging exchange risk can increase the value of firm through its affect on future expected cash flows and the firm‟s borrowing costs Financial hedging includes both natural hedging using foreign currency debt and financial market hedging using contracts like forwards, futures, options and swaps on currencies of firm‟s foreign exchange (FX) exposure

Present paper is an attempt to measure various FX exposures for an Indian exporter Bajaj Auto limited (BAL), and to study the hedging measures undertaken by the company Bajaj Auto Limited is ranked as the world's fourth largest two- and three- wheeler manufacturer and the Bajaj brand is well-known across several countries in Latin America, Africa, Middle East, South and South East Asia The Exports of BAL presently constitutes substantial portion of the turnover Prices of the BAL products are predetermined for each product in each region These prices are fixed in USD based on an assumed USD/INR rate The Company also imports raw materials and components for its Motorcycles etc However, the value of such imports is not material as compared to the value of exports Apart from exports and imports, the company has another source of FX exposure in the form of its fully owned subsidiaries in Thailand and Netherland The company is currently using various hedging techniques including foreign currency debt, range forward contracts etc

The present paper calculates various FX exposures for BAL like FX revenue and cost exposure, FX operating Exposure and FX equity Exposure, and explores the possibility of using more sophisticated hedging techniques like currency options and currency swap at Bajaj Auto Limited The paper has also estimated an empirical FX equity exposure by regressing time series

of Bajaj Auto Limited‟s stock returns against percentage changes in the spot FX price of US dollar with a time lag of 10, 20, 40, 60 and 90 days The closest beta in the regression to the priory calculated equity exposure was found to be present in case of a 20 days‟ time lag and also

a 90 days‟ time lag However, 90 days time lag is more because of a spillover effect rather than the actual time lag Thus, result indicates that it takes around 20 days to reflect the foreign exchange value change in stock price for Bajaj Auto Limited

2 Literature Review

In the literature, three types of exposures under floating exchange rate regimes are identified; economic, translation and transaction Translation and transaction exposures are accounting based and defined in terms of the book values of assets and liabilities denominated in foreign currency Economic exposure is the sensitivity of company value to exchange rate movements At the corporate level, changes in exchange rates affect the firm value, because future cash flows of the firm will change with exchange rate fluctuations In other words, exchange rate changes have important implications for financial decision-making and for firm profitability Adler and Dumas (1984) show that even firms whose entire operations are domestic may be affected by exchange rates, if their input and output prices are influenced by currency movements

It is widely believed that changing exchange rates affect the competitiveness of firms engaged in international competition A falling home currency promotes the competitiveness of firms in home country by allowing them to undercut prices charged for goods manufactured abroad (Luehrman, 1991) In economic analysis it is suggested that firm value is related to exchange rate movements Shapiro (1975) predicted an increase in the value of home country firm with a depreciation of home country currency Adler and Dumas (1984) stated that even firms, which operate in domestic markets, might be affected by exchange rate movements Luetherman (1991) tested the hypothesis that an exogenous real home currency depreciation enhance the competitiveness of home country manufacturers vis -a -vis foreign competitor His finding did not support that hypothesis Firms did not benefit from a depreciation of the home country On the contrary a significant decline in their market share of industry was found in a depreciation of the home currency

Bodner and Gentry (1993) examined industry level exposures for three countries, Canada, Japan and USA They revealed that some industries in all three countries had significant exposure Choi and Prasad 1995 developed a model and examined the exchange rate sensitivity of 409 US multinational firms Their findings indicated that change in exchange rate affected firm value They found that 60 percent of firms had significant exchange rate exposure Domely and Sheehy (1996) found contemporaneous relation between the foreign exchange rate and the market value

of large exporters in their study

Miller & Reuer (1998) conducted a study on the implications of differences in strategy and industry structure for firms‟ economic exposures to foreign exchange rate movements According to their results, 13-17 % of US manufacturing firms exposed for foreign exchange rate movements Also they indicated that foreign direct investment reduces economic exposure

to foreign exhange rate movements Glaum, Brunner and Himmet (2000) examined the economic exposure of German corporations to change in DM/US dollar exchange rate They found that German firms are significantly exposed to changes in DM/US dollar rate Several studies focused

on the some companies and they demonstrated that exporter firms‟ stock values are more sensitive to change in foreign exchange rates (Mao and Kao, 1990; Bortov and Bodnar, 1992)

In the most of the studies foreign exchange exposure was measured by regression analysis by using stock returns Adler and Simon (1986) measured economic exposure as the slope of stock return on exchange rate change Jorion‟s (1990) model was established by adding the return of the market to control for market movements As Jorion, Booth and Rotenberg (1990) and Bodnar and Gentry (1993) examined economic exposure with market return, Miller and Reuner (2000) estimated economic exposure by multivariate modeling approach They applied three-currency model, also add some specified macroeconomic variables such overall stock market return and

interest rates Flanney and James (1984) and Sweeney and Warga (1986) also used interest rates

in their models Doneely and Sheehy (1996) formed a porfolio with 39 companies, and examined the relationship between abnormal return on exporting firms‟ portfolio and return on sterling Khoo (1994) estimated mining companies‟ economic exposure by using exchange rates, interest rates and price of oil

3 Risk Management Policy at Bajaj Auto Limited

The Exports of BAL, presently constituting substantial portion of the turnover, are at prices predetermined for each product in each region These prices are fixed in USD based on an assumed USD/INR rate (Budgeted rate of realization) Exports are then affected at such price and hence it is desirable for the company to shield itself from adverse movements in forex rates

at a future date The Company also imports raw materials and components for its Motorcycles etc However, the value of such imports is not material as compared to the value of exports Nevertheless, the company may wish to secure its procurement prices in terms of INR to be able

to forecast its pricing and profitability Consequently the company may wish to hedge such exposures, future and current, to achieve the aforesaid objective The exchange rate between the Indian rupee and foreign currencies has changed substantially in recent periods and may continue to fluctuate substantially in the future Consequently, the Company uses derivative financial instruments, such as foreign exchange forward and option contracts, to mitigate the risk of changes in foreign currency exchange rates in respect of its forecasted cash flows and trade receivables Counter-party risk encompasses settlement risk on foreign currency derivative contracts Exposure to these risks is closely monitored and kept within predetermined parameters The Company does not expect any losses from non-performance by these counter-parties The Company‟s policy is to transact with credit worthy banks, which are reviewed on an

on-going basis Bajaj Auto Limited is using highest safety investment grade (55 per cent) and high safety investment grade (45 percent) foreign exchange forward contract to hedge its Foreign exchange risk

4 Foreign Exchange Exposure of BAL

The Bajaj Auto Ltd was found to be exposed to currency fluctuations because of the following factors:

1 Import of raw material

2 Export to African, Middle-Eastern, South Asian countries

3 Subsidiary present in Netherlands and Thailand

Shown below are the expenditures as well as earnings in the foreign currency for the company; these are divided into the following:

A Import of raw materials (exposure to COGS, cost exposure)

B Earnings from the exports (revenue exposure)

C Expenditure other than raw material (operating cash flow and net cash flow exposure)

D Foreign borrowings (equity exposure and hedging)

Table 1: C.I.F Value of Imports, Earnings and Expenditure in Foreign Currencies:

(i) Raw materials:

Converted in Equivalent USD at closing

rate of 31 March

Earnings in Foreign Currencies:

(i) F.O.B Value of exports 4551.75 (USD 974.6 M) 3245.75 (USD 681.7 M) (ii) F.O.B Value of Exports-goods

Expenditures in foreign currencies:

(iii) Technical Consultancy, net of

tax

(vii) Advertising & Publicity 26.21 6.92

(ix) Capital expenditure at overseas

Short term loan from a bank in

foreign currency as packing

credit facility against exports

The underlined part shows the foreign borrowing of the firm

4 Research Methodology:

Foreign exchange operating exposure, or FX operating exposure, is the long-term FX exposure

of a firm‟s anticipated operating profit stream (or operating cash flow stream) The main components of FX operating exposure are FX revenue exposure and FX cost exposure FX revenue exposure is the elasticity of a firm‟s anticipated revenue to FX changes, viewed from the perspective of the firm‟s base currency Here, for Bajaj Auto Limited the base currency is Indian Rupee, and for all the foreign transactions, US dollar has been assumed as foreign currency, as BAL is pricing its exports in US dollar only FX cost exposure is the elasticity of a firm‟s anticipated costs to FX changes If RRs. represents the level of a firm‟s revenues measured in base currency i.e Indian rupee, Bajaj Auto‟s FX revenue exposure to US dollar would be denoted by

Similarly, we define FX cost exposure and FX operating Cash Flow exposure as follows:

FX Cost Exposure of BAL Ę Rs. C$ = %∆ C Rs. /x Rs./$ -(2)