Corporate Hedging for Foreign Exchange Risk in India

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation. Corporate struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivatives-foreign currency, interest rate, and commodity derivatives emerged as means of managing risks.

In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only. This paper attempts to evaluate the various alternatives available to the Indian corporate for hedging financial risks. This study aims to provide a perspective on managing the risk that firm's face due to fluctuating exchange rates. It investigates the prudence in investing resources towards the purpose of hedging. By studying the use of hedging instruments by major Indian firms from different sectors, the paper concludes that forwards and options are preferred as short term hedging instruments while swaps are preferred as long term hedging instruments. The high usage of forward contracts by Indian firms as compared to firms in other markets underscores the need for rupee futures in India. In addition, the paper also looks at the necessity of managing foreign currency risks, and looks at ways by which it is accomplished.