Foreign exchange risk management and equ

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 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 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 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 counterparties 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 Foreign Exchange Exposure of BAL The Bajaj Auto Ltd was found to be exposed to currency fluctuations because of the following factors: Import of raw material Export to African, Middle-Eastern, South Asian countries 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: C.I.F Value of Imports (i) Raw materials: Steel and Non-Ferrous Material Components Sub Total (ii) (iii) (iv) (v) Machinery Spares Capital Goods Stores, Tools etc Total 2011 2010 (Rs in Crores) 109.27 405.40 514.67 34.17 245.61 279.78 6.83 37.78 5.25 564.53 5.14 32.11 2.47 319.50 Converted in Equivalent USD at closing rate of 31 March Earnings in Foreign Currencies: (i) F.O.B Value of exports (ii) F.O.B Value of Exports-goods traded in (iii) Forwarding Charges exports recovered (iv) Interest (v) Royalty (vi) Technical Know how (vii) Asset Disposal (viii) Others Expenditures in foreign currencies: (i) Travelling expenses (ii) Royalty, net of tax (iii) Technical Consultancy, net of tax (iv) Interest (v) R&D expenditure (vi) Consultancy charges (vii) Advertising & Publicity (viii) Other matters (ix) Capital expenditure at overseas offices (x) Investment in shares of PT Bajaj Indonesia (xi) Investment in shares of BAIH BV 127 71 4551.75 (USD 974.6 M) Nil 3245.75 (USD 681.7 M) 0.07 (USD 13946) 8.77 17.97 1.40 0.59 Nil 0.12 2.15 3.33 0.74 Nil Nil 1.09 3.71 2.36 5.29 4.00 3.75 6.81 1.38 0.45 1.93 26.21 28.56 Nil 0.55 0.12 2.30 6.92 34.92 Nil Nil 81.14 210.08 1.60 Table 2: Foreign Borrowings: 2011 2010 (Rs in Crores) Secured loans: Cash credit 23.53 Unsecured loans: Sales tax deferral 167.30 Liability/Loan Fixed Deposits, unclaimed 0.01 Short term loan from a bank in 134.31 foreign currency as packing credit facility against exports Total 325.15 The underlined part shows the foreign borrowing of the firm 10 12.98 1325.58 0.02 Nil 1338.58 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 ĘRs.R$ and would be computed as percentage change in rupee revenue divided by percentage change in FX value of US dollar with respect to Indian rupee FX Revenue Exposure of BAL ĘRs.R$ = %∆ RRs./xRs./$ -(1) Where, xRs /$ = (X1Rs./$ - X0Rs./$)/ X0Rs./$ Similarly, we define FX cost exposure and FX operating Cash Flow exposure as follows: FX Cost Exposure of BAL ĘRs.C$ = %∆ CRs./xRs./$ -(2) Where, xRs /$ = (X1Rs /$ - X0Rs./$)/ X0Rs /$ FX Operating Exposure of BAL ĘRs.O$ = %∆ ORs./xRs./$ - (3) Where, xRs /$ = (X1Rs /$ - X0Rs./$)/ X0Rs /$ If a firm‟s revenues remain stable with respect to change in FX value of the foreign currency, then its FX Revenue exposure to that currency would be zero If firm‟s FX revenue exposure comes out to be then it is known as FX conversion exposure, here firm‟s revenues fluctuate in the same direction and magnitude as change in the FX value of foreign currency Firms typically 11 experience changes in selling price and sales volume when FX rates change The influence of FX rate changes on a product‟s local currency selling price is referred to as FX pass-through A 100 per cent stability of firm‟s local currency prices, it means the firm can fully transfer the effect of any adverse FX movement to the customers in foreign market If there is zero per cent stability of firm‟s local currency prices, then firm has to bear entire risk of any adverse movement of FX movement Bajaj Auto Limited A firm‟s cost exposure often depends on the international locations of its own operations and those of its suppliers and potential suppliers If Bajaj Auto imports raw materials whose cost is stable in Indian rupee then its FX cost exposure would be zero, however if Bajaj Auto import raw material whose cost is fixed in terms of US dollar then its FX cost exposure to dollar would be FX operating of any firm depends upon its FX revenue exposure and FX cost exposure A positive FX operating exposure means that firm‟s operating cash flows will move in the direction of FX value of the exposure foreign currency A negative FX operating exposure conveys negative relation between firm‟s operating cash flows and FX value of exposure foreign currency Generally an exporting firm has positive FX operating exposure and an importing firm has negative FX operating exposure When we deduct the amount of foreign currency loan taken by the firm from its operating cash flows, result is net operating cash flows of the firm Change in net operating cash flows along with FX value of foreign currency is known as FX net cash flow exposure Foreign currency debt work as hedging for firm having positive FX operating exposure However, for a firm having negative FX operating exposure, foreign currency debt proves to be counterproductive, as it will make FX net cash flow and FX equity exposure more negative Bajaj Auto Limited having significant revenues coming in foreign currency i.e., US dollar, 12 should have positive FX operating exposure, and any loan taken by the company in US dollar should work as hedging against FX fluctuations of US dollar Thus US dollar loan should be highly useful for Bajaj Auto Limited to reduce its FX net cash flow exposure and FX equity exposure A firm‟s FX equity exposure is defined to be the elasticity of the firm‟s intrinsic stock value to FX changes, viewed from the perspective of the firm‟s base currency Subscript “S” has been used for “stock” in the FX equity exposure notation Thus for Bajaj Auto Limited whose base currency is Indian rupee, its FX equity exposure to US dollar is denoted Ę RsS$ and is computed as %∆ SRs./xRs./$ Three elements determine a firm‟s FX equity exposure to a currency: (1) the firm‟s FX operating exposure, (2) the financial leverage, (3) the relative amount of debt denominated in FX operating exposure currency If DRs$ denote the value, measured in Indian rupee, of the firm‟s dollar denominated debt, DRs denote the value of all the firm‟s debt, measured in Indian rupees regardless of currency denomination The relationship for FX equity exposure as a function of FX operating exposure and capital structure is shown as: ĘRsS$ = ĘRsO$ - DRs$/VRs 1- DRs/VR.s -(4) Making DRs$/VRs equals to ĘRsO$, in the above equation will make firm‟s FX equity exposure as zero DRs$/VRs is shows hedging effect, and DRs/VR.s shows leveraging effect Any firm having small FX operating exposure can completely eliminate its FX equity exposure by using foreign currency debt, however, for a firms having large positive FX operating exposure and negative FX operating exposure, leveraging effect will surpass the hedging effect of foreign 13 currency loan, and firm had to explore other options of hedging like use of financial derivatives such as forward contracts, options and currency swaps A firm can also estimate its FX equity exposure with actual stock returns This would assume implicitly that stock prices reflect intrinsic stock values How sensitive actual stock prices changes are to FX changes depends on whether investors recognize how FX changes affect the intrinsic value of the firm‟s equity Present paper has 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 The following methodology has been used in calculating the time lag: Use regression to analyze the relation between changes in the equity value and the forex rates Consider changes in the forex value as independent and changes in the equity value as dependent on changes of forex value Regress equity value of last ten dates with forex changes x days ago, where x is the time lag Model Used: %change in MPS= Beta0 (Intercept) + Beta1 (%change in forex rates) Result and Analysis FX revenue exposure, FX cost exposure, FX operating exposure, and FX net cash flow exposure are calculated for Bajaj Auto Limited using financial data of the firm for years 2010 and 2011 along change in the FX value of US dollar for the same period For calculating empirical value of BAL‟s equity exposure to FX changes, time Lag has been taken as the period 14 which the equity of the company takes in order to respond to the changes in the foreign exchange rates according to the equity exposure of the firm Table 3.FX Revenue, FX Cost, FX Operating Cash flow, and FX Net Cash flow exposure of BAL: (Revenues and Costs are in Rs Crore) Change in FX rate Year 2010 Year 2011 Change % Change in Revenue FX Exposure Revenue Exposure Cost Exposure Operating Exposure 20 17,860.49 18,278.93 418.44 0.023428 0.117141 0.2 12,073.38 12,125.13 51.75 0.004286 0.021431 0.2 3523.78 3788.81 265.03 0.075212 0.37606 Net Cash Flow Exposure 0.2 3,521.39 3,786.42 265.03 0.075263 0.376315 Table.3 shows the calculation for FX Revenue Exposure, FX Cost Exposure, FX Operating Cash flow Exposure and FX Net Cash flow Exposure for the year 2010-2011 FX Revenue Exposure of 0.117141 shows that for every one percent change in the value of foreign currency (US dollar) the revenue of BAL will increase by 0.117 percent FX Cost of exposure of 0.021431 shows that for every one percent change in value of US dollar BAL‟s cost will increase by 0.02143 per cent FX revenue exposure of 0.117141 for the firm is higher than its FX cost exposure of 0.0214 However, both FX revenue and FX cost exposure of the company are not very significant The reason can be explained by the fact that even after a significant change in the value of foreign currency i.e., US dollar, the revenue of Bajaj Auto Limited has not changed significantly During 2010-11 US dollar has appreciated against BAL‟s base currency Indian rupee by approximately 20 per cent This fact also highlight one of the limitation of the study that it is not able to capture the effect of FX value change of US dollar with respect to the local currencies of the BAL‟s export markets like African countries If there is an appreciation in US dollar (the pricing currency of BAL) against the local currencies of the export market, there would be a decline in 15 the demand for the products priced in US dollar In case of a depreciation of US dollar against local currencies, the demand for BAL products will increase This exposure is known as FX economic exposure Due to unavailability of local currency data, study is not able to capture the FX economic exposure FX Operating Cash flow exposure and FX net cash flow exposure for BAL are 0.37606 and 0.376315 respectively An exposure of 0.376 shows that for every one percent change in foreign currency (US dollar), BAL‟s operating cash flow and net cash flow will increase by 0.376 percent Given the 20 percent change in the value of US dollar for year 2010-2011, FX operating and FX net cash flow exposure 0.376 has resulted in a significant change of 7.52 per cent in operating and net cash flow for BAL A very low difference of (0.000255) between FX Operating Exposure and FX Net Cash flow exposure shows that BAL is not using foreign currency debt very effectively to reduce the FX NCF exposure Table FX Equity Exposure of BAL: Current Share Price as of 31st March 2011 Number of outstanding Shares Market Value of Equity Book Value of Debt Value of Firm (Debt + Equity) Debt/Value Foreign currency debt value Foreign Debt/Value of Firm FX operating exposure (as calculated in table 6) FX Equity Exposure Rs 1460 289.37 Cr Rs 422480.2 Cr Rs 347.45 Cr 422827.7 0.000822 134.31 0.000318 0.38 0.37995 Table shows calculation of FX equity exposure of BAL The above calculation has been done using the formula: Equity Exposure= (Operating exposure - Debtforeigncurrency/Valuef)/ (1 – Debttotal/Valuef) 16 Since the company is using very low debt (Rs.347.45 Cr) in the capital structure and value of foreign debt is even lower at Rs 134.31 Cr, both leveraging ratio that is Debt/Value and hedging ratio Foreign Debt/Value is insignificant Due to very low leveraging and hedging ratios, there is no much difference between FX equity exposure and FX operating exposure of BAL result also indicate that the firm is not using foreign currency debt appropriately to hedge against the FX fluctuations Table Empirical Estimation of FX Equity Exposure with 20 days time lag: Table.5 provides empirical estimation of BAL‟s stock price exposure with FX value of exposure currency i.e., US dollar with a time lag of 20 Days The study has calculated regression based FX equity exposure for 10 days, 20 days, 40 days, 60 days and 90 days The closest beta in the regression to the priory calculated (refer Table 5) 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 The supporting results for the regression models are given in tables above along with the beta figures which have been highlighted 17 Conclusion: The company has very low FX revenue and FX cost exposure against US dollar It uses hedging tools like forward contracts and range forward contracts in order to protect its exposure to forex changes in the value of the raw material input The firm also has low and manageable FX operating exposure of 0.38 There is insignificant difference between BAL‟s FX operating exposure and its FX equity exposures, which is due to very low level of leveraging and also extremely low value of foreign currency debt in its capital structure The firm is relatively less exposed to the forex movements but still has taken precautionary measure If BAL focuses on managing its Net cash flow exposure, use foreign 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