Management Motivations for Use of Foreign Currency Derivatives in India
IIML Working Paper No. 2007-08/8
Posted: 27 Jun 2007 Last revised: 25 Sep 2008
The paper examines management motivations of foreign currency derivatives usage in corporate India and identifies significant differences, if any, in the motivations of the firms who are either using foreign currency derivatives or having a documented foreign exchange risk management policy vis-¿-vis the firms who do not. It also captures the management motivations of foreign currency derivatives usage in a factor-analytic framework.
The universe of companies selected for this study consisted of 640 companies, which are common across two most widely used Indian stock market indices namely S&P CNX 500 and BSE 500 firms as at the end of March 31, 2004 having foreign exchange exposure, which is a fair representation of corporate India. A nationwide questionnaire-based survey was conducted to capture the management motivations of foreign currency derivatives usage. 55 responses were received leading to a response rate of 8.59%.
The most of the respondent firms (70.4%) have documented foreign exchange risk management plan/policy/programme. The transaction exposure as a foreign currency risk is more critical to the firms (74.5%) followed by translation exposure (58.3% responded as moderate degree of risk) and economic exposure (54.3% responded as low degree of risk). To reduce the volatility in profits after tax, cash flows, and to reduce the cost of capital and thus increase the value of the firm on one side of the pole and to reduce the risks faced by the management on the other side of the pole are the major motivations of the firms using foreign currency derivatives in India. The firms with high debt ratio are more likely to use foreign currency derivatives. The major objective of using derivatives is hedging the risk (96.1% responded as rank one objective), for arbitrage purpose (55.3% assigned rank two) and price discovery (36.4% assigned rank two and 33.3% assigned rank three). The speculation as objective of using foreign currency derivative is the least preferred option (62.1% assigned it as rank four).
The management motivations for the use of foreign currency derivatives captured in factor-analytic framework are 'hedging to improve value of firm', 'management utility and compensation', 'accounting and disclosure requirements', 'strengthen control systems', and 'avail tax benefits and reduce cost of capital'. The firm characteristics such as high degree of debt ratio and ESOPs usage influence the use of foreign currency derivatives. These seven factors explain 59.28% of the total variance.
Keywords: Risk Management and shareholder value, derivatives use, currency derivatives
JEL Classification: F30, F31, G32
Suggested Citation: Suggested Citation