Hedging and effectiveness of Indian currency futures market
| DOI | https://doi.org/10.1108/JABS-10-2018-0279 |
| Pages | 581-597 |
| Published date | 24 February 2020 |
| Date | 24 February 2020 |
| Author | Varuna Kharbanda,Archana Singh |
| Subject Matter | International business,Strategy |
Hedging and effectiveness of Indian
currency futures market
Varuna Kharbanda and Archana Singh
Abstract
Purpose –The purposeof this paper is to measure the effectiveness of the hedgingwith futures currency
contracts. Measuringthe effectiveness of hedging has become mandatory for Indiancompanies as the
new Indian accounting standards, Ind-AS, specify that the effectiveness of hedges taken by the
companies should be evaluated using quantitative methods but leaves it to the company to choose a
methodof evaluation.
Design/methodology/approach –The papercompares three models for evaluatingthe effectiveness of
hedge –ordinary least square (OLS), vector error correction model (VECM) and dynamic conditional
correlation multivariate GARCH (DCC-MGARCH) model. The OLS and VECM are the static models,
whereasDCC-MGARCH is a dynamic model.
Findings –The overall resultsof the study show that dynamic model (DCC-MGARCH) is a bettermodel
for calculatingthe hedge effectiveness asit outperforms OLS and VECM models.
Practical implications –The new Indian accounting standards (Ind-AS) mandates the calculation of
hedge effectiveness. The results of this study are useful for the treasurers in identifying appropriate
method for evaluation of hedgeeffectiveness. Similarly, policymakers and auditorsare benefitted as the
study providesclarity on different methodsof evaluation of hedging effectiveness.
Originality/value –Many previous studies haveevaluated the efficiency of the Indian currency futures
market, but with risingimportance of hedging in the Indian companies, ReserveBank of India’s initiatives
and encouragement for the use of futures for hedging the currency risk and now the mandatory
accounting requirementfor measuring hedging effectiveness, it has becomemore relevant to evaluate
the effectiveness of hedge. To the authors’ best knowledge, this is one of the first few papers which
evaluatethe effectiveness of the currency future hedging.
Keywords Futures, Foreign exchange (FX), Constant hedge ratio, Dynamic hedge ratio,
Hedging effectiveness
Paper type Research paper
1. Introduction
Currency hedging involves taking a position in the derivatives market which protects a
company’s finances from any unfavorable exchange rate movement. Companies determine
their forex exposure and adopt various hedging strategies using different derivatives
instruments to contain this risk. As per the International Accounting Standards (IAS), a
hedge would be called as effective if the extent to which changes in the cash flow of the
hedging instrument offset changes in the cash flow of the hedged item. Company
treasurers should, therefore, adopt such a hedging strategy which would be effective in
reducing the exchange rate exposure.
The Indian companies are facing increasing currency exposure. Indian currency too has
undergone a lot of fluctuations over the years against major currencies of the world. This is
depicted in Figure I, which indicates the movement of the four currencies –United States
Dollar (US$), Great Britain Pound (GBP), EURO and Japanese Yen (JPY) against Indian
Rupee (INR). This movement could be attributed to the unsustainable fiscal deficit, volatile
Varuna Kharbanda and
Archana Singh are both
based at the Delhi School
of Management, Delhi
Technological University,
Delhi, India.
Received 16 October 2018
Revised 3 July 2019
21 November 2019
Accepted 23 January 2020
DOI 10.1108/JABS-10-2018-0279 VOL. 14 NO. 5 2020, pp. 581-597, ©Emerald Publishing Limited, ISSN 1558-7894 jJOURNAL OF ASIA BUSINESS STUDIES jPAGE 581
foreign direct investment (FDI) and foreign institutional investors (FII) flows and high trade
deficit. The Reserve Bank of India (RBI) insisted in its Financial Stability Report 2012 that
excessive volatility inthe exchange rate makes it difficult to take optimal businessdecisions,
and therefore, the companies are required to understand, measure and manage the
currency risk embedded in the business using appropriate derivative instruments
(Figure 1).
RBI is taking measures to strengthen the Indian foreign exchange market. In 2015, RBI
announced exchange cross-currency futures contracts and options for hedging the forex
exposure. Then a year later, RBI clarified hedging of the external commercial borrowings
(ECB’s), and set guidelines for the foreign companies for hedging their forex exposure. In
March 2017, RBI granted operational flexibility to the MNCs exposed to forex risk in India.
RBI further simplified hedging for the resident entities and permitted them to operate in the
foreign derivative marketwith the authorized banks.
Along with making these changes, RBI, along with Institute of Chartered Accountants of
India (ICAI), provided new accounting standards known as Ind-AS which became
mandatory for the firms to follow from the financial year 2016-2017. These guidelines are in
line with the international standards for accounting and mandates that the hedging
effectiveness test should be carried out as soon as a company takes a hedging position
which should then be periodicallyreviewed. The policymakers rationalized that only takinga
cover for the exposure was not a solution to the risk management but regular check on the
effectiveness of the hedging strategy was required for proper risk management. These new
standards specify that the effectiveness should be evaluated using qualitative and
quantitative methods but leaves it to the company to choose the quantitative method
consistent with their risk managementpolicies.
RBI has made various policy changes for the hedging of the currency risk; it, therefore,
becomes relevant to study the currency hedging in the present scenario. Moreover, as per
the new accounting standards, the corporates must ensure that their hedge is effective. In
the absence of a defined quantitative method of measuring hedgeeffectiveness, it is vital to
identify an effective method for measuring this. Finally, with the increasing popularity of the
Figure 1 Currency fluctuation
PAGE 582 jJOURNAL OF ASIA BUSINESS STUDIES jVOL. 14 NO. 5 2020
To continue reading
Request your trial