Hedging currency risk at TT Textile Case Solution
Is this Hedge:
The swap arrangement could be classified as hedge because it has met all the characteristics of derivative instruments and hedging. Hedging can be done by using the derivative instruments; a derivative instrument has three main characteristics, which are listed below:
- The derivative instrument does not have its own price rather its prices are derived from another underlying financial instrument.
- Initial investment is very low or in some cases it is zero.
- It will be settled at a later date.
The instrument used by TT Textile and ABC Bank is a derivative instrument as it has met all the three criteria of derivative instruments. There is no initial investment in the swap arrangement as no party will have to pay or receive any amount at the start of the contract. Furthermore, there is no value of currency swap as the value of the swap is based on the CHF/USD spot rate. Lastly, the swap will be settled three years after the start of the swap, which fulfills the last condition of the swap.
However, by fulfilling the conditions of the derivative it cannot be said that the derivative instrument is for hedging purpose because the derivative instrument is used for speculation purpose as well. The derivative instrument can also be classified for hedging if it is used for the purpose of risk minimization, if the financial instrument is used for return maximization then it will be classified as speculation.
It can be said,that the management of TT Textile have used currency swap to reduce the currency exposure that is being faced by the company. The foreign currency (forex) risk faced by TT Textile would be reduced and minimized by the currency swap, as the receipt in USD would be protected from adverse changes in the exchange rates.
What should Sanjay Jain do?
The currency swap arrangement in which the TT Textile has entered can be profitable for the company and it can have adverse impacts on the profitability of the company. The swap arrangement gives Mr. Jain both the options he can terminate the currency swap arrangement or he can maintain his current position, which means that the payments will be made and received at the end of the life of swap arrangement.
The currency swaps seems to have favorable impacts on the profitability of TT Textile in the initial periods because of the anticipated good performance of CHF to USD, and general economic environment of the world is favorable for business. However, due to the great financial recession that affected the economic environment of almost all parts of the world has caused great negative implications on the value of all the currencies.
Because of this financial distress, the value of INR and CHF deteriorates drastically and the CHF falls below to 1.04, as a result of this depreciation in the value of Swiss Franc, the TT Textile will have to incur significant mark to market losses. However, the value of Swiss Franc will rise substantially in very quick time which gives Mr. Jain some sort of confidence. Mr. Jain is considering terminating the swap arrangement now, if he terminates the swap arrangement now the TT Textile will receive approximately INR nine-nineteen million more than the expected receipt.
However, if the value of CHF will increase further and the swap will not be terminated TT Textile could receive even more than this amount. However, if the value deteriorates and goes below to 1.04, TT Textile will have to pay INR fifty five-Sixty three million more than the expected payments if the contract does not end until maturity.
It is recommended that Mr. Jain should terminate the currency swap arrangement immediately, as the purpose of the hedging arrangement is to minimize the risk, it can be argued that the risk has been hedged and the purpose of hedging has been accomplished. On the other hand, the swap arrangement can have very adverse consequences on the profitability if the value of CHF deteriorates, which makes it very beneficial for TT Textile to terminate the swap arrangement now……………………
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