Case study- Derivatives and risk management:

Ram Hosiery is a manufacturer and exporter of undergarments and T-shirts. Its manufacturing facilities are located in Tiruppur, Tamil Nadu. Its operations were started in the year 2006, and in the past three years, its sales have increased from INR 8 million to INR 12 billion. Of this, 20% of the sales are from Europe and 60% of the sales are from the USA. The other 20% are from Asian countries. The European customers are invoiced in euros, while the customers in the USA and Asia are invoiced in U.S. dollars. Since 80% of the total sales are invoiced in U.S. dollars, Mr Hari, the Chief Executive Officer of Ram Hosiery, is concerned about the movement of the Indian rupee against the U.S. dollar. His assistant has looked at the exchange rate between the U.S. dollar and the Indian rupee for the period from September 2008 to February 2009 and found that it has been highly volatile. The exchange rate movements are shown in Fig. 1. Mr Hari is aware that the exchange rate has been fluctuating, and he needs to have an estimate of his revenue in rupees when he receives it in U.S. dollars. This will aid him in preparing his cash flow statement and also help him to finance his short-term needs. He has heard about the forward contracts that he can enter into with banks. He is also aware that currency futures have been introduced in Indian exchanges. However, he is not sure about the procedure that is to be followed. Discussion Questions 1. Should he hedge with forwards or futures? Or should he just leave the exposure unhedged? 2. Mr Hari approaches you for guidance. Explain to him the best course of action for him by considering the exchange rate variability.