Hedging Strategy for Indian IT

Gopi Suvanam and Amit Trivedi

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Hedging Strategy for Indian IT Topic

Introduction Why Hedge? Exposure For-ex risk management v/s Directional bias Advantages of using derivatives Common myths about hedging Risk management framework Degree of hedging Optimal Hedge Ratio For-ex Risk management in TCS, Infosys and Wipro Exporters v/s Importers Hedging strategies/ Instruments Forwards Swaps Options

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Introduction
India is referred to as the back office of the world owing mainly to IT and ITes Sector. The revenue of the information technology sector has grown from 1.2 per cent of the gross domestic product (GDP) in 1997-98 to an estimated 5.8 per cent in 2008-09. Today, Indian IT companies have carved a great niche for themselves in the global market and are known for their IT prowess. Global giants are using the successful outsourcing strategy and keeping ahead of their rivals - thanks to the competitive advantage gained by investing in India. In these changing scenarios, it becomes important for IT companies to conquer the numerous extraneous threats to bottom line. Indian Rupee has seen unprecedented swings in its value since 2007. The recent macroeconomic developments in the US are now having their effects on the Indian market as well. Thus, IT Company today needs a risk management framework which not only considers the current risk profile of the company but also incorporates potential future threats. This paper discusses hedging and other risk management strategies for Indian IT companies and also proposes a template for For-ex risk management for big/small IT firms.

Why Hedge?
Over 66% of revenue for most Indian IT firms comes from foreign clients (i.e. via exports). The transactions are usually quoted/executed in foreign currency denominations. Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures.

Indias IT

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Exposure
Exposure is contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. Types of exposures: Accounting exposure Reconciliation of financial statements of a foreign subsidiary with its parent company. Includes translational risk. Economic exposure Unexpected changes in foreign currency affecting bottom line and stock prices. Also affect asset valuation (of CDs, A/P, A/R) and hence overall balance sheet. This is called balance sheet exposure. Transaction exposure results from fixed price contracting in an atmosphere of exchange rate volatility. Operating exposure Changes in present value of firm result

Other potential exposures could be in the form of wage inflations, foreign Currency Cash Flows/ Schedules, variability of Cash flows - how certain are the amounts and/ or value dates?, Inflow-Outflow Mismatches / Gaps, time mismatches / gaps, currency portfolio mix, floating / fixed Interest Rate ratio.

For-ex risk management v/s Directional bias

For-ex risk management provides a better alternative to taking a 100% view based position because foreign exchange markets are weak form efficient. This means that successive changes in currency prices cannot be predicted using only historical data. Moreover, these markets run round the clock, their reaction time is very short and the news arrives randomly. Hence, employing resources to predict currency direction is not a feasible strategy.

Advantages of using derivatives

Derivatives contracts have lower margin requirements as compared to cash transaction. Hence, a small premium can absorb a lot of risk. Variety of pay-off profiles can be generated using simple instruments, which facilitates designing of hedges that best suit a companys need. Futures and options contracts are exchange mediated hence there is no counter-party risk. Moreover, since near month liquidities are good, exit strategy is also very easy.

Common myths about hedging

Hedging instruments are considered to be speculative in nature; however, the exact opposite is true. Hedging is done with the purpose of reducing volatility in income and not to make Page 3

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profits. Most people assume that hedging strategies are complex and beyond the reach of small organizations. On the contrary, hedging instruments are very simple to understand and their pay-off is completely predictable. Provision for hedging via margin payment makes them affordable for all firm sizes. Firms assume shareholders value will not increase due to hedging however it has been statistically proven that hedging reduces volatility in income which in turn sends a strong positive signal amongst the investors.

Risk management framework

We have devised a risk management framework which we feel best applies in the Indian IT perspective. Forecast

Risk-Estimation

Benchmarking

Hedging

Stop Loss

Reporting and review

Risk Management Framework

Forecast After determining exposure, forecast market trend for currency movement. The time horizon of the forecast ideally is one to two business cycles. Since we are hedging net foreign currency exposure, out forecast focuses on 1) Foreign revenue and 2) Expenditure in foreign currency. While (2) is fairly predictable (and can be adjusted for scale), foreign revenue inflow is predicted from analysis of contract specified currency rates, exchange

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fluctuations, competitor dynamics and company targets. Balance sheet and Income statement serve as the starting point of most stand-alone forecasts. Risk estimation - Based on the forecast a measure of Value at Risk (VaR) and probability of this risk is ascertained. This includes market-specific problems like liquidity and system specific problems like reporting gaps. Risk estimation also includes some basic assumptions like mean-reversion of interest rates and sustained correlation between benchmarks and variables etc. Benchmarking Deciding whether to manage on a cost-center or profit-center basis. Hedging Post benchmarking, we decide the appropriate hedging strategy based on the company specific requirements. Choice of hedging instrument (discussed later) is based on the hedging strategy (long/short/neutral/time-adjusted) and time frame under consideration. We have performed research on movement trends and correlations between various currencies vis--vis Indian Rupee, Nifty, Gold etc. These correlation trends help us zero down on the appropriate hedging instrument. For example, a sample correlation matrix between some securities, nifty and currencies is shown below.

Furthermore, extensive correlation analysis between currencies and other parameter is performed. For example, $/Nifty as shown below:-

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Bases on a mix of analysis like these, a suitable hedging instrument is chosen. The view/direction choice is taken after due diligence and client involvement. Note: Hedging itself can be classified as internal hedging (through sourcing, exposure netting, leading lagging etc.) and external hedging (using derivative instruments). Our proprietary methods concentrate on the latter. Stop loss A monitoring system triggers rescue trades. Reporting and review Reports include P&L (on mark to market basis), profitability vis--vis benchmarks and changes in overall exposure. Review of our performance against benchmarks and loss reductions achieved compared to a no-hedge scenario.

Degree of Hedging
Firm size Larger firms have economies of scale and more credit-worthiness thus lesser cost of hedging. (value of firm being measured by book value) Leverage Higher leveraged firms have greater incentive for hedging. Liquidity and profitability High liquidity implies lesser exposure (liquidity being measures by quick ratio and profitability by EBIT/Book assets) Sales growth Hedging reduces the probability of having to rely on external financing thus high sales growth firms should hedge to enjoy uninterrupted growth.

Optimal Hedge Ratio

The purpose of hedging is not to make profits but to reduce volatility in income alternatively, to cut down on potential losses. Assume two competitors A & B who are both exporters of IT services. A completely hedges its current revenue from Rupee upside by buying ITM rupee calls. B on the other hand does not hedge anything. Suppose the rupee goes down, while both A & B benefit due to downfall of domestic currency, A loses the premium that it paid to purchase options. As a result, to sell at competitive prices, A will have to fight on margins. In any case, bottom line of A will take a hit. Thus 100% hedging is not a recommended strategy for all firms. The optimal hedge ratio for any company is based on: P&L expectations and factors affecting it. Growth target set by management. Asset conservation requirements.

A sample P&L simulation below depicts the effect of hedging on the companys P&L using various hedge ratios. This simulation assumes various possible scenarios for the business P&L in view of an underlying asset. An appropriate hedge instrument in chosen based on

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aforementioned parameters. Price of the hedge instrument (and resulting m2m2 positions) are mapped with the changing price of the underlying. It is observable the variability in observed earning is least in an optimal hedging scenario. Thus, we emphasize on an optimal hedge as compared to total hedge.

Biz PnL
Probability

Net with optimal hedge Net with total hedge

PnL

250,000 200,000 150,000 100,000 50,000 Imm Month

Net PnL

Net Biz PnL Hedge PnL

First Month

Second Month

For-ex Risk management in TCS, Infosys and Wipro

TCS TCS gets over 90% of its total revenue from exports. Major exposures exists in the $/INR domains. Its net exposure in (all) foreign currency was Rs. 13953 cr for FY 09. TCS favors the

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use of options as a hedging instrument and has currently deployed Rs. 7203 cr worth of short and long terms hedges. Thus it has hedged approximately 51.63% of its total exposure.

Infosys Infosys gets over 98% of its total revenue from exports. They use forwards and range barrier options to hedge their foreign currency revenue exposure of Rs 7679 cr. While their current hedge ratio (30.08%) is significantly lower than their historical average, the impact of currency movement can be judged by a statement in their annual report Every 1% movement in the Rupee against dollar has an impact of approximately 40bps in operating margin. Wirpo Hedging for Wipro is a crucial strategy considering their diversified investment profile. In terms of IT however, Wipro hedged approximately 88.4% of their total Euro+USA zone revenue. Wirpo extensively uses floating for floating and floating for fixed cross currency interest rate swaps for Japanese Yen and has over 26B JPY designated for the same.

Exporters v/s Importers

Exporters of services/goods quote their prices in foreign currency to keep their earning in Rupee constant. If value of INR falls, their quoted foreign currency price goes down which results in Indian exports becoming cheaper. As a result of which there is a greater demand for exports and hence greater revenues. Thus exporters want rupee to depreciate in value and would hedge against an appreciating rupee. Importers on the other hand, quote their prices in domestic currency. They would like the Rupee to appreciate thus making imports cheaper. India is a net importer of crude oil, machinery, gems, fertilizer, chemicals.

Hedging instruments
Forwards - A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. Futures- A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. Options- A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. Swaps - A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate.

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Foreign debt FRAs- A contract agreement specifying an interest rate amount to be settled at a predetermined interest rate on the date of the contract.

Payoff profile of forwards/futures

Payoff From Long

Payoff from Short

Profit

Profit

Price of Underlying

Price of Underlying

Swaps
A swap is any agreement to future exchange of one cash flow for another. Interest rate swap: In these contracts one type of interest payment(e.g. floating with standard) is exchanged for another.

Currency swaps: In these contracts one currency is exchanged for another at pre-specified terms on one or more pre-specified dates.

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Options
Options give their owners the right but not the obligation to sell/buy an underlying security at a certain price at a certain time. A variety of pay-off profiles can be constructed using simple call options (which give the right to buy at a specified time and price) and put options (which give the right to sell at specified time and price). Here K is the strike price and St is the stock price.

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