Hedging for indian it firm

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  • 1. Hedging Strategy forIndian ITGopi Suvanam and Amit Trivedi 10
  • 2. Hedging Strategy for Indian ITTopic Page 2IntroductionWhy Hedge? 2Exposure 3For-ex risk management v/s Directional bias 3Advantages of using derivatives 3Common myths about hedging 3Risk management framework 4Degree of hedging 6Optimal Hedge Ratio 6For-ex Risk management in TCS, Infosys and 7WiproExporters v/s Importers 8Hedging strategies/ Instruments 8Forwards 9Swaps 9Options 10 Page 1
  • 3. Hedging Strategy for Indian ITIntroductionIndia is referred to as the back office of the world owing mainly to IT and ITes Sector. Therevenue of the information technology sector has grown from 1.2 per cent of the grossdomestic product (GDP) in 1997-98 to an estimated 5.8 per cent in 2008-09. Today, Indian ITcompanies have carved a great niche for themselves in the global market and are known fortheir IT prowess. Global giants are using the successful outsourcing strategy and keepingahead 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 numerousextraneous threats to bottom line. Indian Rupee has seen unprecedented swings in its valuesince 2007. The recent macroeconomic developments in the US are now having their effectson the Indian market as well. Thus, IT Company today needs a risk management frameworkwhich not only considers the current risk profile of the company but also incorporatespotential future threats. This paper discusses hedging and other risk management strategiesfor Indian IT companies and also proposes a template for For-ex risk management forbig/small IT firms.Why Hedge?Over 66% of revenue for most Indian IT firms comes from foreign clients (i.e. via exports). Thetransactions are usually quoted/executed in foreign currency denominations. Firms dealing inmultiple currencies face a risk (an unanticipated gain/loss) on account ofsudden/unanticipated changes in exchange rates, quantified in terms of exposures. India’s IT Page 2
  • 4. Hedging Strategy for Indian ITExposureExposure is contracted, projected or contingent cash flow whose magnitude is not certain atthe 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 resultOther potential exposures could be in the form of wage inflations, foreign Currency CashFlows/ Schedules, variability of Cash flows - how certain are the amounts and/ or valuedates?, Inflow-Outflow Mismatches / Gaps, time mismatches / gaps, currency portfolio mix,floating / fixed Interest Rate ratio.For-ex risk management v/s Directional biasFor-ex risk management provides a better alternative to taking a 100% view based positionbecause foreign exchange markets are weak form efficient. This means that successivechanges in currency prices cannot be predicted using only historical data. Moreover, thesemarkets 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 derivativesDerivatives 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 generatedusing simple instruments, which facilitates designing of hedges that best suit a company’sneed. Futures and options contracts are exchange mediated hence there is no counter-partyrisk. Moreover, since near month liquidities are good, exit strategy is also very easy.Common myths about hedgingHedging instruments are considered to be speculative in nature; however, the exact oppositeis true. Hedging is done with the purpose of reducing volatility in income and not to make Page 3
  • 5. Hedging Strategy for Indian ITprofits. Most people assume that hedging strategies are complex and beyond the reach ofsmall organizations. On the contrary, hedging instruments are very simple to understand andtheir pay-off is completely predictable. Provision for hedging via margin payment makes themaffordable for all firm sizes. Firms assume shareholder’s value will not increase due tohedging however it has been statistically proven that hedging reduces volatility in incomewhich in turn sends a strong positive signal amongst the investors.Risk management frameworkWe have devised a risk management framework which we feel best applies in the Indian ITperspective. Forecast Risk-Estimation Benchmarking Hedging Stop Loss Reporting and review Risk Management FrameworkForecast – After determining exposure, forecast market trend for currency movement. Thetime horizon of the forecast ideally is one to two business cycles. Since we are hedging netforeign currency ‘exposure’, out forecast focuses on 1) Foreign revenue and 2) Expenditure inforeign currency. While (2) is fairly predictable (and can be adjusted for scale), foreignrevenue inflow is predicted from analysis of contract specified currency rates, exchange Page 4
  • 6. Hedging Strategy for Indian ITfluctuations, competitor dynamics and company targets. Balance sheet and Income statementserve as the starting point of most stand-alone forecasts.Risk estimation - Based on the forecast a measure of Value at Risk (VaR) and probability ofthis risk is ascertained. This includes market-specific problems like liquidity and systemspecific problems like reporting gaps. Risk estimation also includes some basic assumptionslike mean-reversion of interest rates and sustained correlation between benchmarks andvariables 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 thecompany specific requirements. Choice of hedging instrument (discussed later) is based onthe hedging strategy (long/short/neutral/time-adjusted) and time frame under consideration.We have performed research on movement trends and correlations between variouscurrencies vis-à-vis Indian Rupee, Nifty, Gold etc. These correlation trends help us zero downon the appropriate hedging instrument. For example, a sample correlation matrix betweensome securities, nifty and currencies is shown below.Furthermore, extensive correlation analysis between currencies and other parameter isperformed. For example, $/Nifty as shown below:- Page 5
  • 7. Hedging Strategy for Indian ITBases on a mix of analysis like these, a suitable hedging instrument is chosen. Theview/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 proprietarymethods 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-à-visbenchmarks and changes in overall exposure. Review of our performance against benchmarksand 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 RatioThe 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 itscurrent revenue from Rupee upside by buying ITM rupee calls. B on the other hand does nothedge anything. Suppose the rupee goes down, while both A & B benefit due to downfall ofdomestic currency, A loses the premium that it paid to purchase options. As a result, to sellat competitive prices, A will have to fight on margins. In any case, bottom line of A will takea 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 company’s P&L usingvarious hedge ratios. This simulation assumes various possible scenarios for the business P&Lin view of an underlying asset. An appropriate hedge instrument in chosen based on Page 6
  • 8. Hedging Strategy for Indian ITaforementioned 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 Net PnL Net Biz PnL 200,000 Hedge PnL 150,000 100,000 50,000 - Imm Month First Month Second MonthFor-ex Risk management in TCS, Infosys and WiproTCS – TCS gets over 90% of its total revenue from exports. Major exposures exists in the $/INRdomains. Its net exposure in (all) foreign currency was Rs. 13953 cr for FY 09. TCS favors the Page 7
  • 9. Hedging Strategy for Indian ITuse of options as a hedging instrument and has currently deployed Rs. 7203 cr worth of shortand 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 rangebarrier options to hedge their foreign currency revenue exposure of Rs 7679 cr. While theircurrent hedge ratio (30.08%) is significantly lower than their historical average, the impact ofcurrency 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 operatingmargin’.Wirpo – Hedging for Wipro is a crucial strategy considering their diversified investmentprofile. In terms of IT however, Wipro hedged approximately 88.4% of their total Euro+USAzone revenue. Wirpo extensively uses floating for floating and floating for fixed cross currencyinterest rate swaps for Japanese Yen and has over 26B JPY designated for the same.Exporters v/s ImportersExporters of services/goods quote their prices in foreign currency to keep their earning inRupee constant. If value of INR falls, their quoted foreign currency price goes down whichresults in Indian exports becoming cheaper. As a result of which there is a greater demand forexports and hence greater revenues. Thus exporters want rupee to depreciate in value andwould hedge against an appreciating rupee.Importers on the other hand, quote their prices in domestic currency. They would like theRupee to appreciate thus making imports cheaper. India is a net importer of crude oil,machinery, gems, fertilizer, chemicals.Hedging instrumentsForwards - A forward is a made-to-measure agreement between two parties to buy/sell aspecified 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 istraded 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 aspecific quantity of one foreign currency in exchange for another at a fixed price; called theExercise Price or Strike Price.Swaps - A swap is a foreign currency contract whereby the buyer and seller exchange equalinitial principal amounts of two different currencies at the spot rate. Page 8
  • 10. Hedging Strategy for Indian ITForeign debtFRAs- A contract agreement specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract.Payoff profile of forwards/futures Payoff From Long Payoff from Short Profit Profit Price of Price of Underlying UnderlyingSwapsA 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 withstandard) is exchanged for another.Currency swaps: In these contracts one currency is exchanged for another at pre-specifiedterms on one or more pre-specified dates. Page 9
  • 11. Hedging Strategy for Indian ITOptionsOptions give their owners the right but not the obligation to sell/buy an underlying security ata certain price at a certain time. A variety of pay-off profiles can be constructed using simplecall options (which give the right to buy at a specified time and price) and put options (whichgive the right to sell at specified time and price). Here K is the strike price and St is the stockprice. Page 10