1. Hedging Strategy for
Indian IT
Gopi Suvanam and Amit Trivedi
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2. Hedging Strategy for Indian IT
Topic Page
2
Introduction
Why Hedge? 2
Exposure 3
For-ex risk management v/s Directional bias 3
Advantages of using derivatives 3
Common myths about hedging 3
Risk management framework 4
Degree of hedging 6
Optimal Hedge Ratio 6
For-ex Risk management in TCS, Infosys and 7
Wipro
Exporters v/s Importers 8
Hedging strategies/ Instruments 8
Forwards 9
Swaps 9
Options 10
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3. Hedging Strategy for Indian IT
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.
India’s IT
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4. Hedging Strategy for Indian IT
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 company’s
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
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5. Hedging Strategy for Indian IT
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 shareholder’s 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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6. Hedging Strategy for Indian IT
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-à-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-à-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 company’s 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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8. Hedging Strategy for Indian IT
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 Net PnL Net
Biz PnL
200,000 Hedge PnL
150,000
100,000
50,000
-
Imm Month 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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9. Hedging Strategy for Indian IT
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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10. Hedging Strategy for Indian IT
Foreign debt
FRAs- 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 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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11. Hedging Strategy for Indian IT
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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