Professional Documents
Culture Documents
10
Page 2 2 3 3 3 3 4 6 6 7
8 8 9 9 10
Page 1
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
Page 2
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.
Risk-Estimation
Benchmarking
Hedging
Stop Loss
Page 4
Furthermore, extensive correlation analysis between currencies and other parameter is performed. For example, $/Nifty as shown below:-
Page 5
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.
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
Page 6
Biz PnL
Probability
PnL
Net PnL
First Month
Second Month
Page 7
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.
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.
Page 8
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.
Page 9
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.
Page 10