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Name - Aniket Gupta
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Roll No. – 17207
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TCS- Hedging Forex Risk
At the end of FY2012, India’s most valuable company – Tata Consultancy Services
(TCS) – had foreign currency hedges worth a notional Rs.8,506.37 crore, other than
hedges worth a notional $2.64 billion in options and $308.53 million in forwards,
which TCS categorised as Cash Flow Hedges. At the 30th March 2012 RBI USDINR
reference rate of 51.1565, these added up to Rs.23,602.77 crore. And if one goes by
TCS’ FY2013 consolidated operational revenue of Rs.62,989.48 crore, it means even
before the start of FY2013, TCS had got almost 37.5% of its forward earnings hedged.
Despite this, the company made a net forex gain of Rs.49.27 crore in FY2013. How?
The answer is in the fact that on the last day of FY2013, RBI USDINR reference rate
had risen to 54.3893, thereby benefitting TCS’ unhedged revenue.

How did TCS tweak its strategy in response? It simply, reduced its hedges! For, at
the end of FY2013, TCS had foreign currency hedges worth a notional Rs.10,665.98
crore, other than hedges worth a notional $1.37 billion in options and $26.28 million
in forwards, categorised as Cash Flow Hedges. This means while at the beginning of
FY2013, TCS had got 37.5% of its forward earnings hedged, at the beginning of
FY2014, TCS had got just 22.3% of its forward earnings hedged!

On thin ice
If you thought hedging just 22.3% of your earnings is too risky, you haven’t seen
anything yet. For example, at the end of FY2013, Infosys Technologies had foreign
currency hedges of Rs.5,985 crore – just 11.9% of its FY2014 earnings! While such
adventures have been not so dangerous for Indian exporters, given the secular
decline in the value of the rupee, history is evident to the fact that, in the long run,
they don’t work out. Just pick up any report from before 2008 and you will find how
Indian IT companies were scrambling for cover as the rupee moved from strength to
strength. For example, the same TCS had increased its foreign currency hedges by
more than 250% between FY2006 and FY2007 – from $566 million notional to $1.43
billion notional – as the rupee appeared to be in a bull run.

On the other hand, finding themselves on the wrong side of the secular decline in the
rupee are Indian importers. In fact, the rapid decline in the rupee in the summer of
2013 had made matters so dire that the RBI had to open a Special Swap Window for
oil marketing PSUs, to help them meet their crude oil payment related dollar
obligations. Despite this the largest among Indian oil PSUs and India’s largest
company by sales – Indian Oil Corporation Ltd. (IOC) – had Rs.81,823.5 crore worth
of unhedged foreign currency obligations at the end of FY2014, against Rs.52,120.1
crore of foreign currency loans!
Why hedge?
Let’s go back to India’s most valuable company – TCS. Being in the IT outsourcing
and consultancy business, TCS earns majority of its revenue from US and Europe –
81.7% in FY2014. But most of its expenditure is done in India, in Indian rupees. So,
let’s say TCS wins an order valued at $1 million, to implement which it figures out it
will have to spend Rs.5 crore. Looking at USDINR at 62 (say), it goes ahead and
spends Rs.5 crore on implementing the project, expecting to pocket a profit of Rs.1.2
crore. But by the time the project is delivered and the payment for it is received,
USDINR has moved to 45 (say). This means when TCS presents the $1 million
cheque to its banker, the latter gives it only Rs.4.5 crore, resulting in TCS making a
loss of Rs.50 lakh on the project, instead of a profit of Rs.1.2 crore. This is only
because of unfavourable foreign exchange movement.

"At the end of FY2014, TCS had reduced its US Dollar Cash flow hedges by over 65%
(YoY)"

TCS and millions of other exporters, all around the world, avoid such situations by
hedging their foreign exchange exposures (at least partly, as we have seen earlier) by
using derivative contracts like futures, forwards, options and swaps. So, in the above
example, the moment TCS signed the deal, it could have hedged its $1 million worth
of foreign exchange exposure, by selling an USDINR forward contract, which would
have been quoting around the spot price of 62. This would have meant in case of any
strengthening of the rupee (fall in USDINR) in the interim, TCS’s ‘short forward’
position would have compensated for the loss in translation. Going back to the same
example, assuming USDINR had fallen to 45 at the time of payment, the forward
position would have given TCS Rs.1.7 crore of profit (assuming the forward was
shorted at par), which would have compensated for the translation loss.

It’s not that hedging is important to negate operational foreign exchange headwinds
only, it is also key to mitigate balance sheet risks. For example, let’s assume an
Indian company avails a $1 million loan from an American bank, to benefit from
lower interest rates in US. Since the company needs the money in India, it
immediately converts the dollars into rupees at the prevailing USDINR rate of 62
(say), thereby, getting Rs.6.2 crore. Let’s assume at the time of paying the loan back,
USDINR has risen to 72. In such a situation, the company ends up coughing up
Rs.7.2 crore (of course, interest as well) to get its hands on $1 million because the
American bank would demand being paid back only in dollars. Even in this case, the
company could have hedged its foreign exchange exposure by buying an USDINR
forward contract, the moment the loan is sanctioned. The ‘long forward’ position, in
return, would have negated all translational loss at the time of paying the loan back.

A bit of lull in rupee volatility, in the last few months, seems to have made a lot of
Indian exporters and importers complacent about their hedging requirements – a
phenomenon that hasn’t gone unnoticed by even the RBI, which feels Indian
corporates are grossly under-hedged

Why not hedge ?


The only reason for not hedging one’s foreign currency exposure is the lure of
favourable currency movement. Going back to the above TCS example, let’s say by
the time TCS received the $1 million payment, USDINR, instead of moving lower
from 62 to 45, had moved higher to 72. In such a situation, TCS’ short forward
position would have incurred a loss of Rs.1 crore, although it would have been
compensated by translational gain. Instead, if TCS had not opted for hedges at all, it
would have gained that extra Rs.1 crore at the time of conversion.

Another reason for not opting for hedging is the cost of it, because while derivatives
like forwards, futures and swaps don’t cost much (other than transaction cost),
derivative instruments like options involve the payment of a premium, which, at
times, can be a very dissuading factor, particularly when a forex pair is not very
volatile.

Even when it comes to forwards and futures, since an efficient market ensures that
all risks and factors are discounted (at least reasonably), they (forwards and futures)
often trade at significant discounts or premiums, in the direction of future prices.
And given the massive interest rate differential between US and India, USDINR
forward contracts are, today, quoting at massive premiums and in a contango. For
example, with USDINR at 62 (say), if three-month USDINR futures and forwards are
trading at 64, six-month contracts are trading at 66, one-year contacts are trading at
68 and so on. So, for a company, which is scheduled to payback a foreign-currency
loan a year later, fully hedging its foreign exchange exposure would mean buying an
USDINR forward at 68 – a very dissuading factor, given where the spot is trading.

Who’s Job
While exporters and importers have their own reason/logic/strategy to whether
completely hedge, partially hedge or not at all hedge their forex exposure, RBI has
started taking note of the fact that corporate India is massively under-hedged. And
while it, probably, doesn’t have the mandate to force companies to hedge their forex
exposures, it certainly is trying to warn one and all. Trying to put across this
message, RBI Deputy Governor, a couple of months back, said, “It is absolutely
essential that corporates should continue to be guided by sound hedging policies
and the financing banks factor the risk of unhedged exposures in their credit
assessment framework.” He went on to add that Indian companies’ hedge ratio for
overseas loans and foreign convertible debt was ‘very low’.

How to Hedge
Having established the need and importance of ensuring your forex exposure is
hedged, the question is how one goes about it. And the answer lies with your
friendly banker. With the world getting increasingly integrated; ever increasing
volumes and value of trade; and currency moves like what the ruble did recently,
every bank worth its salt, today, has an active risk management and treasury
department. What these banks essentially do is act as a bridge between exporters
and importers – those who would be inversely affected by the movement in a
currency pair – and hence, are trying to find someone to take the opposite side of the
trade. Banks also, very often, act as counterparties themselves. And given that a
bank acts as a counterparty to both exporters and importers, its own risk gets
negated, at least partially.

Going back to the above mentioned example, if TCS goes to XYZ Bank (say) the
moment it receives the $1 million order and tries to hedge its forex exposure, XYZ
Bank would be, typically, ready with quotes for various periods. So, with spot
USDINR at 62, it might be ready to act as the counterparty for a one-month period at
63, three-month period at 64, and so on. What about XYZ Bank’s risk if USDINR falls
to 45 (say)? The bank would typically try to negate this loss by acting as the
counterparty for an importer. So, the moment a three-month forward is traded at 64
between TCS and XYZ Bank (here XYZ Bank is acting as a buyer), it would try to
find another company, most likely an importer, who is looking to buy a three-month
forward at 64.5 (here XYZ bank is a seller), thereby making itself immune from forex
risks, and at the same time, pocketing a small profit of 0.5.

Today, we also have organised exchanges like MCX, NSE and BSE, where
standardised future and option contracts of various currency pairs like USDINR,
EURINR, GBPINR etc. are traded, enabling even the smallest of exporter/importer to
hedge its forex exposure, without worrying about counterparty risks. At the same
time, for those who want to hedge their forex risk, but also want to profit from
favourable currency movement, there are slightly more complex derivative products
like options, which come at a slight cost.

In fact, interestingly options are increasingly becoming the instrument of choice for
India Inc. as can be seen from TCS’ FY2014 Annual Report, which reveals that all of
the company’s outstanding positions under Cash Flow Hedges are option contracts.

"Companies don’t hedge all their forex exposures to benefit from favourable forex
movement"

Hedge for an edge


The reason for a company to exist in a business is because it thinks the business
model is profitable; it’s because it offers great goods and services; it’s because there
is enough demand for its goods and services at the price at which it is offering them;
and the price at which it is offering its goods and services, allows it to make profits.
It’s not in business to speculate in the forex market. Given all this, forex exposure
related risk is, at best, a nuisance, which is best avoided. And the only way to avoid
it, is by, what else, but hedging.

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