Post on 09-May-2015
Sarita Misra
Standard Chartered Bank Financial Markets
November 2013
Risk Management for IT/ITES Companies
Need for Risk Management
Indian IT-BPO Industry1:
• Export revenues of USD 75.8 billion in FY2013
• Export revenues account for ~70% of total revenues
• Year-on-year (YoY) growth rate of 10.9% on a constant currency basis
• Exports growth expected at 12-14% p.a.
Need for Hedging:
• With more than two-thirds of revenues in foreign currency and cost base
primarily in INR, Indian IT-BPO firms face the risk of an unexpected gain/loss
due to sudden/unexpected changes in exchange rates on exposures in
multiple currencies
• A 1% drop in the currency boosts the operating margin of IT exporters by
approx 20-30 basis points on an unhedged basis (compared to 30-40 bps
earlier)
• With INR being extremely volatile in the recent past, there is a need for an
active corporate treasury to manage this foreign exchange risk whose
objective is not to make profits but to reduce volatility in income.
1Source: NASSCOM
Risk Management Objectives
Secure short-term committed exposures
• Primarily Accounting Focus
• Entails hedging a fixed level of committed foreign exchange flows for the next few months - Predominately aims at achieving short-term certainty
• It buys a corporate time to adjust its operational and/or pricing strategy in order to offset impacts of changing market prices
• Does not reduce the volatility per se of either earnings or cash flows - merely postpones the impact.
Reduce volatility / deviations to Budget
• Both Accounting and economic Focus
• Involves hedging committed and forecasted foreign exchange flows for the next few months
• Aims at predominately reducing earnings and/or cash flow volatility over time and could also be combined with an objective of hedging the risk of extreme levels
• This strategy is likely to be adopted by a company with a somewhat higher risk appetite than Strategy I
Achieve best rates / beat the market
• Primary attempt to lock in rates when they appear to be at favourable levels in the cycle
• Significant flexibility needed in terms of the quantum of exposure to be hedged and tenor of the hedge
• Consequently, of the three strategies it demands the most developed treasury infrastructure and a rigorous controls. This strategy could be regarded as being a pro-active risk management approach
Others
• Minimize cost of hedging
• Due to competitive pressure or business unit pressure
• Minimize shortfalls to budget – Avoid bad surprises
• Optimize domestic currency value of the budget
Risk Management Objectives
Risk Management Steps
Risk Management
Steps
Identify Exposure
Design/
Implement Hedge
Strategy
Track & Assess
Performance
Plan for contingencies
Hedging Strategy Designing - Factors
• Competitors' hedging strategy Competition Landscape
• To what extent is the objective of your shareholder base to gain exposure to energy, commodity, FX and/or IR risks
Shareholders / Investors
• Risk tolerance - critical levels of FX, IR rates and commodity prices
• Risk appetite Risk
• Identify any internal, natural and operational hedges in order to only hedge net positions in the financial markets
Natural Hedges
Hedging Strategy Implementation - Parameters
• Hedge over multiple dates
• Hedge 100% for near-dated exposures and subsequently increase the hedge %
Hedge Frequency
• Forecast uncertainty
• Perform historical analysis to determine appropriate hedge ratio Hedge Ratio
• Hedge to a specific date cash is needed; if no specific time frame –hedge to the period-ending dates. Hedge Tenor
• Cost of hedge
• Risk appetite
• Market liquidity
• Accounting considerations
Hedge Instrument
Rule Based Hedging Strategies
This involved execution of the hedges
for all quarterly exposures of that year
at the beginning of the accounting year
Q0 Q1 Q2 Q3 Q4
100%
100%
100%
100%
Static Hedge Rolling Hedge Layered Hedge
Hedge
Cover 100% of the exposures 100% of the exposures Only part of the exposures (say 25%)
Hedge
Frequency Once in the accounting year
Multiple times in the accounting year
Multiple times in the accounting year
Benefit Hedge and forget policy, simplest of
the strategies
Exposures are covered only when they
are certain
Smoothens the Q-Q gain/loss
considerably, ideal when forecast
uncertainty is high
Limitation Forecast uncertainty Does not eliminate volatility per se –
just postpones it
Difficult to implement, regular tracking of
exposures and hedge performance
required
Static Hedge
Q0 Q1 Q2 Q3 Q4
100%
100%
100%
100%
Rolling Hedge
This involved execution of the hedges
at different points in the year as and
when exposures become certain.
Q0 Q1 Q2 Q3 Q4
25%
25%
25%
25% 25%
25%
25%
Layered Hedge
This involved execution of the hedges
at different points in the year to cover
different a certain exposure in phased
manner. Exposures are covered in
phases and coverage is increased as
and when they become certain
• Assuming that nearly all of the FC exposure is
derived from the USDINR, we have calculated
the historically realized rates for each of the
hedging strategies for a hedging tenor of 1 year:
o Static Hedge – Hedge 100% exposure
through 3m, 6m, 9m and 1y forwards at the
beginning of the year
o Rolling Hedge – Hedge 100% exposure
through 3m forwards on a quarterly basis for
each quarter
o Layered Hedge – Hedge 25% exposure
through 3m, 6m, 9m and 1y forwards on a
quarterly basis
• Hedging Instruments considered are only
Forwards
• The adjacent chart summarizes the Average
Realized Rate and the Standard Derivation for
each of the strategies.
Hedging Strategies – Historical analysis
FX Risk-Reward Quantification
Conclusions
Static Rolling Layered
Average 47.75 47.95 47.58
Standard deviation 4.35 4.46 4.02
3.70
3.80
3.90
4.00
4.10
4.20
4.30
4.40
4.50
47.30
47.40
47.50
47.60
47.70
47.80
47.90
48.00
Average Standard deviation
• Though average realized rate is higher for a Rolling hedge strategy, the standard deviation is also significantly higher
• The average realized rate is lowest for a Layered hedge strategy and the standard deviation is also significantly lower
• Thus layered hedging is a less risky strategy than static or rolling hedges as it smoothens out the rate on each of the
realization dates
Risk Management Case Study I
• Consider the case of an Indian software exporter with 80% of
revenues and 30% of operating expenditure denominated in
USD
• With USDINR at current market levels, the company expects to
achieve an EBITDA margin of 30% in FY 2014-15
• However, with a net USD exposure of approximately 59% of
total revenues, every 1 Re appreciation in INR could reduce
the EBITDA margins by ~ 30 bps
• The impact of USDINR movement on EBITDA margins is
shown in the table alongside
• In case of a 2-sigma movement in USDINR to 53.14, the
EBITDA Margin reduces to 27.08%
• The company can consider hedging a portion of their future
net receivables in order to avoid potential fluctuations in the
operating margins due to currency movements
• For the same, the company would need to first define a risk
tolerance
• As a start, we propose the risk tolerance to be 100 bps in
EBITDA margins. This implies that any potential fluctuation in
FX will not cause the EBITDA margins to dip below 29%
• Based on the above risk tolerance, we would propose for the
company to hedge 30% of its net USD exposure using par
forwards
• This would ensure that the EBITDA margin remains at 29%
even if USDINR appreciates to the 2-sigma level of 53.14 in
March 2015
• Post such hedging, every 1 Re movement in INR would impact
the EBITDA margins by ~ 20 bps
Impact of USDINR on EBITDA Margins for various USDINR levels
USDINR on 31 Mar’15 EBITDA Margin
50.0 26.06%
52.5 26.88%
55.0 27.66%
57.5 28.42%
60.0 29.15%
62.5 29.86%
65.0 30.55%
67.5 31.22%
70.0 31.86%
72.5 32.49%
75.0 33.10%
EBITDA Margins for various USDINR levels post hedge
USDINR on 31 Mar’15 EBITDA Margin
53.14 29.01%
55.00 29.37%
57.50 29.84%
60.00 30.30%
62.50 30.75%
65.00 31.19%
67.50 31.61%
70.00 32.03%
72.50 32.44%
75.00 32.83%
Risk Management Case Study II
• Consider the case of an Indian software exporter who
currently hedges his USD receivables through Forwards.
• In view of the steep INR depreciation in the recent past, the
corporate is evaluating hedging a portion of his export
receivables in the 3-month tenor through USD Put options,
which would allow him participation in INR depreciation while
protecting him at a fixed Strike.
• The corporate treasury is evaluating various strikes for the
USD Put options against the premium to be paid.
• The table alongside presents an analysis of the various
strikes and associated premia.
• As can be seen from the table, on a net of premium basis &
comparing benefit of better strikes for paying additional
premium, ITM put options make sense
Option Strikes vs Premium for a tenor of 3 months
Strike Premium
Intrinsic
Value (IV)
wrt Spot
IV/Premium
Ratio
Change
in Strike
Change in
Premium
60.00 0.24 0.00 0.00 - -
63.00
(ATMS) 0.81 0.00 0.00 3.00 0.57
63.50 1.00 0.50 0.50 0.50 0.19
64.39
(ATMF) 1.41 1.39 0.99 0.89 0.41
65.00 1.75 2.00 1.14 0.61 0.34
Realized Rate for various levels of USDINR at maturity
USDINR at maturity Realized rate (net of premium)
60.00 63.25
61.00 63.25
62.00 63.25
63.00 63.25
64.00 63.25
65.00 63.25
66.14 64.39
67.00 65.25
68.00 66.25
69.00 67.25
70.00 68.25
Cost-Benefit Analysis wrt hedging through Forwards
• Hedging through put options benefits the exporter as compared
to a forward only if INR depreciates vs the USD.
• If INR appreciates vs the USD, the exporter is better-off hedging
through forwards as he avoids the payment of option premium,
which is akin to a sunk cost for insurance.
• The table along side depicts the Realized Rate for the exporter
post hedge through a USD Put Option @ 65.00 with a premium
of INR 1.75.
• As can be seen in the table alongside, the exporter would get a
higher realized rate (net of option premium) as compared to the
Forward if USDINR is higher than 66.14 at maturity.
Risk Management Best Practices
Risk Management Best Practices: Indian IT Sector
TCS Infosys Wipro
Adoption of AS30 Yes Yes Yes
Cashflow hedges Yes No Yes
Net Investment hedges No No Yes
Use of FX Forwards Yes Yes Yes
Use of FX Options Yes No Yes
Max Tenor of outstanding hedges Not available 1 year Not available
Outstanding short hedges as a %age of FY12-13 Forex revenues ~40% ~20% ~50%
Source: Company Annual Report FY 2012-13
Market Themes
Unhedged Forward ATMS Put Range Fwd Seagull
Rank5 40% 32% 27% 0% 0%
Rank4 14% 8% 22% 23% 33%
Rank3 6% 2% 26% 39% 27%
Rank2 7% 18% 24% 39% 12%
Rank1 32% 40% 0% 0% 28%
0%
20%
40%
60%
80%
100%
Forward ATMS
Put Range
Forward Seagull
Average Gain/Loss 0.40% 0.51% 0.44% 0.05%
Lowest 1 Percentile Loss
-11.54% -2.42% -10.24% -10.43%
-14.00%
-12.00%
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
Forward ATMS
Put Range
Forward Seagull
Percentage of Gains 59.10% 41.60% 54.70% 69.70%
30.00%
50.00%
70.00%
90.00%
• Historical analysis suggests that remaining unhedged and fully hedged through forwards, being view based strategies, have historically had
a high percentage of best (Rank 1) and worst (Rank 5) performance.
• Historically, option strategies have been medium performing strategies in terms of performance ranking. Also from settlement perspective,
option strategies have proven to have a success rate of over 50%.
Hedging of Near-term USD Receivables
Strategic Hedging of Long term USD Receivables
• While remaining unhedged on USD receivables has been beneficial in
the recent past due to secular INR depreciation, Indian IT companies with
steady USD revenues year-on-year need to take a strategic perspective
on their long-term USD receivables.
• Remaining unhedged has historically led to a lower realized rate on USD
receivables as compared to hedging through a 5y outright forward.
• Thus, corporates with stable USD revenues and INR cost base should
consider hedging a portion of their USD receivables in the longer term at
the current elevated USDINR levels.
• Benefits: Stability to future revenue forecasts.
• Risks: Opportunity loss in case of INR depreciation beyond the current
forward levels and potential MTM swings during the tenor of the trade
• The table below shows the 2017 Revenues for a Corporate with 70% of
USD /USD linked revenues for a fully hedged vs a fully unhedged
position for various levels of USDINR at expiry. Assuming an EBIT of
30% at current spot levels, it also depicts the impact of hedging on EBIT
for a fully hedged vs unhedged position.
USDINR Forwards vs Forecast
100% Unhedged 100% Hedged
@Forward
Rate USDINR@
Current Spot
USDINR@
Median
Forecast
Realized USDINR 63 55 78
USD Revenue (USD) 70 70 70
INR Revenue (INR) 1890 1890 1890
Total Revenue (INR) 6300 5740 7350
Total Costs (INR) 4410 4410 4410
EBIT (INR) 1890 1330 2940
EBIT Margin 30% 23% 40%
Impact on EBIT for various hedge ratios (assuming USDINR @forecast)
Hedge Ratio EBIT
0% 23%
25% 28%
50% 33%
75% 37%
100% 40%
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