Published on March 6, 2014
Risk Management for IT/ITES Companies Sarita Misra Standard Chartered Bank Financial Markets November 2013
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 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 Reduce volatility / deviations to Budget • Both Accounting and economic Focus • Involves hedging committed and forecasted foreign exchange flows for the next few months • It buys a corporate time to adjust its operational and/or pricing strategy in order to offset impacts of changing market prices • 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 • Does not reduce the volatility per se of either earnings or cash flows - merely postpones the impact. • 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 Others • Primary attempt to lock in rates when they appear to be at favourable levels in the cycle • Minimize cost of hedging • Significant flexibility needed in terms of the quantum of exposure to be hedged and tenor of the hedge • Minimize shortfalls to budget – Avoid bad surprises • Consequently, of the three strategies it demands the most developed treasury infrastructure and a rigorous controls. This strategy could be regarded as being a proactive risk management approach • Due to competitive pressure or business unit pressure • Optimize domestic currency value of the budget
Risk Management Steps Identify Exposure Plan for contingencies Risk Management Steps Track & Assess Performance Design/ Implement Hedge Strategy
Hedging Strategy Designing - Factors Competition Landscape Shareholders / Investors Risk Natural Hedges • Competitors' hedging strategy • To what extent is the objective of your shareholder base to gain exposure to energy, commodity, FX and/or IR risks • • Risk tolerance - critical levels of FX, IR rates and commodity prices Risk appetite • Identify any internal, natural and operational hedges in order to only hedge net positions in the financial markets
Hedging Strategy Implementation - Parameters Hedge Ratio • • Hedge over multiple dates Hedge 100% for near-dated exposures and subsequently increase the hedge % • • Forecast uncertainty Perform historical analysis to determine appropriate hedge ratio • Hedge Frequency Hedge to a specific date cash is needed; if no specific time frame – hedge to the period-ending dates. • • • • Cost of hedge Risk appetite Market liquidity Accounting considerations Hedge Tenor Hedge Instrument
Rule Based Hedging Strategies Rolling Hedge Static Hedge Q1 Q0 Q2 Q3 Q4 100% Q0 Q1 Q2 Layered Hedge Q3 Q4 Q0 Q1 Q2 Q3 Q4 25% 100% 25% 100% 100% 25% 100% 100% 100% 100% 25% 25% 25% 25% This involved execution of the hedges for all quarterly exposures of that year at the beginning of the accounting year This involved execution of the hedges at different points in the year as and when exposures become certain. 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 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 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 Multiple times in the accounting year Multiple times in the accounting year
Hedging Strategies – Historical analysis FX Risk-Reward Quantification • 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 48.00 4.50 47.90 4.40 47.80 4.30 4.20 47.70 4.10 47.60 4.00 47.50 3.90 47.40 3.80 47.30 Static Rolling Layered Average 47.75 47.95 47.58 Standard deviation 4.35 4.46 3.70 4.02 Forwards • The adjacent chart summarizes the Average Average Standard deviation Realized Rate and the Standard Derivation for each of the strategies. Conclusions • 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 Cost-Benefit Analysis wrt hedging through Forwards • • • • Option Strikes vs Premium for a tenor of 3 months Strike Intrinsic IV/Premium Change Premium Value (IV) Ratio in Strike wrt Spot 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 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. 61.00 63.25 62.00 63.25 63.00 63.25 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. 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 Hedging through put options benefits the exporter as compared to a forward only if INR depreciates vs the USD. 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 Not available 1 year Not available ~40% ~20% ~50% Max Tenor of outstanding hedges Outstanding short hedges as a %age of FY12-13 Forex revenues Source: Company Annual Report FY 2012-13
Hedging of Near-term USD Receivables 100% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% -10.00% -12.00% -14.00% 80% 60% 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% 40% 20% 0% 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% 90.00% 70.00% 50.00% 30.00% 28% Forward Percentage of Gains ATMS Put Range Forward Seagull 59.10% 41.60% 54.70% 69.70% • 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%.
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. • USDINR Forwards vs Forecast 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. Risks: Opportunity loss in case of INR depreciation beyond the current forward levels and potential MTM swings during the tenor of the trade 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 Total Costs (INR) 4410 EBIT (INR) EBIT Margin Impact on EBIT for various hedge ratios (assuming USDINR @forecast) Hedge Ratio EBIT 0% 23% 25% 28% 7350 50% 33% 4410 4410 75% 37% 1890 1330 2940 100% 40% 30% 23% 40%
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