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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