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Hedging takes the shine away

Jul 6, 2012

Exporters always welcome rupee depreciation. Why? Because their foreign currency earnings fetch them greater value without any extra effort on their part.

In this rupee depreciation scenario, the Indian Information Technology (IT) sector draws a lot of attention since most of its clients are international. As per NASSCOM (National Association of Software and Services Companies) the Indian IT sector is estimated to be US$ 100 bn in FY12, and it drums up close to 70% of its revenue from the export market.

In fact, in FY11, this IT sector represented as much as 26% of all Indian (merchandise plus services) exports. And in FY98 this IT sector accounted for a mere 4% of all Indian exports.

So, with the recent free fall of the Indian rupee, investors first think that Indian software companies will report excellent numbers in the coming quarters.

Is this investor perception right?

Source: Trend
Well, yes and no.

Yes because revenues will "seem" to be higher, and no because net profits will not grow correspondingly. Why? The catch is because companies hedge.

Hedging - A Risk Management Tool ... Impact on Revenues and Profits

The core business of exporters, including IT companies, is whatever products or services they export. In fact they do not want their fortunes to depend on the uncertainty of foreign exchange fluctuation. Foreign exchange risk is just a factor they have to contend with - it is not their core business. To minimize or eliminate this foreign exchange risk, exporters hedge the price movement of the currencies they have to deal in.

Hedging allows exporters to peg a predetermined currency rate at which they can buy and sell the foreign currency (e.g. US Dollar) in which they are earning revenues. So, whether the price goes above or below that rate, the exporters are not affected by changes in the currency rates. Exporters do need to decide how much of their currency they should hedge, and at what rate. And there is a transaction cost to hedging. Essentially, the more a company is hedged, the less it will be impacted by currency fluctuation.

How does hedging actually work?

Hedging is done by companies buying and later selling derivative contracts for the currencies the company deals with (buying and selling means transaction costs).

Impact of Hedging
  NO Hedging Hedging
Hedge Position (US$)     1000 1000
Hedged at Rate (Rs per US$)     52 52
Hedge expires - must sell     after 3 months after 3 months
3 Months Later Situation Rupee becomes Rupee becomes Rupee becomes Rupee becomes
  Weaker Stronger Weaker Stronger
Revenue (US$) 1,000 1,000 1,000 1,000
3 months later Rs per US$ 55 48 55 48
Revenue (Rs) 55,000 48,000 55,000 48,000
Hedging loss/gain     (3,000) 4,000
Net Postion 55,000 48,000 52,000 52,000

Notes:
  • Here hedged positions are contracts to sell dollars at a specified future time at a predetermined price

  • WITHOUT hedging the Net Position varies greatly from Rs 55,000 to Rs 48,000 showing the risk to the company.

  • WITH hedging, the company has more certainty, the Net Position remains at Rs 52 whether the currency goes up or down.

  • Hedging transaction costs will also be incurred but are not shown in the example above.
All major export (and import) companies have hedging policies and procedures. If there is rupee depreciation, companies will report higher revenue increases than the actual core business growth. However, the additional gains due to a stronger dollar will be offset by hedged positions. And so the all important net profit parameter will not enjoy the seemingly positive or negative thrust due to the variation of currency prices.

How is hedging affecting IT companies?

Let's look at the end of FY12 hedged positions of some of the Indian IT giants. These companies generally hedge some portion of their total revenues.

For example, the biggest India IT company Tata Consultancy Services (TCS) has total revenues of approximately US$ 10 bn, and a hedge position worth close to US$ 3 bn. Wipro has about US$ 2 bn of forex contracts hedges outstanding. The erstwhile bellwether Infosys has lowest forex position among the Indian IT giants, US$ 889 mn.

Depending on the rates at which the contracts are made, companies would experience hedging gains/losses albeit notional gains/losses during the life of the contract. These may be taken onto the company's balance sheet through the adjustments in other income or other comprehensive income (depending on the accounting standards being used)as and when they square off their derivative positions. Actual gains/losses are realized at the time of squaring off the derivative positions which would affect the company's profit and loss statement.

Interestingly, the current slide in rupee seems to be luring many software companies, especially smaller ones, to review their hedging strategy. They are planning to keep a larger part of their forex positions unhedged to gain from the rupee slide. No doubt, this strategy looks attractive in the short term. However, this opportunistic approach can backfire if the rupee appreciates sharply.

We believe that IT companies would do well to focus on their core businesses, and not fall prey to speculative short term gains. They should use hedging as a risk management tool. After all, they are in the business of exporting IT services, not in profiting from currency movements.

Investors need to understand that currency movement does not result in automatic increases in profits or losses for companies that hedge. They must also evaluate the hedged positions of the companies.

Finally, long term investment decisions must be taken on the basis of strong fundamentals of the core business of a company. Certainly not on the some "unhedged" risky information regarding currency movement.


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