Managing the Challenges of Volatile FX Markets within the Accounting Parlance

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1 Managing the Challenges of Volatile FX Markets within the Accounting Parlance Treasury Perspective 22 July 2008 TCS Public

2 Why should we hedge? Business is exposed to several risks, currency risk being one of them Objective of hedging is to ensure: Predictability in Income Statement thereby reducing cash flow volatility. Revenue is generated & receivables are collected at budgeted rates Maintaining margins on long term projects as these projects are priced & bid with an exchange rate assumption, which needs to be protected to ensure desired margins Managing the translation risks in case of multiple geographies & overseas entities 22 July

3 Hedging Policy - Best Practices A good risk management and hedging policy should be debated, understood & approved at the highest level (Board) The policy should indentify risks entity is exposed to, ways to measure these risks & suggest methods to mitigate these risks Should specify clear identification of responsibilities, authorities & limitations on its implementation Should state the purpose of hedging clearly - profit, protection, reducing volatility. Should suggest appropriate risk management tools like Sensitivity Analysis, VAR to contain risks Should be reviewed periodically by board in view of changing risks, market dynamics. Encourage use of natural hedges to reduce hedging costs 22 July

4 TCS Policy Risk Management Policy approved by Board of Directors stating risks, means to mitigate these risks; defining authorities, responsibilities & controls and stating broad parameters within which treasury has to function. Policy reviewed by board periodically Risk Management Board is responsible for policy implementation, strategy formulation & periodic review of decisions TCS Treasury is not a profit centre but a facilitator with an objective of protecting accounting / budgeted rates thereby reducing unpredictability & volatility Follows globally used FAS 133 accounting standard Use of only simple accounting compliant structures. It necessitates that each hedge to be mapped with a specific set of underlying. No exotics allowed Policy is to hedge the net exposure: Budgeted Revenue 100 Budgeted Expenses 30 (Provides Natural Hedge) Net Exposure 70 Maximum Hedges July

5 Types of Exposures Exposure Nature of Risk Sources of Exposure Risk 1>Receivables Current Risk Credit Period Exchange Risk on Collection 2>Current Revenue Current Risk Daily invoicing Missing Profit Targets 3>Future Revenue Future Risk Long Term Contracts/Bids Missing profitability with long term exchange risk/ Costing going haywire 22 July

6 Managing Current Risks All the current risks (Receivables, current revenue) & hedges against current risks (non-cash flow hedges) are marked to market every quarter end and booked in P&L based on matching concept. ILLUSTRATION CASE 1 CASE 2 Month 1 Billing done at Hedged at Month 3 Money collected at P&L Impact Gain / Loss on collection Gain / Loss on hedge Net Impact Hedging has protected collection at billing rate, thereby providing predictability in P&L. Had hedging not been done, operation would lose Rs on collection in Case 1 22 July

7 Managing Future Risks TCS on an ongoing basis negotiates long term contracts with clients. pricing of which is done with targeted profit margins at a given exchange rate Predictability of exchange rates in such long term contracts is essential to meet the desired profit margin sharp exchange rate movements will make entire costing go haywire. Long term hedging (Cash Flow Hedges) for such contracts ensures that the target profit margins are met and business is not exposed to long term exchange fluctuations 22 July

8 Scenario Analysis ILLUSTRATION 5 year contract of USD while bidding. Target profit margin of 30%, all expenses are in INR Revenue in INR 4000 Expense (say) (2800) Profit 1200 Target Profit Margin 30% 40 Un-hedged Maturity Rate Revenue Expense (2800) (2800) (2800) (2800) Hedge Impact 200 (200) 0 0 Total P/L Margins achieved 30% 30% 25% 35% Hedging has ensured that target profit of 30% is met irrespective of INR level thereby providing predictability in P&L By not hedging, the P&L is exposed to huge risk and uncertainty over long term. Companies that do not hedge these long term assured contracts are taking speculative call on currencies & profitability. 22 July

9 FAS 133: Tool for Long Term Hedging FAS 133 & IAS 39 are globally accepted & progressive accounting standards Majority of the Fortune 500 companies use these standards for forex accounting. Similar type of guidelines are proposed in Accounting Standard - 30 by ICAI FAS differentiates between current risk and future risk. It requires mapping of risk & hedge associated with it on a matching concept FAS requires to state at hedge inception itself whether the current or future risk is being hedged. Hedge inception document needs to be created establishing the relationship that has to pass statutory audit test. There is no discretion left to the user 22 July

10 The Robust Accounting Standard Once the hedge objective and relationship are defined, under no circumstance can the relationship be altered. The transfer of cash flow hedge to non-cash flow hedges and vice-versa is not allowed Accordingly, all current risks and hedges to protect those risks should be revalued and booked in P&L every quarter (Non-cash flow hedges) All hedges (Cash Flow Hedges) against future risks should be revalued & shown in Balance Sheet. On maturity, these hedges should be matched against projected revenue and passed through P&L statement If due to any reason, the CFH is terminated, the profit/loss will lie in Balance sheet till the period for which the hedge was taken thereby ensuring that market participants do not misuse the standard 22 July

11 Hedging strategies Treasury Perspective 22 July 2008 TCS Public

12 Basic Hedging Instruments Instrument Advantage Disadvantage Forward Contracts Full downside protection No cost No participation in case of upside Vanilla Options Provides full upside as well downside protection Initial Cost Range Forward Options Complete downside protection Generally no upfront cost Upside participation up to a level. Choice of structure depends on market conditions and expectations at given time. Optimal hedging strategy should have optimal mix of all structures 22 July

13 Options, a superior hedging tools in uncertain times.. Plain Option is a right but not an obligation. It is a superior hedging tool that enables significant participation in case of INR depreciation at same time protecting the budget rate FAS 133 clearly specifies hedge compliant structures. Structures not permitted - sold obligations > than buying right, No leverage, No exotics, No correlations only plain structures TCS has hedges of USD INR 2.3 bio as of 30 th June 2008 spread over quarters to manage it s future & current risk. In addition, hedges of GBP USD 71 mio and EUR USD 36 mio Hedges of USD 2.3 bio does not imply opportunity loss on USD 2.3 bio in case of INR depreciation. Options enable significant upside participation. For instance TCS is hedged more than 50% for FY09 however upside participation is intact on 80% of exposure 22 July

14 CASE STUDY Expected revenue of USD 100 mio for FY at 40.0 Entity A lacks option expertise & hedges using forward contracts at Entity B hedges through a mix of forwards and options as under: a) 25 % 40.25; b) 25% Plain 40; Cost 25 paise and c) 50% Range Forwards: Long 40 & participation up to as Short ENTITY A INR at 38 INR at 42 Gain/Loss on forward 2.25 (1.75) Net Realization Hedge Ratio 100% Participation Ratio 0% ENTITY B INR at 38 INR at 42 Gain/Loss on Forward Gain Loss on Plain Option Gain/Loss on Range Forward Premium Expense Total (0.06) 2.00 (0.43) (0.25) (0.06) (.74) Net Realization Rate Hedge Ratio 100% Participation Ratio Upto Beyond % 25% 22 July

15 MTM vs HTM Marked to Market (M to M) is the current value of hedges & Hold to Maturity (H to M) implies the actual value of hedges on maturity date FAS requires all Cash flow hedges (CFH) normally to be held to maturity. H to M is relevant measure of profitability & M to M is only interim notional valuation MTM shall be higher than HTM due to: Time value for unexpired period Optionality cost for residual period With time decay, these two factors fade away & become nil. HTM is relevant for books of accounts Q2 Q3 Q4 FY08-09 Total MTM as on 30 th June 2008 (at 45) (782) (485) (548) (1816) HTM at 43 (505) (213) (200) (918) TCS hedges of USD 2.3 bio revalued at 45.0 as of June 30 th for MTM purpose against actual rate of July

16 Currency Movement: Economic Impact Budgeted Revenue: Budget Rate Hedge Ratio 60% Hedged at Upside Participation USD 1000 mio Spot at Impact on Revenue (2000) (1000) Hedge Impact (600) Total Economic Impact (800) (400) All figures are in Rs. millions Hence, by hedging for future risks, not only is the downside protected, but also gains realized in case of depreciation provided optimal mix of hedging instruments is used 22 July

17 Thank You 22 July

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