Context and Issue:
- Several decades ago, we developed a FX risk management policy for Infosys. When we were discussing the best tenor to identify risk, Narayan Murthy said, “Cash is real, profits are an opinion. We should identify risk as far forward as we can.” Keep in mind that forward premiums were 5-6%+ in those days.
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That first policy identified risk out to 24 months; since then it was extended even further, sometimes up to 60 months
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In recent years, as the company’s asset value became more controlling, they completely changed their approach and now (we believe) identify risk only out to 3-4 months, focusing only on their accounts
They do have a trading desk, though, to try to capture cash value separately
- Thus, depending on business positioning, companies need to take this call
Our Mandate
We were approached by the new CFO of a leading tyre manufacturer who wanted us to vet its longstanding risk management strategy, which was fully P&L focused
- Imports and exports were managed separately; they were identified when confirmed – imports on PO date; exports on invoicing, and all exposures were hedged 100% with forwards on identification
- Since PO to payment period of imports was longer than the invoice to cash receipt period of exports, treasury was paying higher amount of premium on imports than the premium earned on exports
- Thus, while there was no FX gain/loss on the P&L, there was a cash risk that was unmonitored and managed
Analysis
- Since they were a price taker, the price of their finished products were not significantly correlated with INR exchange rate (against EUR and USD); as a result, the company carries FX risk on exports beyond each order cycle
Thus, exports should be identified using forecasts on a rolling 12-month basis
- Wherever possible, imports should be hedged against equivalent exports to eliminate spot risk using buy-sell swaps to manage the timing mismatch; this reduces hedging costs (on imports) and earns risk free premium.
Risk on net imports should be identified on PO date
- Net exposure should be hedged through systematic hedging program which (i) does not use any market view, (ii) sets and protects a risk limit (worst acceptable rate), and (iii) enables opportunity capture at pre-defined levels
Impact of the recommendations
- Naturally hedging (i) USD exports with equivalent USD imports and (ii) EUR loan payments with EUR exports, using sell/buy swaps resulted in a substantial reduction in risk and led to some premium earnings
- On the remaining EUR exports, the longer tenor hedges led to significant cash gains
- On the remaining USD imports, the strategy recommended carrying a fixed amount of risk; after building in the cash gains made on the natural hedge and the EUR exports, the company was always cash positive
- However, given that EURINR is quite volatile, there was some P&L volatility, but the CFO was able to convince the board that the cash gains outweighed the impact of P&L volatility
- It was also determined that the approach would be reviewed every 2-3 years
Business context:
- An EPC contractor engaged in design, testing, manufacture and supply of galvanized towers; manufacture of conductors; and construction services
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About 30% of the revenue was through export projects
- Imported procurement was roughly 20% of the export revenue
- Additionally, cost of part of domestic procurement is USD linked
- Entire export business and about 35% of domestic business was under Firm Price contracts; the balance revenue was under contracts with a Price Variation clause
Risk management issues:
- All projects and supply contracts are for long tenors, averaging 24 months. Since entire export business is under Firm Price contract, company is exposed to FX and Commodity risk over this long tenor.
- Further, under these contracts, company is exposed to contingent risk during Bid to Award period (about 3-6 months), during which FX and Commodity prices could move adversely.
- While significant FX exposure is naturally hedged, the timing mismatch was not being managed actively.
- FX and commodity risk were also being managed selectively and based on individuals’ market views; in particular, the risk on domestic purchases was not even considered; as a result cash flows were at the mercy of market movement.
The solution we developed:
- Objectives of Treasury clearly articulated.
- FX and Commodity Risk Profile developed separately, but the MIS was designed to ensure they fed into each other at the “risk limit” level; the risk profile included the risk from domestic purchases.
- For the natural hedge, optimal approach was defined ensuring that the import payment rate is always lower than the effective export realization rate; domestic FX-linked purchases were built into the natural hedge.
- Systematic hedging approach for FX risk on net exports, independent of any market view.
- Process for monitoring commodity risk during Bid to Award Period and building in that impact while managing the risk after award of contract.
- Data interface between business and treasury, MIS formats defined for seamless implementation.
Impact of the recommendations:
- Economic Impact – Risk is identified and monitored from its inception, reducing dramatically project cost overruns and diminution of margins; natural hedge management ensures positive cash flow impact.
- Decision support – Structured approach provides decision support on FX hedge timing and amount. Strategy for commodity risk provides decision support on bid rate calculation and subsequent commodity hedging after the award.
- Operations – Effective data interface and automated MIS minimized operational risk by ensuring accurate risk identification and transparent reporting and performance evaluation.
Our Mandate:
We were approached by a leading pharma company asked to conduct a review of its FX risk management operations to assess
- Whether the current strategy used adequately covers the risk on profit margins; could any other alternative provide a better risk/return positioning
- Whether the currently used hedge instruments were suitable under different volatility environment
- How could the natural hedge be optimized and the asset liability mismatch be kept at a minimum
Business context and current operations:
- The company was engaged in the manufacture of generics and biosimilars, and had a commercial R&D operation; total revenues were over INR 6,000 cr.
- 75-80% of the revenue was from exports; imported raw material costs were about 40% of the revenue
- Cash flow risk at global subsidiaries was managed structurally, matching local costs with domestic revenue, USD exports with USD labilities, etc.
- Supply contracts were for long tenors and FX risk could not be passed on to customers; thus, any adverse FX movement directly affects profit margins.
- All stakeholders are very sensitive towards ‘FX gain/loss’ in the accounts.
Existing Hedge Strategy:
- A fixed hedge ratio was maintained over a defined tenor of risk identification
- Very wide range forwards were used to hedge the exposures over rolling 24 months; while this allowed opportunity capture, it also resulted in open risk (because of the wide range)
- Natural Hedge is managed through EEFC account, on occasions requiring blocking of funds
- Risk was not monitored on a regular (even daily) basis, over the hedging operation
The Solution:
Strategic Changes
- Risk Limit: We recommended setting a risk limit (defining the worst acceptable conversion rate) for net exports.
- Risk/Reward-based Strategy: We analyzed the risk/reward of different hedge instruments over the preceding decade. Based on this, we recommended a hybrid strategy, which was a combination of plain vanilla forwards, range forwards and our proprietary hedge model – the selected strategy protected the risk on cash flows over the entire tenor, generated reasonable opportunity gains, and limited the volatility on the P&L
Process Changes
- Natural Hedge: Recommended an optimal approach which ensured that the import payment rate was always lower than the effective export realization rate
- Decision-making: Shifting from the earlier largely discretionary process, we recommended a structured approach to ensure minimal dependence on market views, in line with the company’s philosophy
- FX ALM: Recommended SOPs to ensure that (1) the balance sheets of group companies were not cross subsidized and (2) asset liability mismatches between long term FX loans and export value-add were reduced/eliminated
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