FOREX RISK MANAGEMENT IN INFORMATION TECHNOLOGY SECTOR – NEED OF THE HOUR

FOREX RISK MANAGEMENT IN INFORMATION TECHNOLOGY SECTOR – NEED OF THE HOUR

-Dr. Akansha Jain

M.Com(gold medalist),PGDBA((Fin)Symbiosis-Pune)

            ABSTRACT

             The major parts of earnings of information technology come through exports in US dollars. The value of US dollar is fluctuating day by day which is, in turn, reducing the quantum of exports and profit margin of such companies. As Information Technology Industry is export oriented industry, hence the study of forex risk management in this sector is of great significance because the foreign exchange risk requires a lot of attention. Under forex risk management, hedging techniques need greater care, caution and management. Hedging techniques includes options, futures, forwards, swaps, short term borrowing etc. Their prudent applications do not only reduce the forex risk, but also accelerates the profitability.

Foreign Exchange refers to the exchange of one currency into another currency and Foreign Exchange Risk refers to the variability in the value that takes place with fluctuations in exchange rates due to a change in demand & supply, interest rates, inflation, Gross Domestic Product, balance of trade, balance of payments, unemployment, war, speculation, capital movement & political situation.

            As regards the determination of Foreign Exchange Rate in India, Reserve Bank of India used to fix the exchange rate of Rupee into Sterling Pound upto Sep. 1975. Thereafter, Rupee's exchange rate was linked to a basket of currencies in view of the diversification of India's foreign trade. This policy existed upto June 1991. In July 1991, a two step devaluation of the Rupee was engineered and US dollar was introduced as an intervention currency. Liberalized Exchange Rate Management System was introduced in March 1992. This was beginning of the dual exchange rate system and the forex market in India effectively, became a two-tier system, with a dual exchange rate system in force. One of which was the administered rate at which specified type of currency exchange had to be transacted. The other rate was determined by the demand and supply in the market and applied to the  remaining transactions. In March 1993, this system was abolished and a single market determined rate was applicable for all transactions. The market spot and forward rates are determined by demand and supply

IT sector is one of the fastest growing industries in the world. IT sector consists of software industry and information technology enabled services(ITES) which also includes business process outsourcing industry.

                       

Indian IT companies like Tata Consultancy Services (TCS) Ltd, WIPRO Ltd, INFOSYS Technologies Ltd , HCL, Satyam Computers Services Ltd (rebranded as Mahindra Satyam) are recognized in global market for their information technology services.

The Indian IT sector is very lucrative because of : (i) Low  wage structure; (ii) Government's Policy; (iii) Quality of work; (iv) Highly skilled human resource; (v) Establishment of Foreign Organizations in India; (vi) Cost competitiveness; (vii) Quality telecommunications infrastructure. (ix) English-speaking professionals; and (x) Quality Standards.

As regards the growth of the Indian IT Sector, the Indian information technology sector is one of the sunshine sectors of the Indian economy witnessing rapid growth. The Indian IT- Business Process Outsourcing sector aims to achieve a target of US$ 60 billion in exports and US$ 73-75 billion in overall software and services revenues by 2010. India’s information and communication technology market also aims to grow 20.3 per cent annually to reach US$ 24.3 billion by 2011. The Indian IT and IT enabled Services  market is targeted to grow at the rate of over 16 per cent to become a US$ 132 billion industry, significantly, the domestic market alone is targeted to become over US$ 50 billion, with an annual compound growth rate of 18.4 per cent. Simultaneously, the IT and IT enabled Services exports are targeted to more than double to US $ 78.62 billion by 2012.[1]

            IT enabled Services offers services such as Knowledge Process Outsourcing (KPO), Legal Process Outsourcing (LPO), Games Process Outsourcing (GPO) etc. More and more sophisticated products are being developed in India. The domestic Business Process Outsourcing segment is growing annually at a rate of nearly 35-40 %. The revenues generated by the BPO’s are almost $ 1.18 million and the domestic market is expected to reach $ 10 billion by the end of 2011-12[2] then IT and IT enabled services will reach nearly US$ 330 million.

Greater fluctuations occur in the exchange rate even in a day which forces to ponder how to manage earnings when the major part of earnings comes through exports in foreign currencies. Fluctuations in the value of dollar is alarming for the-export oriented companies and that is why export oriented companies are forced to hedge their earnings.

Types of Forex  Risk

            Foreign exchange exposure is usually categorized as (i) Transaction Exposure; (ii) Translation Exposure and (iii) Economic Exposure.

            Transaction exposure arises because of denomination of a payable or receivable in a foreign currency. Translation exposure arises on the consolidation of foreign currency denominated assets and liabilities in the process of preparing consolidated accounts. It is also regarded as accounting exposure. Economic exposure arises because the present value of a stream of expected future cash flows which are  denominated in the home currency or in a foreign currency may vary due to exchange fluctuations. Transaction and economic exposure are both considered as cash flow exposures.

Transaction exposure can also be considered as subset of economic exposure. It can be viewed because of fact that the present value of an uncovered foreign currency denominated receivable or payable changes as exchange rates changes. The value of an international operation can be expressed as the present value of expected future operating cash flows, which are incremental to that international activity discounted at the appropriate discount rate.

Methods of Forex Risk Management

Once the company recognizes its exposure to forex risk , it needs to manage it. Exposure Management techniques are classified into internal and external techniques according to their basic origin. Internal techniques are mainly used as a part of company’s regulatory financial management & aims at minimizing its exposure to exchange risk. These basically aim at reducing or preventing an exposed position from arising. The external techniques are used to provide protection against the possibility that exchange losses will result from the foreign exchange risk exposure which the internal measures have not been able to eliminate. These consists of basically the contractual measures to provide protection against an exchange loss which may arise from an existing translation or exposed position.

 Hedging Strategies

Various Hedging instruments are:-         

·         Forward Exchange Contracts

Forward exchange contracts refer to agreements in which two parties agree upon the exchange rate at which currencies will be exchanged on future date or within future specified duration. Forward contracts reduces exchange risk element in the foreign transactions. Price is paid for the protectionism and best-cost alternative should be chosen to reduce the cost of purchase.

·         Options

Options are rights & not obligations to make buy and sell decision. An option is a contract between two parties known as the buyer and the seller or writer. The buyer pays a price or premium to the seller for the right but not the obligation to buy or sell a certain amount of a specified quantity of one currency in exchange at a fixed price for a specified period of time. The right to buy is a call option and the right to sell is a put option. The set or fixed price is the exercise or strike price. The period ends on the maturity or expiration date. The item to which the option applies is the underlying asset and its value determines the value of the option. Options refer to instruments which are used as a tool to hedge foreign exchange risk.

·         Futures

Futures are contracts to buy or sell financial instruments for forward delivery or settlement on standardized terms and conditions. Future contacts are similar to forward contracts but are more liquid as these are traded on recognized exchanges. Fluctuations in currency can be hedged by buying & selling futures. Depreciation in currency can be hedged by selling futures & appreciation can be hedged by purchasing futures.

            A futures contract provides a tool of risk management to participants. Risk and uncertainty in the form of price volatility and opportunism are two main reasons that give rise to future trading

·         Swaps

   Swaps refer to a contract between two parties, termed as counter-parties, who exchange payments between them for an agreed period of time according to certain specified rules. It is defined as a financial transaction involving two counter-parties who agreed terms to exchange streams of payments or cash flows overtime on the basis of  agreed at the beginning of the contract. Swap is like a series of forward contracts. Swaps involve a series of exchanges at specific futures dates between counter parties

·         Short term Borrowing

Another alternative to hedge risks in the forward market is the short-term borrowing technique. A company can borrow either dollar or some other foreign currency or the local currency. Through short term borrowing techniques, two major difficulties of  the settlement dates and the continuing stream of foreign currency are easily solved. Short-term borrowing has some advantages over forward cover. The cost of short-term borrowing cover is the home currency amount which would have been received if the exposed receivable has been measurable. The foreign currency converted into home currency at the settlement dateless spot rate is the amount which the short-term borrowing technique yielded.

·         Discounting

This technique is used to resolve the problems of continuing foreign currency exposures and uncertain settlement dates. The discounting technique for covering receivables exposures is very similar to short term borrowing. In discounting techniques, the effective discount rate less the home currency deposit rate rather that the foreign currency borrowing rate less the home currency rate as is short term borrowing techniques, is the cost. The basic aim in discounting is to convert the proceeds from the foreign currency receivable into the home currency as soon as possible.

Factors affecting the decision to hedge foreign currency risk

    Factors which affects hedging decisions includes (1)Firm size, (2)  Liquidity,(3) Leverage,(4) Profitability and (5)Turnover position

Conclusions and suggestions

      Derivatives used for hedging must increase due to  global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures.

Companies should do their best to make internal hedging system more sound. Emphasis should be laid on the use of balance accrued income with outstanding expenses or prepaid expenses with income received in Advance, External currency inflow with currency outflow or vice-versa.

Rupee-Dollar futures should be introduced in  Indian stock exchanges as a new product of derivatives so as to provide an another route for hedging forex risk. In order to reduce the cost of hedging, it is suggested that the Government of India should revise its regulations wherein corporate should be allowed directly to deal in foreign currency derivative market in place of the banks which have so far been allowed to deal in foreign exchange market.

BIBLIOGRAPHY

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·                      Bhatia, R.K., High Commissioner of India, at seminar entitled "India@Futurex" in Johannesburg, South Africa, , May 17, 2007.

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·                      Choudhary, Anil B. Roy, "Analysis and Interpretation of Financial Statements through Financial Ratios", New Delhi, Orient Longman; 1970.

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·                     

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[1] Quoted from the Speech of Mr. R.K. Bhatia, High Commissioner of India, at seminar entitled "India@Futurex" in Johannesburg, South Africa, , May 17, 2007.

[2] I.bid.