This is a report to critically analyse and discuss about the usage of derivatives in Tata Consultancy Services (TCS) Company. TCS is a software services and consulting company, which offers wide range of solutions in IT services and business process outsourcing. TCS established in 1968 have headquartered in India. It has grown its current position as the largest IT service provider with outstanding service, innovative, collaboration partnership and corporate responsibility. It serves various industries like Banking, financial services, insurance, manufacturing, telecommunication, retail, transport, health care, entertainment, etc. TCS has been named as the official technology partner for the Boston Marathon. This operates primarily in India, America and Europe. (TCS, 2010)
Derivatives
A derivative security is an agreement between two parties to transact something (underlying asset) at a future date for some agreed upon price. The relation between derivative and underlying can be modelled through the following equation.
Derivative Price Change
Underlying Price change
Price of the underlying will determine the price of the derivatives. Since price is derived from the value of something else it is called as derivative. Derivatives are traded at exchange market or Over-The-Counter (OTC) markets. There are mainly two purposes why do we need derivatives - Hedging, Speculations.
Hedging: this is a process of reducing the risk. Corporations often have unwanted risks. In the case of TCS, Company has to pay workers who are working in US in the form of Dollars rather than INR. If price of the rupee fluctuates a lot, it leads to a currency risk. Since TCS Company cannot handle all these risks, It will go for derivatives in order to structure the situations. This means transferring the risk to someone else who can handle better. TCS follows hedging.
Speculation: This is a kind of gambling where one party says that derivative will go up and other party says that derivative will go down. This is very dangerous because of they are so volatile. In case of failures, there will be a huge loss. There is a lot of scrutiny because of they are always not as well regulated. yet they can call as such value that can create a great systemic dangerous as we have seen credit crisis system as a whole. TCS does not use the speculation.
Types of Derivatives
Futures
This is a contract between two parties to buy or sell an asset at an agreed price and on a specific future date. Couple of important factors are there is no cash exchange when a futures contract is signed. And next is the actual asset or money exchange does not occur until the specified date. If one of parties defaults and does not honour the contract then clearing house of the futures exchange mediates the trades in the future market. Both parties deposit a certain amount of money in a margin account that will provide insurance in case one of the parties defaults. Margin money is just a deposit and it does not go towards the cost of the trade. Actually money in the margin account earns a reasonable rate of interest.
The important terms in future contacts are long and short position. The party that agrees to buy an asset is considered is taking long position. A party that agrees to sell is considered as taking a short position. The reason to why would someone enter in a futures contract is a futures contract will help to protect a long position holder from future price increases of the underlying asset. The long position holder is one type of derivatives trader who has entered into the contract with the expectation that the underlying asset price will rise.
Forwards
Futures and forwards are very similar except that forwards are traded in OTC markets. Forwards are not standardized and they can be very different from contract to contract.
A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain price. Some of the popular agreements are
- Forward rate agreements
- Repurchase agreements ( REPOS) and etc
For the last 5 years TCS uses Foreign exchange forward contracts to hedge the currency risk. In 2007, Rupee was appreciated to 10 years maximum level as shown in the below diagram 1.1. India times (2007) provides the information that 90% of the annual revenue of TCS was generated from overseas which was about $4 billion and 30 to 50 basis points of Operating margins will come down if one percent rise in the rupee against the dollar. Though situation was very bad, based on predictions, from 2006 to 2007 TCS has increased its hedging about 30% which is $1 billion. Through this hedging process of forward contract TCS received dollars with a pre determined price which made them in a good saviour position. In 2008, rupee strengthen very strongly against US Dollar, which leads to critical situation to TCS as well as IT firms in India and it's been prevailed over through the hedging strategy. To hedge this currency risk, Forward prices are estimated for different expiry or maturities like 3 moths, 6 months, 1 year. If spot rate is lesser than the forward price, then foreign currency called as forward premium or else it is called as forward discount. Mathematically,
Where N is the number of months forward.
US Dollar vs Indian Rupee Intraday Forex Chart
Diagram 1.1 : US Dollar vs Indian Rupee Forex Chart
Source : Advfn (2010)
Options
This is a contract that gives the option holder the right to buy or sell an asset at a certain price with a certain expiration date. Contract price is referred as strike price.
Option is just a right to sell or buy not an obligation. An option holder may or may not trade the underlying asset. Since it is a contract with a right buying, an option cost some money which is known as a premium. During this contract period if the option holder trades the instrument, this is referred to as exercising the option. If option holder does not exercise his option he would lose his premium.
There are two types of options:
PUT Option and CALL option
A CALL option is the right to buy the underlying asset at a premium determined price within a specified period. PUT option is the right to sell the underlying asset at a predetermined price within a specified period. Here buyer of the call or put option is called buyer. Seller is called as option writer. Buyer has to pay some premium to writer.
TCS uses plain vanilla option which consists of standard components. American style options and European style options are treated as plain vanilla options which are straight forward strike price.TCS use these options to hedge its exposure of US Dollar rather than forwards. The reason for the adaption is high volatile conditions between US Dollar and INR. In volatile conditions, Options are more beneficial instruments since they offer unrestricted of upside profitability while prevarication the downside risk but there is a risk with forwards if the anticipation of the exchange rate is wrong as firms drop out on some profit.
Swaps
This is an agreement between two parties to exchange cash flows in the future based on a certain formula. The agreement defines when the cash flow will be exchanged and the formula to be used to calculate the cash flow. The formula can be based on the interest rate or exchange rate or any other market variable.
The following table demonstrates TCS and Its competitors risk exposure and associated hedging instruments.
Company Name
Purpose
Instruments Used
Proportion & Trend
Currencies Hedged in
TCS
Future Cash Flows
Hedging
Forwards
Used Forward to hedge currency risk in last Financial Year but the proportion was just to the tune of 10%
USD, Euro, GBP
Options Vanilla
Increased the cash flow hedging through options by more than 300% in FY 07-08
Infosys
Hedging for debtors
Forwards
Started using more off late as compared to previous years
USD, Euro
Options Exotic(Range Barrier)
Was used more extensively in last financial year
Gokaldas Exports
Hedging for debtors
Forwards
Used Forward Only
USD, SEK, JPY
HCL Technologies
Hedging for debtors
Forwards
Used Forward Only
USD, JPY, SEK
Rsystems
Hedging for debtors
Forwards
Used Forward Only
USD
From TCS 2009 annual reports, TCS hedges the risks associated with fluctuations in foreign currency related to certain firm commitment and predicted transactions, Companies use foreign currency forward contracts and currency options. By applying the recognition and measurement principles set out in the Accounting Standard 30 these hedging instruments are designated as cash flow hedges by the companies.
By using forward contracts and options, TCS is hedging its currency risk. Its currency risk is hedged in US Dollar, Euro & Sterling Pound. By using forward contracts and maximum 8 years period option TCS hedges its currency risk for the future revenue stream (cash flow hedge) and debtors (fair value hedge). (India times, 2007)
TCS hedging trends:
In the financial year 07-08, may be with an intention to hedge against future cash flows for more period of time TCS used 90% options and 10% forwards to manage its currency risks.
TCS has increased its hedged exposure by using both forwards and options in between the financial years 06-07 & 07-08.
When comparing the increase in hedged exposure it was $280 million in forward contract while it was $3171 million using options.
TCS has increased the investment hugely in recent years to hedge in order to ensure proper receiving from the recent deals with UK Government which covers the National Employment Savings Trust for 10 years.
Usage of derivative has been changed over the years. From 2005 to 2006, Initially Foreign currency forward contract derivative instruments are calculated at fair value, and are re evaluated at consequent reporting dates. From 2004 to 2005, initially there were no future contracts, later on started with forward contracts and then as per huge currency fluctuations, started research towards reduce the risk and then resulted options to mitigate the risks . ( Neoadvisory 2007)
As personal interview conducted through colleague for TCS hedging process the following outcomes are received.
Q1. In TCS, are there any hedging tools. If so what are the risks and how are they managed. What are the different tools company is using?.
Since TCS is a MNC and IT services company, earning 90% of revenues through foreign currencies. The main risk associated to these activities is currency exposure. Even for small amount of Indian rupee appreciations are significantly impacts Company turnover. Company is using forward contracts to hedge foreign currency risk and primary purpose of this one is to hedge for the receivables like billed or unbilled. Company don't use for speculative purpose.
Q2. When there are many number of software companies who are exposed to a variety of tools such as futures and options and even exotic options to avert currency risk, what is the reason behind using only forwards as your tool?
Almost we hedge probable receivables and don't indulge in speculative hedging since it's our company policy to hedge using fair value approach. Taking other companies into consideration, due to getting stuck into exotic options there is a considerable amount of loss in Hexaware and other companies. For managing foreign currency risk many software companies have taken a traditional stand.
Q3. What is the time frame of your forward contracts?
Since we don't hedge for future cash flows and reduce ourselves in hedging our receivables 3-6 months is generally the time frame of our forward contracts. Hence, as per our books time frame depends on the receivables.
Q4. Is it in proportion to the average collection period?
Along with some other elements that come into play the average collection point reflects with the amount of risk hedged. Hence it doesn't exclusively depend on the average collection period.
Q5. What are the institutions using for hedging?
TCS Company buys forward contracts through banks which eliminates the risk from the counterparties. And also does not maintain same bank for all contracts.
Conclusions
As per the overall derivative analysis of TCS, It is using forward contact and options instruments for mitigating the risk through hedging process and does not using speculation. Since Indian rupee INR continuously is strengthening in recent years, which decreases the incoming foreign currency. In this current situation derivative instruments are playing a key role and it is directly reflecting in Companies profits.
