Page 61 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes Experts were divided over HCL Tech’s decision to cancel its currency forward hedge.
According to an analyst, “It’s a one-time act that the company is taking to clean up the
balance sheet. After this, the numbers can focus on its operations rather than get impacted
by currency fluctuations. Of course, this will impact the company’s surplus cash reserve as
well, as in the next few quarters the dividend payout might get negatively impacted.”
According to an ICICI Securities report, the loss on account of cancellation of these contracts
would be ` 5,200 million at the spot rate of ` 49.69 against the hedge rate of ` 41. However,
according to the management, the cancellation was likely to be spread out.
The report also mentioned that the loss due to cancellation would be debited in the
respective quarters of maturity as against the earlier policy of booking losses in the
quarter of cancellation. The report expressed the view that the new policy was fair and in
accordance with the US GAAP and that it reduced earnings volatility.
Some analysts held the opposite view. HCL Tech had unwound the covers for the currency
forward, putting them in an un-hedge position, as company inflows would be converted
at the spot rate. This fundamentally defeated the very purpose of the company’s hedging
policy, they said. With the cancellation of the currency hedge, the company might benefit
if the rupee continued to further depreciate. Analysts expressed concern about the company’s
position should the rupee appreciate further against the US dollar. They even opined that
this cancellation raised the basic question of how HCL Tech could hedge or manage the
currency exposure as most of the revenue came in foreign currency terms.
HCL Tech, a leading global IT player, had a presence in 18 countries at 60 locations all over
the world. It was the fifth largest Indian IT player as of 2008 with a 3% contribution in the
IT-ITES sector. It provided a wide range of IT-related products and services to mid- and
large size enterprises all over the world with the help of more than 50,000 employees.

As a major part of HCL Tech’s revenue was generated from outside India, the cash flows of
the company were influenced by currency movements. The company therefore used
derivative financial instruments like foreign currency forwards to hedge its currency risk
for a certain forecasted period.
The Indian Rupee (INR) recorded its strongest mark against the US Dollar (USD) in
November 2007 at ` 39, having strengthened by around 11% from ` 44 per dollar at the
beginning of the year 2007. The strengthening of the Indian Rupee was mainly due to the
depreciation in the USD. The depreciation was mainly due to the slowdown in the US
economy, high spending on wars, and the negative balance of payment in the US. In the
same year, foreign capital investment in India increased.
HCL Tech took the forward hedge covers for the next coming 7 to 10 quarters, depending
upon the earnings visibility and forex market. As the rupee appreciated from ` 44.27 per
dollar in January 2007 to ` 39.45 per dollar in November 2007, HCL Tech reported a huge
forex gain as it had already covered its revenues at around ` 44 per dollar.
As the company reported on a mark-to-market basis, the gains or losses occurring from
the forward hedge covers of future quarter revenues caused huge fluctuations in its reported
profits. This also created a mismatch between the reported revenues and the forex losses/
gains.

With the cancellation of currency hedges, industry analysts opined that the company’s
move toward unhedged currency forwards reflected its expectations that the rupee would
depreciate against the dollar and sustain at ` 47 to ` 50 in the short to medium term. But
they wondered what the company’s position would be if the rupee appreciated above ` 47
against the dollar.
Contd...

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