Case 085Macro and commodity sensitivityCore

An Indian IT exporter earns 80% of its revenue in dollars. The rupee strengthens from 84 to 80 and half the exposure is hedged at 83. What happens to rupee revenue and margin?

State StreetBoston · 2020

The situation

Kovaris Infotech has revenue equivalent to USD 1.2 billion. 80% of it, USD 960 million, is billed in dollars; the other 20%, Rs 2,016 crore, is billed in rupees to Indian clients. Almost all its costs are salaries in India, paid in rupees. Last year the rupee averaged 84 to the dollar and the EBIT margin was 21%.

This year the rupee strengthens to 80. Kovaris hedged half its dollar revenue at 83 with forward contracts. Management's rule of thumb: every 1% move in the rupee shifts the EBIT margin by 30 basis points before hedges.

Your task

What happens to rupee revenue and to the EBIT margin this year, and why is the hedge not the end of the story?

Quick check

Is a stronger rupee good or bad for Kovaris?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Rupee revenue falls 2.4% and the margin about 89 basis points this year, with a bigger hit to come. Unhedged, the 4.8% rupee move would cut the margin by 143 basis points. Half hedged at 83, Kovaris realises an average 81.5, so the hit is 89 basis points and the margin is about 20.1%. When the hedges roll at rates near 80, the full hit arrives. A stronger rupee hurts exporters; hedges delay it.

Step 1Why does a strong rupee hurt an exporter?

Think of a nurse working in Dubai who sends money home. When the rupee strengthens, each dirham she sends buys fewer rupees, and her family's monthly budget shrinks even though her salary did not change. Kovaris is that nurse in reverse: it earns in dollars and pays in rupees, so a stronger rupee shrinks revenue while costs stay put. A move from 84 to 80 is a 4.8% fall in rupees per dollar. On USD 960 million that is Rs 384 crore less revenue, with no saving on salaries.

Step 2How much does the hedge save this year?

Half the dollars, USD 480 million, convert at the forward rate of 83, worth Rs 3,984 crore. The other half converts at 80, worth Rs 3,840 crore. The hedge adds Rs 144 crore against converting everything at 80, but it still loses a rupee on every hedged dollar against last year's 84. Total revenue is Rs 9,840 crore against Rs 10,080 crore, down 2.4%, instead of the 3.8% fall without the hedge. A forward contractAn agreement to exchange currencies on a future date at a rate fixed today, whatever the market rate turns out to be. fixes a rate; it does not fix last year's rate.

A stronger rupee shrinks dollar revenue; the hedge halves the slope78808284867,4007,7008,0008,300Rupees per dollar (lower = stronger rupee)Dollar revenue in Rs croreunhedgedhalf hedged at 83last year: 8,064unhedged: 7,680hedged: 7,824gap at 80: the hedge adds Rs 144 crore
Kovaris's dollar revenue is worth Rs 8,064 crore at 84; at 80 it falls to Rs 7,680 crore unhedged but only to Rs 7,824 crore with half hedged at 83, a hedge benefit of Rs 144 crore.
Rs croreLast year at 84This year, half hedgedThis year, unhedged
Dollar revenue in rupees8,0647,8247,680
Rupee-billed revenue2,0162,0162,016
Total revenue10,0809,8409,696
Realised rate84.081.580.0
Margin hit at 30 bp per 1%89 bp143 bp
EBIT margin21.0%20.1%19.6%
The hedge keeps Kovaris's revenue fall to 2.4% and its margin hit to 89 basis points this year, against 3.8% and 143 basis points unhedged.
Step 3Why is the hedge only a delay?

Because hedges expire and are replaced at the rates of the day. Next year's forwards will be struck near 80, so the full 143 basis point hit reaches the margin a year late. Model it that way: 20.1% this year, about 19.6% next year if the rupee stays at 80, unless Kovaris offsets it with price increases, cheaper delivery locations or a higher share of work done offshore.

The hedge delays the hit by about a year; it does not remove it21.0%Last yearrate 8420.1%This yearhalf hedged at 8319.6%Next yearhedges rolled near 8019.0%
Kovaris's margin slips from 21.0% to 20.1% this year while the hedges at 83 run off, and to about 19.6% next year once new hedges are struck near 80, so the hedge moves the hit later rather than removing it.

Say the limit of the rule of thumb. Thirty basis points per 1% assumes the whole cost base is in rupees and prices do not move. Kovaris's onsite staff abroad are paid in dollars, which cushions the hit, and clients sometimes share currency gains in renegotiations. The rule is a starting point for the question to management, not the answer.

Where candidates lose it

Many candidates answer that a strong currency is a sign of a strong economy and so is good news. For a company that earns in dollars and pays in rupees, it is the opposite, and the interviewer is checking whether you think about which side of the ledger each currency sits on.

The second miss is treating the hedge as protection. It protects the rate you locked, 83, not last year's 84, and it runs off.

What the interviewer asks next

  • What happens to Kovaris's reported other income if hedges are marked to market before they mature?
  • Which Indian sectors gain from a stronger rupee, and why?
  • If 30% of costs were onsite and paid in dollars, what would the 30 bp rule of thumb become?

Asked at State Street, Equity Research, Boston, 2020 (Wall Street Oasis): What is an exchange rate and what does it mean to have a strong currency?

Company names and figures are illustrative.