Jul-Sep 2013

Hedging Currency Risk at TT Textiles

This summary is based on the case study by Professor Rajesh Chakrabarti, where he highlights  the impact of currency rate fluctuations on the profitability  of an export-oriented  textile manufacturing firm,  TT Textiles. The company’s swap deal, which was based on the historical stability of the Swiss franc (CHF) against the US dollar (US$) initially seemed safe and lucrative, became a pain point with the global financial meltdown of 2008. A turnaround in 2009 saved TT Textiles from further losses, but left its management in a quandary. Should they quit the deal or hold to maturity?

On  a hot March morning in Kolkata in 2009, Sanjay K Jain, Joint Managing Director of TT Textiles, watched the  sunlight  stream  through  his  office  window and pondered  over the  ramifications  of the recent movements  of the Swiss franc (CHF). The Swiss franc had touched 1.17 CHF/US  dollar (US$)  from  the previous  year’s record  of 0.96CHF/US$. Was  this currency fluctuation  good for his company or did it spell doom?   Not a Greenhorn Founded in 1978,  TT  Textiles had a presence in the entire  cotton  value chain and was India’s first knitwear company to go public. The company’s core businesses were agri-commodities, cotton, yarn, fabric and garments. It had manufacturing  units  spread across India. An exporter to clients in over 30 countries, it typically  used for wards to manage currency risk. A significant proportion  of TT Textile’s  revenue came from exports. In an attempt  to hedge currency risk, in 2006-07, when the Indian rupee (INR) was expected to appreciate,  the  company  had  entered  into an apparently  safe and profitable   swap deal. The  swap deal was based on the historical  stability  of the Swiss franc against the US dollar.  However, the story did not pan out as expected as the global financial crisis of 2008 played spoilsport. Fortunately for TT Textiles, 2009 did show  some semblance of recovery.  With three months left on the contract, Jain had to decide whether to quit now or hold it to maturity.   The Indian Scenario Most  Indian  companies depended on  their banks to hedge  currency   exposures  as currency  derivative products   were  relatively  new  entrants   in  India. Indian  corporations either  entered into a  forward contract or left  the exposure open. However, both had associated disadvantages. On July 7, 2003, when the Reserve Bank of India (RBI) introduced foreign currency-rupee  options,  the time  was ripe  for this move. It was well received by Indian  corporations  as well  as banks, and the first  day of trading  saw brisk activity. The currency market became one of India’s biggest financial  markets. Exchange-traded currency derivatives, such as foreign exchange (forex)  for wards and futures markets in the country, traded the INR/ US$, while derivatives on other currencies were not traded. For foreign institutional  investors (FIIs) who had  limited   access to the forwards markets  in the domestic INR/US$  markets, there was active trading for cash-settled INR/US$  for wards in Hong Kong, Singapore, Dubai and London in what were termed “non-deliverable  for wards”  (NDF) markets.  The INR/US$ forward  market  was an over-the-counter (OTC)   market.  The  total  daily  average turnover  in forex OTC or off-exchange trading markets expanded exponentially  and was significantly  more  than  the average turnover   of exchange-traded currency contracts. Both  exchange-traded and off-exchange traded markets  had complex  procedural  requirements.  In order to simplify matters for the small and medium enterprise  (SME)  sector, RBI granted flexibility  in hedging  underlying  and  future   exposures.  In late 2006, when the Indian rupee was rapidly appreciating and the US dollar was depreciating, the Indian textile industry  was reeling  under   severe currency pressures.  The  most  irksome   aspect  of this   was that the rupee’s appreciation was driven by foreign portfolio  investment flows to India rather than global factors, thus causing Indian  exports  to lose  out to competition.  Subsequently, currency hedging became very important  in a commoditised industry such  as the textile  industry, which  operated  on  razor  thin margins domestically and internationally.

In 2006, with exports becoming costlier, textile companies had to either boost domestic sales or hedge against the upward movement of the Indian rupee against the US dollar in order to remain afloat. TT Textiles focussed on the latter option.

Hedging Currency Risk In 2006, with exports becoming costlier,  textile companies had to either boost domestic sales or hedge against the upward  movement  of the Indian  rupee against the US dollar  in order to remain afloat. TT Textiles focussed on the latter option.  Its currency risk hedging strategy was in line with  the rest of the textile industry,  where   forwards  were  used  to safeguard against adverse currency  movements.  While  it was in the midst of finalising a hedging option, the company received  a  visit  from ABC  Bank’s  derivatives  sales representative.1 He introduced  TT Textiles to a new instrument called currency  swaps, which  enabled the company to limit  its exposure to fluctuations in the rate of the US dollar.  The three-year  swap was on the historically stable US dollar  and Swiss franc. The US dollar had never gone below the exchange rate of 1.09  CHF,  making  the  latter  a very  stable currency;  by offering  a better cut-off mark than 1.09 CHF/US$,  the ABC representative evidently fail- proofed  the  proposal  and  assuaged Jain’s concerns about the swap deal. The interest rate that the bank would  be paying to TT Textiles would  be based on the contract’s notional principal  amount, which was in Indian rupees. No  initial  principal  exchange took place in this swap deal, and on maturity,  TT Textiles had to pay the bank the Swiss franc equivalent of the contract’s notional principal amount after receiving the same in Indian  rupees from the bank. TT Textiles did not have to pay any interest,  but the bank had to do  so twice  a year. This  was a very lucrative  and safe deal  as TT Textiles  was assured of fixed returns without  having to do much,  as long as the exchange rates  stayed  within reasonable boundaries.  The company was virtually  assured of an earning over the life  of the deal as the bank  offered  it a credit limit on the basis of its balance sheet to cover the margins and mark-to-market  losses. In the final month before the contract’s maturity, the company could sell a part of the contract’s notional principal  amount at a predetermined  rate if the US$/ CHF traded at or below the cut-off  mark at any time during the said month. However, it had an obligation to sell US  dollars  at the  same predetermined  rate if US$/CHF  went above this rate on maturity.  The protection  on US$/INR  was similar to that on US$/ CHF,  with  the only difference  being that there was no barrier  of any form.  Though  Jain was aware that there were risks associated with  the swap deal if there were extreme fluctuations in the currencies, the historical stability  of the Swiss franc and the US dollar alleviated his doubts. TT Textiles entered into the  swap deal with ABC Bank in September 2006.   Unforeseen Upheavals When it received the first  cheque from  ABC Bank, everything was moving along in the expected manner for TT Textiles, and the company, like others, began increasing its exposure to this instrument. The good times  were,  however, short-lived.  If, in 2007,  the Indian  rupee appreciated against the US dollar  due to increased foreign investments (FIIs),  in 2008, it drastically  depreciated  due to massive  FII outflows triggered by a global financial meltdown.  If, in 2007, exporters lost out to competition due to the rupee’s appreciation,  in 2008,  the  economic  recession in importing  countries  and  subsequent protectionist measures  added  to the  woes  of these exporters. Domestic  demand  was also affected  on  account  of marked  inflation  and a fall in GDP growth. By the end 2007,  the  US  economy was heading towards recession. Subsequently, the  Indian  stock  market crashed spectacularly, more FIIs flowed out, the INR crept  up,  Indian corporations   over-hedged  their futures and some banks allegedly started mis-selling.

Jain had two choices: He could either continue with the swap deal of CHF/US$, which was due to expire in October 2009; or he could exit it at this favourable juncture and put an end to any uncertainty.

Meanwhile, in Europe,  there  were no  signs of recession. The Swiss franc started becoming stronger than the US dollar and eventually crossed the strike rate that was specified in TT  Textiles’  swap deal. This implied that the company would slump into the red. The bank also faced liquidity  challenges and perforce turned down the company’s demand for a credit  limit increase.   A Stitch in Time Could Save Nine  In early 2009, the US dollar gained momentum and started reversing. This put TT Textiles and Jain in a Catch-22 situation. Though he sought opinions from a host of financial experts, Jain was not able to form a clear  view  of his next move. He had two choices: He could either continue  with  the swap deal of CHF/ US$, which  was due to expire in October 2009; or he could exit it at this favourable juncture and put an end to any uncertainty. The decision pivoted around the dollar’s movements, which could result in high returns on the swap, but could also be very risky. The  sun had shifted  but the furrows  on Jain’s forehead lingered. Having witnessed the unexpected and  alarming  behaviour  of the  supposedly  steady exchange rate relationship  between the US dollar and the Swiss franc, he was still undecided  about the right course of action. Should he close out his positions or should he trust that the US dollar would be able to maintain its current position and thus run the risk of exposing his firm to losses? Time  was running out and Jain had a critical decision to make. 1   The name of the bank has been disguised for  confidentiality reasons

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