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