Fenil's Library

As companies report their results for the quarter ended March, one thing that is attracting attention is that a lot of companies are reporting reduced profits and ascribing some of it to the losses incurred on account of forex fluctuations.

Among others, Biocon reported sales of Rs 486.6 crore, profit after tax (PAT), excluding mark-to-market (MTM) loss of Rs. 74.9 cr and MTM losses of Rs 41.4 crore; Ranbaxy Laboratories reported sales of Rs 1,558.4 crore, PAT (excluding forex losses) of Rs 26.2 crore and forex loss of Rs 918.80 crore; HCL Technologies reported revenue of Rs 2,861.5 crore, net profit before forex loss of Rs 419.4 crore and forex loss of 201.3 crore; MindTree reported revenue of Rs 256.56 crore, forex loss of Rs 43.90 crore and PAT (after forex loss) of Rs 3.31 crore.

On the face of it, one would think the company could have done better but for the forex loss. But try asking the company: 

Investor: Why did you have the MTM loss? 

Company: Oh, we entered into a contract with a bank promising to sell dollars to it at Rs 40 one month down the line. 

Investor: Why did you do this? 

Company: Because we have revenues in dollars and we will receive these dollars at the end of the month. Now, if the rupee goes to Rs 35 from Rs 40 one month down the line, then we convert dollars at Rs 35 and not at Rs 40, thereby having a loss of Rs 5. 

Investor: Smart move. So why are you having losses? 

Company: The rupee actually moved from Rs 40 to Rs 50 to a dollar. 

Investor: That’s good. Now you can convert you dollar revenue at Rs 50, so that’s a gain of Rs 10 per dollar, which is a profit. 

Company: Yes. But since we promised to sell the dollars at Rs 40, and now it is at Rs 50, we are incurring a loss of Rs 10 on this particular transaction. 

Investor: But, you are also getting a profit of Rs 10 per dollar when you convert dollars into rupees. So net-net it has had no impact as far as your operating efficiency is concerned. What you lost in the forex market, you made it up in the other market by selling your revenue dollars at a higher price. So what’s the fuss all about?

Indeed, it is common knowledge that when you hedge, you buy certainty. Had the rupee gone to Rs 35, you would have gained on the contract, but lost on the dollar-revenue conversion and vice-versa. 

So the message for investors is, don’t think the company has lost money. It was a trade-off. It wanted to bring certainty to cash flows, which is what hedging is for. If the company makes the drug at Rs 38, then anything less than Rs 38 would lead to a loss. Now if it sells this drug at $1 when the dollar is Rs 40, it would earn a profit of Rs 2. But, this earned dollar would be received one month down the line. What if the rupee-dollar rate at that time is Rs 35? You incur a loss of Rs 3. To avoid such an eventuality, you sell dollar at Rs 40 one month down the line. If after the month the dollar is at Rs 35, you make a profit of Rs 5 since you can buy dollars at Rs 35 and sell it at the contracted price of Rs 40. However, you also receive your $1 from the international customer. You can convert it at Rs 35. So this Rs 35 and Rs 5 gives you a total of Rs 40, which is what you expected to get from your sales. If the rupee goes to Rs 50 to a dollar, you stand to loose Rs 10 since you will have to buy rupee at Rs 50 and sell it to the contracted party at Rs 40. But now, the dollar that you receive from your customer will be converted at Rs 50, so this Rs 50 and a loss of Rs 10 again results in your getting Rs 40 effectively. So, in all the cases, you would get Rs 40. Thus you are certain of getting this Rs 40 and thus certain of making a profit of Rs 2. So if the rupee increases to Rs 50, don’t say that your profits would have been higher but for the loss on the forward contract, but if the rupee goes to Rs 35, pat yourself on the back that you avoided a loss to the company. 

We still haven’t discussed MTM, which involves marking your instruments to the market.

Let’s understand the concept through an example. Let’s say a company has made sales, which would be realised by April or May, and the company wishes to hedge this exposure since it would receive dollars only one or two month later. For this purpose, it has entered into a contract with a bank to sell the dollar one and two months down the line, at a particular rate, say Rs 46. 

However, the company has to finalise its account for the period April 2008 to March 2009 and on March 31, it finds the rupee-dollar rate to be about Rs 50. So, as of March 31, the company is incurring a loss of Rs 4 on its forward contract (it sold dollar at Rs 46 and assuming it has to honour the contract on March 31, it would have to buy the dollar from the market at Rs 50, thus 

incurring the difference as the loss).

This is MTM. It asks the company to show the net profit or loss on a contract at prices prevailing on the date of finalisation of its accounts. Thus, MTM is like a notional gain or loss since though the company has agreed to sell dollars at April end (say at Rs 40 for dollar), its actual profit or loss position can only be found by knowing prices at April end. If the dollar is less than Rs 40, the company would have a profit, and a loss if it is more than Rs 40. Thus, if the dollar-rupee rate at March end is less than Rs 40, the company can report a higher profit (which is on account of MTM) and pat itself on the back, but if it is more than Rs 40, then blame it on the MTM losses. Thus, the bottomline is that when a company hedges by selling dollars in future, it is sure what its net-net future profit or loss will be. You always know the result.