Infosys - The Toyota Way

In the linked article Jitendra V. Singh, dean of Singapore's Nanyang Business School argues that Indian firms should use the rupee's strength to their advantage by adapting their business models in innovative ways, much as Japan's automakers did during the 1980s.

The article provides a good starting point for Indian IT industry to think ways to reduce their currency risk. The risk is inherent by the nature of business where predominantly revenue is in USD while costs are in INR. Ideal situation as also suggested in the article is to follow Japanese automakers when they shifted production of low margin products to US thereby reducing impact of currency appreciation. But in the Indian scenario the fundamentals are different. While Japanese did enjoy the low cost advantage but they also had very high productivity which enabled them to be highly competitive even when shifted manufacturing to US. The Indian IT industry is still far from matching US productivity let alone surpass it. Indian advantage is genuinely labor arbitrage which more than compensates low productivity and enables firms like Infy to earn margins close to 30%. But as the article speculates on an exchange rate close to INR 20 / USD this would kill the Indian advantage if productivity does not rise large enough and also fast enough. The fact with any arbitrage is that it remains only for a short while before markets become efficient and wipe it out.

The exchange rates are beyond control of Indian IT firms so what can they do to still stay competitive? Answer lies in productivity improvement. Apart from organic ways of doing it through training, companies like Infy should use their accumulated funds and make logical overseas acquisitions in the space of high end IT services. The integration of these companies and their practices back in India would be very important as it is here where the productivity gains are required. High end services would also enable to expand the margins thereby providing thicker cushions against USD fall. These overseas acquisitions will also help IT companies in having a more geographically balanced revenue-cost structure thereby providing a partial hedge.

So overall its not just the Toyota Way for Indian IT companies but they need to find a innovative solution to the rupee appreciation. How about a (Shinning) India providing large part of revenues to Infy in our very own rupee?
...

Butterfly

Butterfly - not this colorful one found in nature but is found around the world's financial markets! ... It is a fixed income (bonds / swaps) basket trading strategy to profit from anomalies of the interest rate term structure. The arbitrage is based on the principal of mean reversion where market expects the term structure's curvature to oscillate around its historical average position. Traders predict the shape of term structure and make a bet on it.

A Butterfly trading strategy is designed to profit from a relative mis-pricing of securities of different maturities while protecting against market and curvature risk. For instance if a trader maintains a view that a particular bond ,say a 4 yr zero, is priced higher relative to other bonds, he could short this bond in the hope that it would become cheaper in the near future. However such a strategy would involve too much market risk. If the interest rates fall then an outright short position in a 4yr bond would lose money anyway even if the trader had been right and the bond did become cheap relative to other bonds.

One way in which the trader could protect the short position is by buying a nearby issue, say a 2yr zero. In this case if the interest rates fall then the loss on the short position would be covered by the corresponding long position in the 2yr bond and vice versa. Thus if the relative mis-pricing were to correct the trader would make money regardless of the direction of the market movement. In other words such a strategy protects the trader against parallel shifts in the term-structure.

However one possible problem with such a strategy arises for non-parallel shifts in term structure. If the yield curve flattens, the yield on the 4yr bond might fall while the 2yr remains unchanged. Thus in this case the trader would lose money on the short position while the long would remain unchanged, thus even if the relative mis-pricing were to correct the trader would lose money. To cover the slope (change) risk the trader might take a long position in another bond with duration higher then 4 yrs, say a 6yr zero. With this strategy in place if the term structure flattens then the trader would lose money on the 4yr bond, gain on the 6yr bond while the position in the 2yr bond remains unchanged. If the term structure becomes steeper the opposite would hold true .Thus if the relative mis-pricing of the 4yr bond were to correct here the trader would register a net gain irrespective of any change in the term structure. In other words the strategy becomes direction neutral.

Such a strategy involving three securities of different maturities is called a butterfly trading strategy. The security in the middle of the maturity range, in this case the 4yr bond, is called the body, while the other two securities are called the wings. As described above such a strategy is designed to profit from relative mis-pricing while protecting against the interest rate level and slope risk.