With the rupee having slipped below 46 against the dollar this week (for the first time since September last year) after having peered above 44 just a few weeks ago, my January forecast – that the rupee will range between 43.50 and 46.50 this year – looks to be getting well filled out.
Interestingly, when the rupee fell below 46 on Monday, I received calls from companies with long US dollar positions, asking whether they should get more aggressive in selling. Correspondingly, when (on July 27) the rupee hit its recent peak, despite semi-hysterical media talking about three-year highs, the reaction from the export sector was remarkably muted. Indeed, the only nervous calls I got were from companies that had significant unhedged import payments and foreign currency loans.
With the rupee having been relatively quiet over the past two years and forward premiums running at a tasty six per cent a year or so, most exporters had been steadily increasing their hedge ratios, whereas people with short dollar positions were edgily waiting and watching and enjoying the carry.
Of course, staying unhedged when the world is brimming over with major risk events – the rolling European sovereign debt crisis, faltering US growth and quantitative easing?, the evolving revolution in West Asia (does anyone even remember that) – creates increasing interest in prudence.
So, what to do? How to be reasonably prudent and yet not pay out a huge amount to hedge dollar payments, when there is every possibility that the rupee will not weaken, and even if it does, not to levels reflected by the forward costs?
Unfortunately, there is no cost-free answer.
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The first step, of course, is to set a stop loss — the level at which you will cut and run if the market moves against you. This is a fundamental requirement of risk management, but one that most companies almost studiously avoid. Even when they do set a stop loss, few treasuries have the discipline to hedge fully when the stop loss is threatened.
I have a lovely story about this. Back in 2006, we were working with a large, integrated steel company and had built a risk-monitoring and decision-support system for them. About a month after we went live, there was a huge surprise in the market — the Chinese government allowed the yuan to appreciate (modestly) for the first time. Global markets were startled and the rupee shot higher. The company had significant exports at the time and the system signalled a large hedge. The head of treasury was a very experienced trader and he believed that this was a knee-jerk reaction and would not sustain. The CFO took his view and overrode the signal.
Sure enough, the treasurer was correct, the rupee slipped back the following day and the company saved some money.
Almost exactly a year later – April 2007 – the rupee, which had been strengthening, suddenly shot above 40 to the dollar, once more triggering a large hedge signal. Once more, the head of treasury viewed this as a temporary blip. Once more the CFO agreed with him and overrode the signal. This time, he was wrong, the rupee continued to strengthen and the company lost nearly Rs 40 crore in that quarter.
The lesson: respect your stop loss, and even if you do override it, set another stop loss just behind it.
The next step is to determine the initial hedge. Depending on your view of the market environment – whether it is likely to be range-bound, trending, or choppy, whether volatility is likely to rise or not and so on – and the forward cost, you would need to choose between different instruments, like plain-vanilla options, forwards, call spreads or other simple structures.
So you would also need to set up a process for locking in positive movements. We have found that a high-water mark based lock-in works best. And, of course, you would need to review your market view at regular intervals — at least once a month.
Following such a hybrid hedging approach delivers superior results. When markets were trending (2007 and 2008), appropriate selection of parameters resulted in an improvement of nearly 1.25 per cent as compared to a 50 per cent hedge. Incidentally, 50 per cent hedge is an excellent benchmark against which to measure treasury performance since it acknowledges market uncertainty, is relatively inexpensive to implement, and generally provides a reasonable performance.
Since 2010, when the rupee has been largely range-bound with low volatility, using appropriate settings has delivered more than 0.75 per cent better than the 50 per cent hedge. This translated to effective protection at a cost of a bit over two per cent a year, in a market where the fully hedged cost was six per cent a year.
With volatility rising, the need for some type of structured solution could not be more important.