Jamal Mecklai: Risk? Risk? Where's the risk?

MARKET MANIAC

In a very broad sense, the objectives of foreign exchange risk management for most companies would be (a) to ensure that the company's cash flows do not suffer any negative surprises as a result of forex fluctuations, and (b) once it is assured, to enable the company to use the forex market judiciously.

These high-level objectives, of course, need to be fleshed out to a more operational level and then further brought down to day-to-day decision-making and control.

In my view, the first""and most critical""fleshing out is needed in the area of risk identification. Many companies identify forex risk only when exposures are crystallised in their accounts.

The company's expected business for the year is defined by the business plan, which includes expected inflows and outflows in foreign exchange. To value these the finance function provides a set of budgeted rates, using a variety of processes""forecasts from a committee of advisors, banks, the current forward rate, and so on""each of which is equally ad hoc.

These budgeted rates are, in most instances, rapidly discarded as the year progresses and each time an exposure crystallises the accounting rate (rate at the time of crystallisation) or some target rate (for instance, the forward rate at the time of crystallisation) becomes the benchmark for risk management. As a result, the risk management process is completely delinked from the company's business plan.

In addition to wasting a lot of management time, this approach suffers from another critical flaw ""it acts as if the company's forex risk for, say, December exports, does not exist till the export order is finalised in, say, October. In other words, in April (or, any time before October) the company acts as if it does not have any forex risk for December.

This is clearly very far from reality. The company has ""perhaps substantial""capital investment in a plant, some part of the production of which is to be exported; the amortisation of the plant cost is partly met from export realisations. Clearly, any risk to export realisations at any point in the future threatens the company's investment and the management needs to keep a focus on forex risk as far forward as it possibly can.

The domestic forex market has reasonable liquidity out to 12 months. So, even though you actually carry forex risk on a permanent time horizon, you can only manage it meaningfully to a tenor of 12 months.

Thus, it makes sense to look at your forex risk on a 12-month horizon, beginning with identifying the forex risk on the annual business plan at the start of the financial year and then tracking it on a rolling 12-month basis. (Companies with forex borrowings, of course, need to look at their risk on a much longer horizon, since global financial markets have liquidity out to virtually any tenor and, with recent improvements in India's credit rating, Indian companies can hedge out to at least 7 years forward.)

While there are several companies who have been tracking their forex risk on a 12-month basis, many others fear that the uncertainty of their business forecasts (whether for nature-of-business reasons or the commodity nature of their product, where the export price is dependent on the exchange rate may result) would render this sort of risk identification counter-productive.

However, and to the contrary, we have worked with several such businesses and find that, in general, the risk on the variance from forecast is usually much, much smaller than the risk on the underlying.

For instance, say, you are a garment exporter and expect to sell, say, 100,000 pieces in December and the expected price is $8 per piece; under our approach you would assess your risk for December as $800,000, set a benchmark value for this exposure at, say, 43.50, and manage the risk.

If, by the time the sale was made, the rupee had appreciated (to, say, 42.50) and your price went up to $ 8.20 per piece, you would receive $820,000, of which $800,000 would be protected at your benchmark level (43.50) and only $20,000 would come in at the stronger rupee level (42.50). If you waited till the contract was signed, you would have to take the entire $820,000 at the 42.50.

On the other hand, if the rupee depreciated (to, say, 44.50), as a result of which your per piece price was only $7.80, you would only receive $780,000; however, in this case, it is likely""depending on how volatile the rupee had been""you would have remained uncovered on foreign exchange because the market would be providing better value than the benchmark (43.50). Thus, you would end up with the same value as compared to the more classical approach.

There would, of course, be cases where this approach may lose money""say, the rupee appreciated to where you had to cover since the benchmark (43.50) was threatened, and depreciated (to, say, 44) after that.

Setting your benchmark in advance could lose money in such a circumstance, although the likelihood would be reduced if you had a pro-active treasury, which more and more companies are now finding necessary.

However, it is important, when you do set up a treasury""and even if you already have one""to ensure that the treasury remains focused on your business needs rather than looking for the Holy Grail of market gains in all circumstances.

To do this, you need to bind the treasury to a target that is directly linked to your business plan and not subject to reset as the market changes. The very least you will get is better predictability and control over your cash flows.