With forex losses piling up at virtually every company, I am — more than ever — amazed at how few companies are able to run a truly disciplined hedging programme. Companies with otherwise excellent managements — not to mention award-winning (ha ha) corporate governance — routinely fall prey to the market-view approach to risk management, obviously unaware that this is not risk management at all.
I guess some of it has to do with the fact that the exchange rate is a very public number, particularly over the past couple of years, and it is impossible for anyone in business not to have a view on it. Again, for the marquee IT companies, and, as a result, much of the listed segment, the analyst community uses the exchange rate and the company’s hedge rate as key significators of business performance.
Thus, the poor chairman (or CEO or audit committee chair) is compelled to (a) not only waste his/her time thinking about the exchange rate, but also (b) from time to time intrude into otherwise well-run operations by actively recommending action (or inaction) during forex committee decision-making.
Structurally, this is a problem, since forex committees usually meet once a fortnight (or, in more active ones, once a week), whereas the market could demand action at any time. Now, given the board’s responsibility, both statutorily and otherwise, to ensure effective forex risk management, this participation is certainly understandable.
However, risk management is too technical and dynamic a field to lend itself to decision-making by committee. It needs to be run by professionals with a clear mandate and accountability. The board should articulate guidelines which stress discipline, ensure that the operating team is fully focused on managing risk rather than speculating, and lay down a framework that ensures adequate control of the operation.
Once such a sensible structure is in place, it should be a relatively simple matter for the treasury to build a hedging program that can CONSISTENTLY deliver superior results. We have developed one such rule-based program, which uses a combination of plain vanilla options and forwards.
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It works wonderfully well — for a 12-month portfolio of net exports running from January 2007 to date, it was able to capture 72 per cent of the opportunity envelope. This means that if the best possible rate that prevailed for a particular exposure over a period was 100 and the worst was 50, our approach resulted in a value of 86 — which is pretty good going, in my view.
The actual values were as follows: the average of the best possible rates for the full 37-month period (Jan 2007 to Feb 2010) was 49.41, including a low of 43.11 (in May 2008) and a high of 52.94 (the forward rate for Feb 2010 on March 4). The average of the worst possible rates was 42.48, including the low of 39.30 (in Nov 2007) and a high of 52.50 (again, forward rate for February 2010, this time on March 6).
We came in at 47.56, which, as mentioned earlier, represented an opportunity capture of 72 per cent. It is important to understand that the process needs to be run over a long period — a minimum of 12 months — to see its true value, since 72 per cent represents the average capture, with certain months coming in quite low (eg, under 35 per cent in July, August and September of 2008), while the current open portfolio (Mar 2009 to Feb 2010) has an over 85 per cent opportunity capture.
Incidentally, I believe this is the best way to measure market performance — track the best and worst possible rates that prevailed over a particular horizon, and see where you stood within this envelope. Given that markets are impossible to forecast, any performance better than 50 per cent should be seen as reasonable. The much better results we see tell me that this program is a consistent winner.
Of course, the approach does not eliminate the possibility of a mark-to-market loss on the company’s books. The only way to achieve that is to stay completely unhedged, which is an extremely high-risk strategy, or to hedge the entire portfolio with plain vanilla options, which is usually much too expensive. The hedged portfolio carried an MTM loss (as on Mar 16) of 1.07 rupees per dollar — quite high, but substantially less than the 5.87 rupees per dollar that a fully hedged book would carry.
Unfortunately, there’s no way around it — you either take some protection and suffer the notional loss if the market moves adverse to your hedge, or you stay unhedged and ride a wholly unpredictable tiger. To my mind, there is really no choice.
The more important issue, however, is that even when the CFO understands all of this and appreciates the value that a structured approach can provide, s/he is often hamstrung and, indeed, undercut by the need to abide by curious — and often really ad hoc — decisions taken by the forex committee.
While having a forex committee is extremely important, I believe it should have more of a strategic mandate, providing the board with inputs for planning. It should also have an audit role, vetting the operational controls and monitoring treasury performance.
But once the controls are in place, let the professionals do their job.