Executive director of Reserve Bank of India V K Sharma, on Thursday said that corporate India should invariably hedge their actual risk exposures without exception as a base-case strategy. “To say the least this is by far the most conservative and prudent strategy. Indeed, against the background of the measures announced by the Reserve Bank of India (RBI) on December 15, withdrawal of the facility to cancel and rebook forward contracts leaves no other option, but to follow the base-case strategy,” he said in Bangalore at a meet on forex risk management organised by the Bangalore Chamber of Industry and Commerce (BCIC), adding that the excruciating and wrenching volatility, experienced recently, unquestionably attests to the credentials of such a base-case strategy of being fully hedged.
“Of course, it does mean that risk is being completely eliminated and, hence, so is the financial return. But then, this is just as well because, as I said earlier, this is not the dharma of business and industry whose cardinal principle it must be to earn their market-competitive return-on-equity from their normal core business risks only to the complete exclusion of foreign exchange, interest rate and commodities price risks,” he said.
He said, risk management is not about eliminating, or which is the same thing as completely hedging risk, but about first determining, like one’s pain threshold, risk tolerance threshold and then aligning an entity’s existing risk, be it currency, interest rate or commodity price risk, with its risk tolerance threshold. “Having said that it would also be in order to have a sense of how risk itself is defined and measured. Risk is uncertainty over future outcomes such as cash flows. In financial theory and practice, it is typically measured by annualised standard deviation of a time-series of percentage changes in asset prices. While courting financial risks in pursuit of financial returns is the staple and dharma of banking and finance industry, it is not so for industrial and manufacturing businesses! The staple and dharma of business and industry is courting their normal core business risk in pursuit of delivering a market-competitive return on equity to shareholders,” he said.
He urged corporates not to be tempted and enticed by the nominally low interest rates in overseas borrowings and invariably rigorously evaluate such foreign currency borrowing options, benchmarking them against the comparable Rupee borrowings. “Only if business and industry find the long-term foreign currency borrowing costs lower, on a fully-hedged basis, than the comparable rupee borrowing costs, must they choose such borrowing options,” he stressed.
He further clarified to industry representatives that the present popular, but uninformed and totally untenable, refrain has been that forward cover for foreign exchange for longer term such as five years, or so, is not available; what is available is up to one month, three months, six months and maximum one year and not beyond.
“But I would state that a long-term forward foreign exchange hedging solution can be easily customised by banks by recourse to what is known as rolling hedging strategy which simply involves simultaneously cancelling, and rebooking, a short-term forward exchange contract until the desired long-term maturity. Incidentally, such simultaneous cancellation and rebooking of forward contracts for rollover is exempt from the RBI restrictions introduced on December 15, 2011.
Of course, precisely the same strategy can be replicated in the exchange-traded foreign currency futures markets as well,” he explained.
