The sharply higher foreign exchange volatility towards the end of 2013 led to substantially increased volatility of earnings, as a result of which many companies have been scurrying to revisit their hedging strategies. The knee-jerk reaction in many cases has been to make wholesale changes in their hedge policy, even if they were working reasonably well in the past. This is, in effect, fighting last year's battle.
A company I know that has large imports and, fortunately, reasonable margins had - without our intervention, I might add - developed a very well-structured hedging policy, which set percentage cost bands at which they would lock in gains and, of course, exit if the stop loss was hit. The target levels were reset every month following the same approach. It was a bit complex to my thinking, but it was delivering value in that the company was well within its margins and, importantly, once the operations team had mastered the complexity, it ran like clockwork.
Until, unfortunately, September of last year, when the rupee's sudden sharp decline hit all its existing stop losses. Unfortunately (again), the treasury team stopped the clock. Senior management intervened and allowed its perception to take over. Unfortunately (yet again), the rupee continued to plummet and when the company finally did hedge, it was way past its stop loss and, on some transactions, ended up losing money.
It has now completely changed its approach and is hedging all imports at inception. I guess the management knows that it was not the failure of its strategy, but the slip in discipline that has brought the company to this sorry pass. Hopefully, it is just convalescing from its burns and will come back to a structured, if less complex, approach soon enough.
On the other side of the long/short divide, several information technology (IT) companies with long-running structured risk management frameworks, and which are smarting from the large foreign exchange losses as well as profit and loss (P&L) volatility that resulted from the rupee's madness, have been moving to shorten their hedge horizon. In some cases, companies are even looking at - perhaps, already implementing - a three-month risk horizon, as if they were a commodity-based company.
For IT companies, many of whom have master service agreements that run three or four years, this is, in my view, creating rather than reducing risk. In general, assuming companies mean what they say when they articulate treasury as a cost centre, all "real" exposures - those that are largely determined in terms of the rate they need to secure to ensure business margins - should be either (a) hedged at inception or (b) managed in a disciplined manner with a defined worst-case benchmark rate.
The best alternative may be a combination of these two approaches, where long-term "real" exposures are hedged out at inception, and the shorter-term book is managed more actively, but with discipline, and, ideally, following a rule-based system.
Selecting the cut-off tenor is, of course, critical and it is necessary to consider several issues, including currency mix, scaling (how important are the longer tenors in terms of business volumes), market interface quality (longer-tenor hedges are always at unattractive rates since these markets are illiquid) and, of course, which tenor provides the best combination of total realisations and P&L volatility.
Of course, the hedge strategy selected - zero hedge, 100 per cent hedge, 50 per cent hedge, ladders with only forwards, ladders with forwards and options, or any other (we recommend a structured programme we have developed that we believe provides the best balance of outcomes) - would affect the outcome.
And, finally, the decision should take into account that, unlike leopards, markets change their spots all the time. Last year was a case of a broadly steady rupee that suddenly sank like a plaintive stone screaming "Bachaooo!". Without doubt there will be several considerably different environments going forward - the most popular view right now is high volatility in a narrow band. Rather than basing their decision on what would have worked last year - fighting last year's battle, as I said - companies should design their risk management frameworks to win the ongoing war.
Sorry, let me correct that - you will never win the war against markets. The best bet is to maintain an ongoing truce, recognising that it carries a cost. The trick is in minimising this cost in as wide a range of market moods as possible.
jamal@mecklai.com
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
