Over the past few years, more and more companies have come to realise that it is critical to have a structured approach to foreign exchange risk management to avoid being caught off balance by the increasingly frequent bouts of extreme rupee volatility.
One approach that is used by several companies, particularly those with good margins, is to use a ladder, where the company hedges, say, 100 per cent of exposures over the first quarter, 75 per cent in the second, 50 per cent in the third and 25 per cent in the fourth. This means that at any point in time, the company has only 37.5 per cent of its 12-month exposure unhedged. The approach is popular because it appears conservative (a high hedge ratio) and also takes into consideration the obvious variability in business forecasts.
Ladders can have many parametric variations. The company may choose to identify its risk out further - say, to 24 months - and use different hedge ratios - say, 80 per cent of the first 12 months and 50 per cent of the second. It could choose different windows - say, 100 per cent to six months, 75 per cent from months seven to 18, and 50 per cent of months 18 to 24; and so on. Both the tenor of risk identification and the hedge ratios are (generally) selected based on elements of the underlying business.
While many companies use only forwards, some use a combination of options and forwards; some, indeed, have a very stringent system in terms of buying options first and then forwards, and so on. While the use of options is recommended, I find that, in many such cases, the ratio of options is too high and the process for selecting the option strike and the timing of option purchase is driven by the need to save on option premium.
The problem is that some companies have a super-hands-off approach to the ladder, and hedge only, say, once a quarter over, say, the last 10 days of the quarter; others hedge and roll the ladder over monthly. This means that, although the initial risk is reasonably low, the fact that the risk remains unhedged - there is no process for modifying the hedge ratio - means that the portfolio could end up carrying huge amounts of risk. For instance, if the rupee were to appreciate by 10 or 15 per cent over a quarter - it did just depreciate by a greater amount in a shorter period - the next ladder rung would be at a much worse level (for exporters).
Where the treasury is permitted to intervene between rungs - or, where the CFO requires intervention when the market goes crazy - the company gets forced into the market view mode, undercutting one of the most important goals of the ladder approach.
And, finally, when the rupee weakens dramatically, as it has in recent months, the opportunity loss from the ladder can get quite substantial. While opportunity loss is a cost one often has to pay to ensure downside protection - and most companies that are at this level of risk management understanding recognise this - the recent market drama has brought several ladder-wallahs to us, mandating a review of their risk management approach and strategies.
We have two basic objections to the ladder, both of which are related. The first is that there is no specified benchmark rate that the CFO can definitively provide the board as a worst case realisation level; as a result, risk is open-ended. The second is that there are (generally) no specific guidelines on how the treasury should act in the event that the market runs away adversely; so, too, if the management feels the market is running away - or about to run away - there are no guideposts for what the treasury should do. As a result, if things go awry, the company gets thrown back into market view-based decision making, which is the very problem a structured risk management approach seeks to avoid.
Our recommendation is to start with a pre-set benchmark that has to be protected whatever happens to the market. The process we employ to ensure this is designed to be completely free of a market view, addressing a primary goal of companies that currently use ladders; thus, while it is a little more transaction-intensive than most ladders, it can be run without significant management attention and/or intervention. The hedge ratio that results is more snake-like, in that it begins at a low level (typically 15-20 per cent) and meanders upwards depending on whether and to what extent the market threatens the benchmark.
For the first company I mentioned - the one with the 100:75:50:25 ladder - our approach definitively protected the benchmark and (over July 2012 to June 2013) delivered a realised value 1.5 per cent better than the ladder; over the more volatile period (January to June 2013), the realisation was nearly three per cent better.
In contrast to the board game, in real life the snake always works better than the ladders.
jamal@mecklai.com
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