Focusing on the Currency Risk Management Process in the Corporate sector

Feb, 16, 2008     By Vikram Murarka    0 comments


Good to be with you again, Gentle Reader! This issue talks about:

  • The need for focusing on the Currency Risk Management Process in the Corporate sector

Please keep those comments coming. We love ‘em!

Focusing On The Wrong Problem?

“RBI bars exotic forex products”. This headline in the Business Standard on 07-Feb-08 had the entire forex market in a tizzy. The report said that following losses of Rs 1000 Cr (about $253 mln) stemming from complex forex derivatives, the RBI has directed banks to sell only plain vanilla rupee-dollar derivative products for hedging corporate forex exposures, not for trading.

Business Standard News ClipAlthough the ban has not been confirmed, the reactions to the headline have centered around whether or not the RBI has been justified in calling for a ban in the first place. Opinions have ranged from “Yes, it was justified” to “No, it wasn't” to “Don't know really.” Some voices, including ours, have called for greater education for the Buy side (Corporate sector) of the market.

Focus on Process missing

HEDGING POLICY HEDGING PRODUCTS
  • Philosophical in nature
  • Lays down overall guidelines, and overall Dos and Don'ts, such as “No leverage to be allowed”
  • Provides authority to Officers and lays down reporting protocols
Contracts such as Forward Contracts, Options and Swaps that are used for implementation of the risk management process.

So far, the discussions have focused on the derivative “products” - whether or not they should be banned; and whether there is a need for greater education regarding these “products”. Ironically, there has been no talk about the need to strengthen the very process of corporate FX risk management .

Of course, it is to be acknowledged that on the insistence of the RBI, many companies have adopted a Currency Risk Management policy at the board level. However, a policy is not the same as a process.

While a “policy” is more philosophical, outlining the overall guiding principles of an activity, a “process” is more practical, involving itself with the nuts-and-bolts issues of the day to day performance of the activity. And derivative “products” are something else altogether. They are merely the instruments used to implement the objectives of the hedging policy and process.

The global currency market has traditionally been driven by the “Sell Side” i.e. Banks. It is a testimony to the salesmanship of the Sell Side that the Buy Side has, quite often, been charmed into buying derivative products, without adequately evaluating their suitability. As in the case of any other product, while buying a derivative, it should be seen whether the product serves the overall objectives of the Customer.

HEDGING PROCESS

It is more practical in nature
It provides answers to the following questions:

  • What to hedge?
  • How much to hedge?
  • When to hedge?
  • For what period to hedge?
  • How to hedge?
  • Which product to use?
  • Why are we hedging in the first place?
  • How do we measure performance?

Hedging Process needed

Herein lies the need for a Hedging Process, as outlined in the table alongside. Notice that “Which product to use” is only one out of the seven questions that a Hedging Process is intended to answer. As can be seen, the overarching emphasis on derivative products leads to a neglect of the other equally vital aspects of a complete hedging process.


Vital Questions

How does one go about formulating a Hedging Process? We suggest a set of questions that every Corporate FX Risk Management Team can ask itself. The answers to these questions will pave the way for the formulation of a Hedging Process for the company.

  1. What is our FX Risk Management Agenda for 2008?
  2. Have we quantified our FX Risk Management Objectives for 2008?
  3. The production and marketing guys have their budgets. Have we worked out a Hedging Cost Budget?
  4. How do we measure FX Risk Management performance? Are we trying to beat the market, or better a Benchmark?
  5. Is our Benchmark based on the past, present or future? Where does Risk lie: in the past, present or future?
  6. The market is ever changing. Is our benchmark fixed? Or Dynamic?
  7. Are we more concerned with the performance of our Hedges than of our Exposures? Why?
  8. What are the five greatest Risk Management challenges we face?
  9. What three wishes would we want to ask of the Treasury Fairy?
  10. Are we willing to explicitly pay for Advice? Should advice be paid for separately from the commission/ brokerage payable on hedging transactions?

Is it worthwhile?

Is it worthwhile taking the trouble to answer these 10 questions and formulating a 7-step Hedging Process? The results of the KSHITIJ Hedging Method, a complete, end-to-end hedging process, suggest it is.

The Kshitij Hedging Method 06-07Under the method, Exports have been covered at an average rate of 45.56 and 43.51 in 2006-07 and 2007-08 respectively, while Imports have been covered at averages of 45.20 and 40.70 in the same periods. Thus, a corporate having both Exports as well as Imports has been able to earn a hedged Export-Import margin of Rs 0.36/ USD, or 0.8%, in 2006-07. This margin increased dramatically to Rs 2.81/ USD, or 6.9%, in 2007-08.

The KSHITIJ Hedging Method, which is centered around a revolutionary concept of Dynamic Benchmarks has enabled both Exporters and Importers to make money simultaneously. Importantly, this has been achieved without resorting to speculation or trading, even while being hedged to the extent of 60%.

The secret in the KSHITIJ method is that it addresses all the aspects of a complete Hedging Process. Derivative products have certainly been used, but merely as instruments, as and when needed, to achieve the objectives of the Method. To reiterate, the focus needs to shift to the overall FX Risk Management objective, and not be confined to the derivative products.

Once a person starts taking care of his health, he will automatically cut down on cigarettes and junk food.

Vikram Murarka

Chief Currency Strategist at KSHITIJ.COM. Likes to look at the markets from many different angles. Weaves many conventional and unconventional technical analysis techniques and fundamental analysis into a global macro perspective. Likes to take the road less traveled.



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