At a time when there has been a big jump in risk aversion in global financial markets, this article challenges two revered canons of forex risk management. The article will first build a case that companies should actively manage currency risk, which is otherwise viewed as a “necessary evil”. Second, it will argue that the concept of “natural hedge” goes against the basic tenets of profit maximization for companies and highlight an example where it was profitable for a company to shun a natural hedge even when it theoretically existed.

While preparing to write this article, I was assailed by a bit of self-doubt. Was I a fool, rushing in where angels feared to tread? It was heartening to find that mine was not the lone voice in the woods.

An article entitled “To Hedge or Not to hedge”, cited in GT News on 01-Aug-2006 quoted James Binny, executive director of ABN AMRO’s FX analytics and risk advisory, as saying, “It is accepted now that you can make money out of currency and it should be a useful part of the portfolio.” The article went on to conclude that “ the idea that FX transactions will cancel themselves out over time is one that is antiquated , and few are still prepared to leave anything to chance and ignore this opportunity to trade.” (Italics are mine).

World without theories

Let us go back to the genesis, to a time when there were no theories regarding forex risk management on Planet Earth. We consider the example of a diamond company, domiciled in India , which imports uncut diamonds, invoiced in US Dollars. It cuts and polishes the diamonds and exports them back, invoicing the exports in US Dollars.

As the charts above show, the company, as an Importer, has an obligation to buy Dollars, which is the same as running a Short position in USD-INR (Fig 1). As an Exporter, it holds a Long position in the export Dollars that it needs to sell (Fig 2). This is the true picture of its foreign exchange exposures, shorn of any theories.

What should the diamond company do? Continuing to live in a world without theories, the company would attempt to buy its Import Dollars (or cover its original “Short” position) at a low rate and at the same time it would want to sell its Export Dollars (or cover its original “Long” position) at a higher rate. Suppose, the company is indeed able to buy Dollars at 42.00 and to sell Dollars at 44.00, it would have captured a net Export-Import margin of INR 2.00 per USD, or 4.65% (2/43) for itself from the foreign exchange market.

Forex is not my business. Is that really so?

This 4.65% net margin is the result of judicious management of the forex rates that the company pays and receives, not from the core business of polishing uncut diamonds. Is there anything wrong in trying to capture this profit? In a competitive world, every variable that a business is exposed to needs to be managed with the intent of adding to shareholder value. Forex is no exception. 

Conventional wisdom says that foreign exchange trading is not the business of a manufacturing company. While one agrees that forex “trading” is not the core business of the company, it is an undeniable fact that the Imports and Exports undertaken in the course of its core business, forces the company to initiate “trades” in the forex market, as demonstrated by Figs 1 and 2 referred to earlier. This fact, as deduced by native logic, flies in the face of established convention, that “forex is not my business”.

A steel manufacturer, although not in the freighting business, tries its best to keep its freight costs down, both while transporting raw materials to its plants and while shipping finished goods out. A car manufacturer, although not a banker, makes all efforts possible to procure working capital at the cheapest possible rates. Thereafter, very legitimately, it tries to deploy any surplus funds that it might have available, at the highest rates possible. Of course, without exposing the company to risk. Variables such as freight, capital and labour costs are integral to each and every business and it is the management’s duty to manage these variables efficiently, and if possible, profitably.

Similarly, although the diamond company in our example might not have wished the forex trades on itself, it does have an obligation to profitably manage the trades it has on hand.

The process of managing the trades is called hedging. It involves framing the answers to the questions listed in the box alongside, and acting accordingly.

We focus on the first two questions, viz. “What to hedge?” and “How much to hedge?” Continuing in the same vein of using unsullied thought, the answer would have to be that both imports and exports should be hedged, and should be hedged in their entirety (not necessarily all in one shot, though), because these are, after all, the company’s original forex trades, and need to be covered .

Natural Hedge? I want a margin!

Conventional wisdom, however, says that since the company has both Imports, on the one hand, and Exports on the other hand, it has a “natural hedge” and needs to hedge only the residual net exposure, or excess of exports over imports. Say, the company imports diamonds worth USD 100 and exports diamonds worth USD 110. Conventional wisdom would ask the company to hedge/ sell only USD 10. Doing that, however, would mean that it should not try to earn an Export-Import Margin from forex on USD 100. At the most it may attempt to earn a forex margin on USD 10. But that would not really be worth writing home about, would it?

Thankfully, there is enough literature that agrees that a “natural hedge” exists only in theory, given the realities of time and amount mismatches. Even if we assume a situation where the utopian concept of “natural hedge” does exist, a profit-seeking company would still want to buy Dollars for its imports at a lower rate and to sell its export Dollars at a higher rate.

What would you think of a grocer who displays a rate list like the one shown alongside (Fig. 4)? Every grocer seeks to be compensated by the customer for taking the trouble of bringing the goods from the wholesaler to a well appointed store in the neighbourhood, for the convenience of the customer. Similarly, the diamond manufacturer would want to secure a reward (difference between its export-import rates) for the currency risk it carries on the entire USD 110, not only on USD 10.

Text Books have not been updated

A bulk of the forex risk management theory in vogue and practice today dates back to the eighties and early nineties (a time when the forex market itself was no more than 15-20 years old) and emanates from bank dealing rooms. It was a time when there were a number of currencies in circulation in Europe , when bid-offer spreads used to be wide and volatility used to be high. Banks did indeed find some positive and negative flows canceling each other out. While managing a mess of several currencies, the banks found it easier to deal with the residual currency amounts. It probably made sense at that time when computers, communication and information systems were less powerful than they are today.

When companies, who were then totally new to tackling currency risk, turned to banks for guidance, the banks simply handed out a manual of what they themselves did, to their clients. Here, it must be remembered that, by nature, banks are risk averse – they seek coverage and collateral at the very outset for the money they lend. Manufacturing companies, on the other hand, thrive by taking risks. “Fortune favours the brave” has been the mantra of all entrepreneurs across time and space.

Further, the eighties and early nineties were times when globalisation and competition were not as fierce as they are today. Profits were easier to come by and companies could afford to leave a few stones unturned during their quest for profits.

Not so today. Times have changed and the textbooks need to be updated. Business competition has increased in general as also in the forex market. Why, Bid-Offer spreads are now down to a few “piplets”, even at the retail level! At the same time, currency volatility has reduced substantially and even George Soros might find it difficult to do an encore of his famous “broke the BOE” trade. Information systems are more robust and real time. In this new environment, there is both a possibility and a need for companies to try and work currencies for their bottomlines, rather than thrusting their heads into the sand like ostriches.

Is it worth it?

Can it really be worthwhile to go against an established belief, to do something radically different? Should the diamond company with a natural hedge really try to adopt a policy of “gross” hedging, rather than “net” hedging? Let the numbers do the talking.

We had worked with one such company, using our proprietary concept of “Dynamic Benchmarks”. We did not go by the “natural hedge” concept and instead, hedged both the imports and exports separately. We used only plain vanilla hedging tools as Forwards and Puts/ Calls. Most importantly, we did not expose the company to any additional risk at all. The average hedge ratio was in the region of 56%.

Over the period Apr-06 to Jan-08, even as the Indian Rupee appreciated against the US Dollar, Exports were covered along the Green line shown in the chart alongside (Fig 5). At the same time, Imports were hedged along the Red line, benefiting from the very same appreciation of the Rupee.

As a result, the company earned a very handsome Export-Import margin – from forex – over and above its normal business.

As seen in the table alongside (Fig 6), net Export realizations, after hedging costs/ benefits, averaged INR 45.56 per USD in the financial year Apr-06 to Mar-07 and averaged 43.30 in FY 07-08. Net Import costs, after hedging costs/ benefits, averaged 45.28 in 06-07 and 40.96 in 07-08, leaving an Export-Import margin of 0.6% and 5.7% in FY 06-07 and 07-08 respectively. Very satisfactory results – achieved by going against the grain of “natural hedge” – without taking risks or speculating.

The times they are a-changin’

As I finish writing this article, I have before me the views of some of the leading CFOs and Treasurers in Corporate India, as featured in the 06-Sep-08 issue of Outlook Business. Mr NS Paramasivan, Global Treasury Head, Essar Group, for instance, say, “Our mandate is to lower the cost of imports as much as possible and increase the realization on exports as much as possible.”

And there’s nothing wrong with it, really, as long as it is done systematically and responsibly, without exposing the company to undue risk. And, when Mr YM Deosthalee, CFO, L&T says, “We have the ability to convert our treasury to a profit center. But we have no plans to do it yet”, it seems all that is needed now is for the academic intelligentsia to concede that trying to manage forex cost efficiently, perhaps profitably, is not a business crime. Indeed, it is just another avenue to be strenuously explored in the overall interests of creating shareholder value.

This article, authored by Vikram Murarka, has been commissioned by GTNews.com, a leading website on Treasury and Finance related issues

Rupee Volatility has increased The last couple of years have been particularly painful for Corporate India in many ways. Forex Risk Management has been one of the ways by which several hundred crores were lost. In one famous case, a company lost close to Rs 1500 Crores, and went from a net profit in 2007-08 to net loss in 2008-09. Also famously, an Accounting Standard was changed to allow companies to capitalise forex losses on foreign loans.

 What went wrong? Most obviously, there was a sharp rise in Dollar-Rupee volatility. Compared with an annual range of 10% (between 43 and 47) from 2003 to 2007, Rupee gained 11% in 2007 and fell 33% in 2008-09.

The less obvious, but more important, thing that went wrong was that the forex risk management techniques used by Corporates came a cropper.

This article makes two contentions. Firstly, forex volatility is here to stay and the sooner Corporate India learns to deal with it, the better. Secondly, extant forex risk management techniques of Corporate India are by and large illequipped to deal with volatility (as has been amply demonstrated) because of some fundamental flaws. The article does not end on a negative note, though. It proposes a set of questions that the top management, including the Board, of companies needs to introspect on and answer, if they want to be able to deal with the new reality of forex volatility.

Volatility to remain high

Over the years, there has been a trend increase in Dollar-Rupee volatility, measured by the percentage movement in a month. The Rupee used to fluctuate an average of 1% (or 45 paise) earlier, but the monthly fluctuation is now averaging 5% (about 225-250 paise). Moreover, the volatility is likely to remain above 3% (135-150 paise) in the future.

The main reason behind the structural increase in volatility is the growth of India’s Current Account, including exports and imports of both goods and services, and India’s Capital Account, which is witness to a high degree of volatility in portfolio investment flows. This has led to a huge increase in the daily turnover in the Dollar-Rupee market, to such an extent that it is now increasingly difficult for the RBI to contain the volatility on a daily basis. As the economy continues to grow and open up, it is unlikely that forex volatility is going to decrease. As such, the sooner Corporate India realizes that forex volatility is a fact of life and learns how to deal with it, the better.

Unfortunately, the way Corporate India has been managing forex risk so far is woefully inadequate to deal with currency volatility. The bleeding financial statements of companies are a testimony to this fact

Fundamental Flaws

The forex risk management systems in Corporate India suffer from some fundamental flaws. Three of these flaws are listed below :

1. No Benchmark

The unadmitted, but implicit, objective of forex risk management in a very large number of companies is to try and beat the market. There is a lot of pressure on the forex desks in companies to make profits. Do not go by what companies say in their annual reports. Ask the dealers and risk managers in the treasury departments of companies to verify this statement.

This happens because a most companies set no Benchmark by which forex risk management is to be guided. As a result, the market becomes the default benchmark and everybody tries to beat it. Hedging decisions are assessed on whether or not the hedge beats the market.

2. Fixed Benchmark, if at all

The few companies that work with Benchmarks tend to have a Fixed Benchmark for the whole year. One particular USD-INR rate is decided upon during the annual budgeting exercise in February-March, and then hedges are undertaken accordingly. This is done because (a) a fixed benchmark lends itself easily to budgeting (b) the marketing and production departments in a company do not want to deal with a “non-domain” variable and (c) there is still an innate “wish” in the minds of most people that exchange rates should remain steady.

<p>However, this approach is far removed from reality. The currency market, like most other markets, is volatile and given to wild swings. The factors on which the annual currency forecast (and benchmark) is based are likely to change. As such, there is a need to revise the Benchmark. Unfortunately, the system is inflexible and does not allow for changes in benchmarks, does not allow for any course correction.

3. No Budget for Hedging

It would be a very rare company, indeed, that had set aside a budget for Hedging in 2007 and 2008. Although every activity in business has a budget allotted to it, be it as mundane as the daily upkeep of toilets, Forex Hedging is supposed to be, or so it seems, costless. That is why forex hedging budgets are unheard of. And that is why we witnessed the phenomenon of hordes of companies taking on 1×2 Put Risk Reversals in 2006 and 2008 to hedge their Exports.

Buying a simple, plain vanilla Put costs money and no company had provided for that. So everybody tried to go in for “zero cost options” and ended up with losses that were several times higher than the option premium they could have chosen to pay earlier on plain vanilla Puts.

Nine Vital Questions

Of course, it is easy to point out what’s wrong. It is more difficult to suggest a solution. Companies need to do some hard introspection if they want to find a way out of the current mess that is forex risk management. A set of nine vital questions is proposed below, which companies can ask themselves. The answers to these questions can pave the way for better forex risk management going forward.

QS 1. What is our FX Risk Management Agenda?

The agenda could include anything, ranging from “We want to avoid losses” to “We want to make profits” to “We want to train our people” to “We want to upgrade our treasury software” etc.

Here, let it be explicitly added, there is nothing wrong in having “We want to make profits” as the agenda of forex risk management. What is important is that the objective be approached in a proper manner.

QS 2. Have we quantified our FX Risk Management Objectives for the year?

Whatever objectives have been included in the Agenda in (1) above, they need to quantified. For instance, if the agenda is to “Avoid losses”, it needs to be quantified as to losses beyond which level are to be avoided, because losses cannot be totally nullified without sacrificing profitability. This also presupposes that work has been done to estimate what quantum of losses is possible and what impact it can have on the companies financials.

Similarly, if the objective is to make profits, the company needs to estimate the profit potential and needs to set out the profit targets that need to be achieved. It also needs to quantify the potential risk in its pursuit of profits.

Without putting numbers to the objectives, the objectives will remain mere homilies.

QS 3. The production and marketing guys have their budgets. Have we worked out a Hedging Cost Budget?

Any and every activity requires some expenditure. Then why not Hedging? Stop Losses on Forward Contracts that go wrong and Option Premium on plain vanilla puts and calls would be paid for from the Hedging Cost Budget. It would make the life of the forex risk manager much easier and actually enable him and empower him to achieve the set objectives.

QS 4. How do we measure FX Risk Management performance? Are we trying to beat the market, or better a Benchmark?

In the absence of quantification of objectives, it becomes difficult to assess the performance of the FX Risk Management function. And by default, and by application of accounting rules, the company ends up trying to beat the market. This happens despite knowing that it is impossible (and even unadvisable) to try and beat the market on an ongoing basis.

QS 5. Is our Benchmark based on the past, present or future?

In the rare instance where a company (say an Exporter) sets a Benchmark, it tends to take the rate on the date of bill of lading as the Benchmark. Or sometimes the average exchange over the last 3 to 6 months may be taken as the Benchmark. Another common practice is to take the Forward Rate on a particular date as the Benchmark. The question is, are these practices effective and correct? If not, is there a better way?

QS 6. Where does Risk lie: in the past, present or future?

This is a rhetoric question. A moment’s thought will tell us that risk lies neither in the past not the present, but in the future. And we also know that the future is likely to be different from the past and the present. So, it is the future that the FX Risk Management team should be concerned about.

QS 7. The market is ever changing. Is our benchmark fixed? Or Dynamic?

In anticipating the future, companies tend to make a “single number” forecast for the entire year ahead and take that to be the benchmark. The reasons why they do that have been outlined earlier in the article. But, it is hardly correct to do so, because the conditions on which that forecast was made are quite likely to change in the future. As such, there will be a need to revise the forecast based on the new, changed conditions. How many companies allow for such change in forecasts and Benchmarks?

QS 8. Are we more concerned with the performance of our Hedges than of our Exposures? Why?

Most companies become very concerned when a Hedge (Forward Contract or Option) goes out of money. In a case where the Exposure (the Export or Import itself) is not fully hedged (an optimal hedge ratio would be about 54%), there should actually be joy if a Hedge goes out of money because when a Hedge goes out of money, the Exposure ends up making money.

The problem occurs because within companies, the profit or loss on Hedges is deemed to be “Treasury profit/ loss” while gains/ losses on the Export/ Import itself are taken to be non-treasury, business gains/ losses. Most managers on the FX Desk in most companies lament this fact. There is a lot to anser for when a hedge goes out of money but there is nary a pat on the back when an exposure that has been purposely left unhedged goes into the money.

Clearly, there is a need for deep introspection within companies on this point. The FX Risk Manager seems to be the most hassled person in a company, in a constant danger of being crucified. Why?

QS 9. Are we willing to explicitly pay for Advice? Should advice be paid for separately from the commission/ brokerage payable on hedging transactions?

Lastly, very few companies recognise the benefits of divorcing advise from transactions.

Banks have tended to proffer free advise in order to attract companies to hedge through them. Companies, on their part have been happy to receive the free advise from banks. They are generally loath to pay explicitly for advice, not realizing that this is, in fact, the better option for them. Free advice has often played on the fear or greed of a Corporate, to induce it to hedge. The truth of this is borne out by the strange phenomenon of Corporate India as a whole selling Dollars at 40-41 in 2008, based on the advice that it would fall to 35.

Had companies sought independent advice, perhaps they might have been able to get an opinion to the contrary. Learning from experience, some companies have started to seek advise from independent, professional risk managers, instead of relying solely on the free advise given by banks. This is a step in the right direction, but there is still a long way to go.

Volatility can be tackled

Companies, especially in the manufacturing sector, routinely deal with the volatility in the prices of their raw materials as well as their final products. And they tend to do so successfully, turning in a neat net profit, year after year. Why then can they not deal with currency volatility, which is, in fact, much less than commodity volatility? What is needed is a proven method of tackling currency volatility. Such a method exists and is arrived at by introspecting on and answering the nine vital questions given above.