Having unhedged import payments today is a merciless double-edged sword. On the one hand, the rupee’s steady to strong behaviour is reducing costs every day. On the other, the fear that it may suddenly fall increases the longer it remains steady; sudden upward blips, as we saw last week, increases the terror. Indeed, we, too, are subject to this terror even though we recommend a structured approach that follows a set of hedging rules with discipline paying no attention to the market. Unfortunately, it is impossible to pay “no attention” to the market, but we have learned that overriding a pre-set programme usually ends up costing money.
In April 2016, we created a hedge programme for one of our clients that has significant imports; the programme was designed to save, on average, at least 50% of the forward premium on the date the exposure was taken into the books. This meant that they could increase the 1-1.5% arbitrage savings they were able to achieve by simply hedging out their buyers’ credit to 4% or more. Of course, to enable these savings, they needed to carry some risk, and recognise that though some exposures may hit the stop loss losing money, on average they would come out ahead.
Things were going swimmingly and they were generating savings of 45-50% of the forward premium for most of their exposures till November 2016. On November 23, the rupee fell sharply, opening near an all-time low (of Rs 68.86), triggering the company’s stop losses. Everyone was terrified at the time and as the team was wondering whether to send out the MIS signalling the hedge, the market started correcting and had gained 25 paise by 11:30 am (at which level the stop loss would not have been triggered). RBI policy the following week was expected to be rupee supportive so we crossed our fingers and decided to override the policy and not hedge.
As things turned out, the decision worked—the rupee steadied and we finally hedged out the exposure two weeks later for a savings of 80 paise (around 1%)! We breathed a sigh of relief and regirded ourselves to be more disciplined from then on. The rupee remained obedient and it was quite simple to follow the rules racking up the savings. In December, the Fed raised interest rates and the premiums fell, suddenly increasing the savings on unhedged exposures. The client felt that it may be a good idea to again override the policy, this time by increasing the hedge to take advantage of the excellent forward rates. We went back and forth and finally decided that rather than doing an ad hoc increase of the hedge, we would build in a lock-in function so that when gains reached an attractive level we would increase the hedge.
You might also want to see this:
This worked well, to a point, and by early March we had saved 75% of the Day 1 premium. Of course, the hedge ratio was much higher and, as the rupee continued in its upward path, we realised that we had perhaps acted in haste since we were missing a lot of opportunity. We ran a back-test and found that if we had not implemented the lock in, the gains would have been 120% of the Day 1 premium—ie, the MTM would have been lower than spot at the time the exposure was created. With the rupee having continued strong, the gains would have been even more today.
The lesson we learned—relearned, actually—is that (a) you need to design your hedge programme with a lot of thought and, ideally, underpinned with a lot of research and back-testing; and (b) once you have set the programme, let it run without being distracted by occasional sudden market movements. Of course, you need to monitor the performance of the programme on an ongoing basis, and, if it starts to deliver unsatisfactory results, go back to the drawing board and create an alternate reset. Simply tinkering, as we did on these occasions, only creates confusion and generally leads to sub-optimal results. As a matter of interest, for this client, we have gone back to the original hedge strategy and so far so good.
Of course, our research team is at work and if the recent soft blips in the rupee turn into something louder—say, stop losses are hit two months in a row—we will (hopefully) be ready with another version which will likely carry more subdued savings targets. In risk management, as in life, it is extremely difficult to maintain the right amount of discipline. On a personal note, I try to do this by not drinking (booze) during Ramzan. This year it’s been relatively easy.
Author is CEO, Mecklai Financial. Views are personal.