If you are not consistently able to beat a 50% hedge, your hedge strategy needs modification
In a word, nothing. Of course, the question itself is wrong. The right question is: “What do I do about my FX risk given that the rupee is, once again, behaving like a mad person?”
Now, the answer to that question is a whole lot easier. First off, we all recognise that the rupee, while impossible to forecast exactly, does appear to follow a pattern where it stays steady (or slightly strong) for a period, then falls sharply, sometimes recovering a bit; then it goes steady again, falls again, and so on. The other “known” is that the forward premiums are quite high—around 7% a year.
Thus, if you are an exporter, every day that you don’t hedge, you are losing premium, unless the rupee depreciates to make up for the premium loss. But how do you decide whether to hedge or to wait? Well, the first rule is to recall that a bird in the hand is always worth more than two in the bush. The difficulty is that the rupee sometimes falls by 8-10% in a matter of weeks, which makes the bird in the hand (7%) appear less attractive.
Nonetheless, prudence (and good sense) suggests it is foolish to pass up the sure thing. I would point out that if you had hedged on a 12-month export every day from January 1 to September 7, in 2014, you would have gained on average more than Rs 2 compared to the spot on the due date—and this includes the recent period of sharp rupee depreciation. Thus, I would insist on a significant cover of 12 month forward exports at (or close to) inception.
Beyond that, the due date realisation should be monitored closely and, if, after a short period—say, 2 months—the value has not improved materially, I would initiate a programme to exit the position on any further adverse movements. On the other hand, if, after a couple of months, the exposure was in the money—i.e., the due date rate was better than the day 1 forward—I would ride the wave as long as I could; again, however, I would build in a certain amount of prudence so as not to lose substantial gains that accrue—we all know that markets can turn on themselves quite quickly and viciously.
To be sure, this approach would result in opportunity losses on some occasions, but, on balance, I believe this is the percentage play. Indeed, a programme that we have developed following these principles very comfortably beats a 50% hedge—both when the rupee collapses and when it doesn’t. Incidentally, if you are not consistently able to beat a 50% hedge, your hedge strategy needs modification.
Importantly, the tenor of the risk is quite important. On a 6-month export exposure, I would hedge at inception, but not as much as I would with a 12-month exposure, since the difference between any potential sharp collapse of the rupee and the (shorter tenor) premium is quite substantial. In turn, I would ride the initial hedge for a shorter period before topping it up.
For even shorter tenors, paradoxically, it may make sense to hedge the highest percentage. The conceptual reason for this is that even though the premium is relatively modest, the probability of the rupee tanking over the short tenor is quite low.
Note, all of this does not at any point talk about where the rupee will head—as already mentioned and as we all know, more so these past few weeks, it is impossible to forecast the rupee (or any other asset) accurately. But, this doesn’t mean it isn’t possible to make money (or save money) by using an intelligent process-driven approach.
Turning all the above on its head for import positions, each day you don’t hedge you are saving money. Thus, the default situation should be a very low initial hedge; however, the programme should require very well-articulated small hedges as time passes and with a very tight and disciplined stop-loss. Our import hedging approach delivers a cost that is on average more than 2% better than a 50% hedge and savings of 2.5-3% from hedging on Day 1.
The key in all this is to stay calm—a tall order in today’s market, I know. Many companies are sitting on hedged exports, which are out of money; others have unhedged imports, which are burning a flaming hole in their hearts and pockets. On the exports side, since these are generally only opportunity losses, it should be relatively easy to focus on fresh exposures. Importers, however, are really feeling the pain and they need to separate out exposures already heavily out of the money and manage them separately—by either biting the bullet or setting (and observing) fresh stop-losses—but very, very importantly, focus on exposures afresh.
The author is CEO, Mecklai Financial