Many—perhaps, most—companies in India consistently leave a lot of money on the table through increased import costs and/or lower export realisations because of weak FX risk management processes. We conducted a study of actual FX rates achieved by a sample of 14 companies and found that, in comparison with the performance of a structured hedging programme we have developed, the effective “loss” suffered by these companies averaged nearly 1.5%. For companies with FX intensity—net FX exposure divided by total sales – of even 40%, this translates to a hit to gross margins of over 50 basis points!
This is a huge impact, which makes it quite surprising that FX risk management often gets only perfunctory attention from most boards and audit committees. A professional we know, who serves on several audit committees pointed out that in most cases the CFO displays a very nice powerpoint, which is the risk management policy, followed by an equally nice excel sheet, which shows the transactions and (sometimes) the mark to market. The link between the two and whether the policy has been scrupulously followed and, indeed, whether the policy remains appropriate given changes in business and markets are issues that are seldom addressed.
To be sure, FX risk management is a relatively arcane subject, as a result of which the general attitude seems to be, “If it ain’t broke don’t fix it”. Until, of course, a crisis comes along, when all hell breaks loose. However, as our study shows the cost of sub-optimal FX risk management, even in “normal” times, can be remarkably high.
We analysed actual FX data for the companies, covering exposures that matured between April 2015 and December 2016. Since different companies have different risk identification horizons—from three months to 12 months—the market in which the study was conducted ran from April 2014 to December 2016. Over this period, the rupee averaged 64.31, with a high of 68.81 and a low of 58.42; importantly, volatility was very low—it averaged 5.4% (max 7.6%, min 3.2%). Thus, it was a relatively quiet period—“normal” times, unlike, as in, say, 2013 or 2009.
The sample set of companies was quite diverse in terms of size—FX exposures ranging from $10 million to over $700 million, exposure type—5 had net imports and 9 had net exports, FX intensity—ratio of net FX exposure to total sales ranged from 10% to 100%, and risk management approach—from sophisticated, policy-based or view-based, high expenditure to simple, hands-off, low cost We compared the performance of each company with the output of a simulation of the Mecklai Hedge Programme (MHP) acting on the company’s actual exposures over the test period. MHP is a structured FX risk management program that we use for clients; it uses no market view yet is able to (a) ensure that the company’s pre-set stop loss is never breached whatever happens to the market, and (b) capture a reasonable amount of market opportunity.
Only one of the 14 companies we studied performed better than MHP. This was a MNC subsidiary with net imports that ran a hands-off policy; this policy was imposed by the parent a few years ago after some hedging misadventures resulted in serious losses. The approach worked well over the test period only because the rupee remained steady to strong with low volatility, because of which staying unhedged was the best strategy.
However, this is a high risk strategy that, in other environments or with a different set of exposures, could spell disaster. One of the pharma companies in our sample had sterling exports and, again for historic reasons, ran a hands-off policy; sterling collapsed as a result of Brexit and this company ended up losing over 10% of value as compared to MHP.
One other company did reasonably well—it matched the MHP performance. This is a promoter-driven company with significant imports and, given the way the market moved, its view-based approach did quite well. On the other hand, none of the other companies that ran a view-based approach, including two with large exposures and well-trained treasury teams, were able to outperform MHP.
What was rather surprising, though, was that even companies that had a policy-based approach performed badly. There could be several reasons for this. While, in general, risk management policies are able to articulate the company’s risk quite well, we have seen several policies where the hedge strategy is poorly constructed, often leaving too much discretion to operations without adequate controls or reporting. Again, few policies have any performance measure in place, so that, as long as there is no crisis, things continue from quarter to quarter without the board having any awareness of the possible substantial opportunity losses that are being left behind. Most frequently, of course, policies fail because of lack of disciplined implementation.
The clear outcome of this analysis is that all companies need to review their FX risk management operations regularly and have their policies vetted for suitability at least every two years.
The author is CEO, Mecklai Financial. Views are personal