Learning from the market is very expensive; but not learning from the market can be disastrous
With the rupee having lost its footing over the past few months and, indeed, having apparently fallen off the trail since August, most importers are in difficult straits. Many are in shock and are frozen in the headlights unable to act (or even sleep).
Yet again, the perils of hedging using judgement are shown up. When a view goes dramatically wrong, decision-making becomes impossible. Dozens of questions swirl around in the brain—will the rupee recover from this level? Will it continue falling? How much longer—and further—can it fall? And, given human nature, you cling to any answer that provides hope. The market doesn’t sell hope.
The point is we have been here before. The rupee fell from 39 to 49 (25%) in six months in 2008; from 44 to 54 (about 23%) in four months in 2011; from 54 to 61 (13%) in four months in 2013 and then further to 69 in another month, bringing the total fall to 28%; and currently from 63 to 72 (14%) in eight months since January. Of course, the immediate terror is the apparent acceleration of the fall since August, when it has fallen by nearly 4 rupees (around 6%) in a little over a month.
Now, the point of detailing this list of horrors is not to terrorise you further. It is to point out that you have likely been in your current situation before. And while you survived to tell the tale, it would have been— and will be—a lot better if you had learned lessons from previous such events. The lesson is simple. DO NOT DEPEND ON A MARKET VIEW. While you will often be correct and save quite a bit of money—witness the benign market through most of 2016 and 2017—the problem is this lulls you into believing that you have your risk management covered. And then, bam! Along comes the real market. But enough lectures. The question is what do you do now?
As you may know, we have developed a structured hedging program (MHP-I) to manage risk on imports that uses no market view, but recognises the obvious fact that since the dollar is in a premium forward, every day you wait you save money but carry risk. To balance this risk with possible savings, we use a stop loss, which is followed with tight discipline. We use a structured process for reducing the exposure based on directional (not rate based) movements in the market.
This model works reasonably well. A client, who has been using it since March 2016, has hedged about $100 mn of 90-day imports at a cost of 3.67% pa; this is about 1.5% pa better than the Day 1 cost, registering cost savings of about Rs 2.5 cr.
To assess this performance objectively, we conducted a post facto study by creating an opportunity envelope showing the best possible performance—where we hedge only when the spot rate on the due date is worse than the Day 1 forward—and the worst possible performance—where we hedge only when the spot rate on the due date is better than the Day 1 forward. As the accompanying table shows, the cost of hedging (3.67% pa) using MHP-I represents capture of 53% of the opportunity between the best and worst possible rates, which, in our view, is pretty good. Note, during this period, staying unhedged all the time would have delivered the best cost, even counting past month’s trauma; however, that is a non-starter , if for no other reason than to preserve your sanity.
MHP-I is easy to implement—you need to send us an Excel-based sheet of exposures and transactions each EOD (the format of which can be tuned to your existing system), we run the analytics and send you a MIS the next day with whether and how much to hedge. The key is following the rules with discipline.
Remember, learning from the market is very expensive; but not learning from the market can be disastrous.