On hedging for the rupee’s value, companies must move beyond simple ladder-type strategies towards more sophisticated programmes.
When I was in graduate school in the US, we had a Monday night poker game. One of the guys at the table—John Edmonds—was very calm, with a dry sense of humour, and you could almost hear the percentages whirring in his head all the time. He was a regular winner.
I was, delightedly, a much bigger winner, despite paying no real attention to the percentages—I usually had many more than a few beers while we were playing. I was lucky, of course, but, when I was a kid growing up, I had learned from my father that winning at poker required creativity way beyond being able to calculate the percentages. You play poker against other people, and one way to win consistently is to create the impression that you bluff a lot while actually bluffing only occasionally to keep the table off balance. Wearing bright shirts—and, OK, being something of a loudmouth—put that particular trick right up my alley, and, as I said, I was generally a big winner.
I thought of this the other day when I was trying to figure out how the recent fall in forward premiums should influence companies’ risk management strategies, particularly given that this decline appears to be structural with the US Fed near certain to continue to raise rates into 2018.
Historically, with premiums ranging between 6% and 9% over the past several years and spot, almost by definition, unpredictable, the percentage play for importers was to stay unhedged as long as they could remain comfortable rather than pay 40 paise a month to hedge. Equally, it made sense for exporters to hedge a significant part of their exposures upfront. Indeed, many companies stretched their tenor of risk identification out beyond the natural 6-12 months to as much as 2 years (and, in some cases, even more) betting that the rupee’s depreciation would not be more than the mouth-watering premium earning. And this percentage play was—broadly speaking—correct.
Between 2013 and today, the rupee fell from around 55 to 69 (although it has recovered a little bit recently) to the dollar—that’s a decline of about 25% over four years. The daily average two-year decline between January 2013 and April 2015 was `7.50 per dollar. The average spot over this period was `60.02 and the average 12-month premium was 7.48%. Selling two-years forward every day over the period would have generated an average gain of `8.96, nearly `1.50 per dollar better than staying unhedged to enjoy the depreciation.
Of course, this was not a sure bet—there is no such thing. The two-year depreciation exceeded the average premium gains (`8.96) as often as 50% of the time, with a worst case two-year depreciation of `19.50. Thus, the hedge would have lost opportunity—and, in some cases, a huge amount of opportunity—much of the time. Still, on average, it was a good percentage bet, and many companies, particularly in the IT and auto sector, followed this approach.
With the premiums have fallen recently—the 12-month premium is a tad under 5% today—the story has changed. With spot at 65, the gain on selling two-years forward is down to `6.40, more than `1 lower than the average two-year depreciation (`7.50). So, too, for shorter tenors—at 12 months, today’s premium (`3.21) almost exactly discounts the average 12-month depreciation (`3.30), as compared to providing a cushion of nearly 50 paise in the earlier, higher premium environment.
Clearly, the percentage play has changed. Companies who had shifted their risk identification to two years to try and take advantage of the premiums need to quickly shift gears, and companies who were comfortably hedging out to 12 months (and even 6 months) need to revisit their strategies.
You may also like to watch this video
Importantly, there is another, and, perhaps, more significant structural change in the works. Judging from recent price action in the rupee and some anecdotal reports, RBI appears to be much more tolerant of higher rupee volatility. This is a necessary condition to develop a deeper and more mature market. On the other hand, it will throw a real spanner into the calculation of percentages—a “real” FX market is far more complex than playing poker, where there are a finite number of variables (cards).
Thus, companies will need to move beyond simple ladder-type strategies—hedge 50% on day 1, or ensure 90% of Q1, 75% of Q2, 50% of Q3 and 25% of Q4 is hedged, etc—towards more sophisticated, dynamic hedging programmes.
— The author is CEO, Mecklai Financial