It is now necessary to monitor kurtosis to assess whether there may be a threat of another rupee dive some time over the next six months
Around mid-August, Trump’s impending sanctions against Iran (amidst his general railing) had started pushing oil prices higher—Brent rose from around $70 a barrel to $85 at the end of September, with irresponsible forecasts of $100-oil from the usual respectable global suspects. This threatened to derail our CAD, which, in any case, was weakening with exports unable to get up off the ground. In addition, there was the IL&FS-triggered crisis in domestic credit markets and a generalised nervousness as the political season got under way with the government coming under a lot of pressure for its poor performance. FPIs, which had started inching back to the Indian market in July, took fright and things started spiralling out of control; by mid-October, the rupee was on the ropes, threatening 75 to the dollar with forecasts of 80 and even higher.
By then, exporters had frozen and stopped hedging and importers, already dead in the water, were becoming glassy-eyed.
Full marks to RBI, which held its nerve, and simply sold dollars from its reserves (only to control volatility, of course), rather than pulling any tricks out of its emergency pack. As things turned out, oil crashed spectacularly, falling by over 30% in a month. While some analysts point to Trump’s exemption to eight countries who import oil from Iran, there is also increasing concern of a glut in supply and a slowdown in China and, perhaps, other large economies. Of course, the Iran exemption only runs for 180 days, so volatility could certainly pick up again. In the event, the rupee has strengthened sharply, gaining more than 5% since the dog days of October; this despite the fact that DXY, too, has been stronger. Clearly, the speculative push on the rupee has been contained.
Where it goes from here is, of course, the billion dollar question. And, as always, the trillion dollar answer is nobody knows. Recent events have increased demand for our structured hedging program (MHP), which has been steadily delivering sterling results—between April 2014 and October 2018, it delivered a positive performance in 42 out of 55 months, with an average gain of 1.65% as compared to a 50% hedge; this despite being almost 2.5% out-of-the-money over the past six months. More and more companies are coming to realise that the cost of trying to manage risk based on a market view—whether Mecklai’s or anybody else’s—is too severe, both in terms of cash (or opportunity) losses as well as lost sleep.
We have been working for some time to enhance MHP by building in some “early warning” triggers, based on volatility and kurtosis of spot movements. While volatility is well understood, the problem with simply using volatility (or the difference between volatility and forward premiums) is that it is a trailing indicator—it rises after the rupee falls and, often, remains high even when the rupee has started to recover.
Kurtosis, which is not as commonly known, is the second derivative of volatility and provides a measure of “fat tails”—when the kurtosis of a distribution peaks, there is very high chance of a big move (in either direction). Between 2013 and today, the kurtosis of USD/INR peaked sharply 12 times—of these, the rupee fell sharply on two occasions, by an extra 9 to the dollar and 6 (in June 2013 and August 2018, respectively; the other 10 peaks did trigger moves in the rupee but they were less intense (the largest was less than an extra 4 to the dollar) and were in both directions.
Our research team has been trying to put these data together and has come up with some preliminary findings. Whenever kurtosis peaks and the volatility is high [i.e., vols minus premium > x%], all open export positions should be hedged over the next 3 months—say, on the 1st of each month—since it is empirically observed that the rupee’s sharp declines usually last for 3-4 months at the most. Correspondingly, imports should hedge all outstanding exposures to 3 months immediately upon getting the signal. At all other times, MHP runs as usual.
We have back-tested this adjustment and found that it captured 50-60% of the last two major down moves of the rupee; overall, since this sort of drama happens infrequently, the average rate (over the 5-year period) has improved by about 25 paise. As is apparent from the price movement, the kurtosis peak has waned, so treasuries should revert to their regular hedge processes.
It is important to note, however, that volatility is still high—the difference between the volatility and the premiums today is over 3%—and the Fed is not done with tightening monetary policy and the ECB will soon be getting into the act. This suggests that global volatility will likely remain elevated for some time. Together with the fact that political factors may well add a domestic tinge to the story, it is now necessary to monitor kurtosis to assess whether there may be a threat of another rupee dive some time over the next six months.
-The author is CEO Mecklai Financial