Now that the rupee has suddenly wobbled through to 66 a dollar, importers, many of whom have had a relatively easy time managing FX risk over the past two years, are appropriately terrified and need to get re-focused on what to do as uncertainty increases. The bad/good news is that credit periods are now shorter—bad because the buyers’ credit show, which had worked wonders for import costs over the past couple of years, has been eliminated; good because with shorter tenors, the risk is lower. Importers can now actually consider simply hedging forward for 90 days since they would have to pay just 60 paise or so. On the other hand, on a funding basis, this is still around 4% a year and old habits—staying unhedged for much of the exposure—die hard.
In fact, over the last two years—actually between July 2015 and December 2017—on average, the rupee actually appreciated by 0.2% (about 11 paise on an average spot of 54) against the dollar over 90 days, which, perhaps, explains the intuitive behaviour of staying unhedged. Unfortunately, while the average was attractive, this approach carried substantial risk, which has had many companies getting burned. The worst 90-day performance over this period was a depreciation of more than 2.50, which would have shot the funding cost up to over 18%! Of course, the worst doesn’t always happen, but the 95 degree confidence VaR of a 90-day unhedged import position was nearly as bad, at about 2 rupees. This means that 5% of the time during the last two years, the rupee fell by more than 2 rupees over a 90-day period, which translates to 15% pa from a funding standpoint. While this analysis is handicapped by autocorrelation, these numbers are, indeed, terrifying—particularly today, when forecasts of 68 and even 70 (representing a drop of 5-6%) are getting more commonplace.
So, what to do? Should importers simply pay the 60 paise premium and eat the funding cost? Should they hedge partially (say, 50%) and carry half the risk?
We have developed a structured approach that we believe provides the best balance between risk and return. The model uses no market view, but simply recognises the obvious fact that if you hedge, you are paying premium, and every day you don’t hedge, you are saving money; it hedges regularly depending on directional market moves.
A client that uses the Mecklai Hedge Programme (MHP) saved 53% of the Day 1 premium on about $40 million of imports that matured between October 15 and December 17. This translated to savings of over Rs 1.2 crore and an average hedging cost of 2.99% as compared with an average Day 1 cost of 5.31%. The key element in this model is setting and following a stop-loss. The stop-loss was set at 5% pa, which means that, in any month over the last two years, the client may have to accept a worst case funding cost of 10.31% (in today’s market, with the premium at 4%, the worst case cost would be 9%). And, indeed, there were occasions when it did end up paying almost as much. However, there were many occasions when the model delivered a negative cost of funding and, on average, as already mentioned, the savings were quite significant.
The accompanying graphic compares MHP on a risk-adjusted basis with a full hedge and a zero hedge; it assumes today’s market, with a rupee at 66 and the premiums at 4%. The return in zero risk is marked as zero; it is actually a cost of 65 paise (-0.65). The calculations for the open position reflect the 95 degree confidence VaR; as already explained, between July 2015 and December 2017, the rupee fell by more than 2 rupees (per dollar) 5% of the time; so, too, did it appreciate by more than 2.75 (per dollar) 5% of the time, which would have been a wonderful gain. Indeed, MHP was, on several occasions, able to capture much of this gain since it was able to stay open if the stop loss was not triggered.
On average, over the period, it generated a return (in terms of reduced premium cost), of nearly Rs 4 lakh per million dollars. Another alternative would be to maintain a stop-loss and try to use a market view to capture value. While this could theoretically work, we generally find that view-based hedging doesn’t add value over the long run and sometimes leads to catastrophic loss, because it is very difficult to be disciplined about a stop-loss when you are using a market view. In the current environment—as always—it is impossible to call the future. Will the rupee, now that it has broken 66, collapse towards 67 or 68? Or, will it turn back at 66.25, which is a strong support? Nobody knows. MHP provides the way forward.
The author is CEO, Mecklai Financial