With the US Fed raising rates since early last year to contain inflation, and really ramping up hikes from June onwards, the USD-INR forward premiums have been falling steadily, breaking below 3% per annum (p.a.) in October 2022. The average six-month premium since October was just 2.38% p.a. as compared with 3.88% p.a. over the preceding year (and 4.52% the year before). This has severely tested export hedging strategies, with most companies cutting back on hedges in the hope that the rupee will once again fall sharply. Unfortunately, and to the contrary, the rupee has been riding (relatively) high, doubtless enjoying the support coming from the surge in services exports. As a result of this, the rate for six-month exports due in March 2023 has fallen from 84.82 on October 1 to 82.34 at maturity, a loss of nearly 3%; April 2023 exports lost 3.7% and May 2023 exports have lost 0.7% to date. Clearly, waiting for Godot is not a good strategy.
Given this environment, we have developed a new structured hedging programme that works reasonably well in a low premium environment. As in all of our programmes, we begin by setting a risk limit at x% below the forward rate, but instead of starting with an initial hedge (as in our regular hedging programme, MHP), we stay unhedged on Day 1. However, and this is the key, we trail the risk limit. This means that each day that the forward rate moves favourably, we build that into the risk limit, effectively moving it higher; any day that the forward rate moves unfavourably, we leave the risk limit where it is (as of the previous day). This process enables all positive moves in the market to be captured into the risk limit. The exposure is only hedged if/when the forward rate falls below the then current risk limit; if it never does that, the exposure is settled at spot.
The justification for this approach is that since the forward premium is so low, the sum of all positive intra-day moves is likely to be more—and, sometimes, much more—than (the premium plus the initial risk limit), as a result of which the approach generally (though, obviously, not always) delivers a better performance than hedging on Day 1.
Given that the premiums are likely to remain low, and possibly even fall, particularly if the Fed is compelled to raise rates some more and/or if RBI starts to lower rates early, we believe that exporters should switch to this strategy at earliest.
The effectiveness of the programme depends, of course, on whether/how long the rupee does not weaken substantively. Thus far, action in the equity market has been strong with inflows surging nicely. Year-to-date portfolio inflows have been a steady $12.5 billion, a huge improvement on last year’s outflow of $18.5 billion. Significantly, we have been enjoying inflows despite the ongoing nervousness in the US banking sector, which suggests India is, at least right now, somewhat insulated from global risk off positioning.
Of course, and importantly, as in any market situation, you need to position yourself nimbly since, as we have often seen, the picture can change overnight. Thus, careful monitoring of the market parameters is a must and if, say, USD-INR volatility starts rising, which often signals a potentially sharply lower rupee ahead, we may need to modify the programme to try to take advantage of that. The skill is in judging where that volatility cut-off is. This is compounded by the fact that volatility is a tricky indicator since, while it does in essence signal that the rupee could be headed lower, the volatility may remain high for some time even after the rupee has fallen sharply, rendering it only 50/50 as a signal.
If we do conclude that volatility may be rising, solutions could be to reduce the tenor of risk identification (so you are not locked in for more than a few months) and/or to increase the risk limit, which would prevent a volatility-driven early exit. Again, selecting which of these modifications to implement can only be determined by ongoing monitoring and experience with the programme.
About the author: Jamal Mecklai, CEO, Mecklai Financial www.mecklai.com. Views are personal.
