By Jamal Mecklai
While the overall trend in premiums is up, they could well stay at current levels for some time yet; this is important for importers planning risk management with the Fed raising rates since April 2022, the forward premiums fell sharply, and since April 2023, had fallen and stayed below 3% per annum (pa).
In fact, the three-month premium bottomed out at 0.98% pa in November last year, by which time there was growing evidence that the Fed was getting ready to cut rates. Premiums inched up, averaging 1.35% — still very low historically – over the next eight months, and then finally jumped higher last month when the Fed cut its funds rate by a sharp 50 basis points, and indicated that there may well be two more cuts this year.
On the other side, the Reserve Bank of India (RBI) held rates steady over the period, even as there was an increasing chorus, particularly from the outside members of the Monetary Policy Committee (MPC), calling for easing. There was also considerable talk on whether food inflation should be moved out of the RBI’s focus basket since food prices were more supply-driven. However, no such foolishness prevailed as the RBI/government needed to manage prices aggressively, particularly given the ongoing slate of state elections. In any event, growth was not doing too badly.
Forward premiums are largely driven by the difference between US and domestic interest rates, so when US rates fall the premiums go up and if Indian interest rates decline the premiums fall.
The road ahead is, unsurprisingly, looking more uncertain again. US employment figures for September showed a huge jump, which, together with the threat of further escalation of the horrors in West Asia, suggest that the inflation risk has not gone away; thus, the Fed may have to be more contained in its easing.
Domestically, too, the September consumer price index came in (at 5.49%) much higher than expected and was at the highest level in nine months. Again, and particularly with a new set of outside members of the MPC on board, this suggests more status quo in India.
Thus, while the overall trend in the premiums is up, they could well stay at current levels (1.9% for three months) for some time yet. This is obviously important for importers who are planning their risk management.
Over the past 18 months, many importers took comfort from the low cost and simply hedged their exposures forward to eliminate risk. As it turned out, and even though the rupee fell by nearly 10% over the period, staying unhedged would have delivered a better result — and average cost of 82.91 versus the average day 1 forward of 83.24.
Of course, staying completely unhedged is always inappropriate — indeed, unprofessional —since things could (and, in many cases, would) turn much worse. The cost of hedging of about 30 paise for three months (equivalent to 1.35% pa) on average over the period should simply be considered the cost of insurance.
Another alternative is to use a structured approach which sets a risk limit to fix the worst case cost and follow a strict set of rules to capture some upside, since there is always some volatility in the market. (There are also different option structures that could provide both risk protection and some upside.)
The chart shows the performance of one of our clients who followed a modified version of our hedge programme (MHP), which was designed to perform best in an environment where the premiums were lower than 3% pa.
The programme performed extremely well delivering a cost that was lower than hedging forward on Day 1 in 15 of the 18 months it was running. The average savings were 18 paise per dollar, and, while that may not seem like a lot, it was more than 50% of the average premium that prevailed over the period. The client, who had average imports of $3 million a month, used this programme to save over `60 lakh a year on its import costs.
We would also like to point out that the volatility of the market was extremely low during this period and in more normal volatility (whatever that is), the performance would likely be even better.
Since, as explained earlier, the premiums are likely to stay around 2% pa for some time yet, and unlikely to rise above 3% for several months — perhaps more than a year — it would make sense to change your hedge approach to this model.
The author is CEO of Mecklai Financial. Views are personal.
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