Main positives of using a ladder are that it does not require the use of a market view, and they can be relatively simple to implement. However, they carry too much risk
Many companies, particularly in the IT and pharma sector, that have long tenor contracts with longstanding clients, use a ladder system to hedge their risk. While in most cases the ladders are of 12-month duration, more and more companies are pushing out to 24 months.
The main positives of using a ladder are that it does not require the use of a market view, and they can be relatively simple to implement. The main issue I have with them, though, is that they carry too much risk.
Let us look at a simple ladder running for 12 months, where 25% of the exposure is hedged to 12 months, 25% to nine months, and 25% to six months with the balance held open for spot. Using a Monte Carlo simulation, we first create a long time series of [changes in spot USD/INR] over three, six, 12 and 24 months. The table shows that the average decline in the rupee (between 2011 and 2019) at each of these tenors was more than the respective forward premiums for those tenors. This would suggest it would be advantageous for an exporter to stay unhedged.
However, the averages hide a lot of variations, and staying unhedged could result in substantial losses between 30-40% of the time. As a result of this, and because the ladder keeps certain parts of the exposure unhedged without any risk limit, the risk carried by ladders is quite high.
In the table, the row marked VaR (to a 95% confidence level) shows that the actual appreciation of the rupee has been higher than this 5% of the time over the time series studied. In other words, between 2011 and 2019, the rupee appreciated on a three-month basis by more than 4.1% on more than 110 days. VaR is widely used as a classic measure of risk.
Under the ladder described above, 25% of the exposure remains unhedged for 12 months, 25% for dix months and 25% for three months. Thus, there is a 5% chance that the exposure could lose more than 25% of (4.6% + 4.1% premium) + 25% of (4.8% + 2.1% premium) + 25% of (4.1% + 1.1% premium) = 5.20% from spot
With spot today at 71.40, it means that there is 5% chance that a 12-month exposure would end up realising worse than 67.69. To my mind, that is a huge risk, and while it may appear ludicrous (making a judgement on today’s market), the truth is that this is just what has happened over the past nine years. In any event, this is the snake in the ladder.
There could, of course, be other ladders, with, for instance, a smaller amount open to spot, which would have a lower risk, but, absent a specific risk limit, the risk will always be quite high and, worse, you will never know the worst rate you can get.
Indeed, as I mentioned earlier, many companies have shifted to 24-month ladders, which carry correspondingly higher risk. One client we did some work for discovered that the risk it on the ladder it had been using was a huge 9.37% of spot—in other words, there was a 5% chance that his rate would be worse than 64.74!
We share the belief that companies that have long-term contracts with longstanding clients should use longer tenors; however, going beyond 24 months would likely result in liquidity issues, which would result in poor pricing. But, at 24 months (or 12 months or any other tenor, for that matter), it is critical that the strategy should have a pre-set worst case rate and, of course, a process to ensure that the worst-case rate is never breached.
In our view, given today’s market volatility, a risk limit of 2.5%/3% (of the forward rate) would be reasonable for a 12/24 month exposure, and adequate to enable reasonable opportunity capture. This would translate to 2.6%/3.24% of the spot rate [adding in 2.5%/3% of the premium cost], which would make the risk limit—or worst case cost—a more reasonable 69.54 for 12 month exposures and 69.08 for 24 month exposures.
Setting—and following—a risk limit is the singular element that separates true risk management from simple exposure management, whether through a ladder, a market view or whatever. Indeed, our structured hedging programme (MHP), which uses a strict limit (as described above), has outperformed 96 out of 96 treasuries it has been tested against.