A New Twist: What Indian Corporates Are Doing to Manage FX Risk

India is certainly in a dynamic economic phase with inflation breaking the 11 percent mark last year. The contributing factors: a booming domestic manufacturing sector (industrial production index at 59 versus all time high of 61.8), strong employment growth, government debt reduction through one time adds from telecom auctions (gain of 1 percent of GDP anticipated), the planned early buyback of INR 200 BN of debt and the central bank sending signals to the market of a 100 basis point rise in rates — all of which portend a stronger INR for the remainder of the year. However, the USD continues its risk accumulation and risk aversion trading which will continue to affect two-way volatility with the USDINR over the next 12 months. This gives impetus to the increasing trend of corporates in India becoming more proactive in hedging currency risk more so than in the past.

The Indian rupee, like many other Asian currencies, has seen large two-way movements in the past two or three years, ranging between 8 percent and 33 percent. Unfortunately as it happens too often, many companies have been caught selling at the lows and buying at the highs. Corporate India has not been used to this kind of volatility. Adding to the angst, the Reserve Bank of India (RBI), which traditionally used to be a regular participant in the dollar-rupee market, has stopped intervening over the past six months. Companies are reconciling themselves to the fact that volatility is here to stay — it cannot be wished away. An increasing number of companies are now trying to learn how to deal with the situation.

The large two-way movements in the USDINR rates have put importers and exporters, buyers and sellers on their toes. Not surprisingly, of course, the old emotions of fear and greed remain as potent as ever, especially at the major trend reversal points. For instance, when the dollar-rupee touched a low near 44.19 in April 2010, importers were certain of a fall to 42, and so were exporters.

How companies are handling hedging
Smaller private companies, in contrast with larger board-driven companies, seem to be more proactive and willing to tackle FX risk management in a systematic manner, rather than on an ad hoc basis. Not having to “manage by committee” obviously works in their favor. In fact, some of the Indian companies we have worked with have become quite sophisticated in examining FX risk with forecast, changes in hedging strategy on revenues repatriation, and netting.

At the height of rupee bullishness in early 2008, when USDINR was near 39.50 and the consensus view was of strengthening even further towards 36 or even 35, it was fashionable for companies to enter into hedges spanning five, or even seven, years. Exporters were seen selling their entire proceeds for the next few years through exotic leveraged options. But then, as the rupee depreciated 33 percent to 52, several of these long-term hedges went deeply out-of-the money. Often, it was found that many of these hedges were not mandated by standing, board-approved hedging policies. A tough lesson to learn, but companies are now generally restricting their hedge maturities, especially on revenue exposures, to 12 months at the most.

Leverage has become a bit of a dirty word among corporate hedgers in India. People are shying away from the once highly popular 1x2 and 1x4 put risk reversals, range forwards, accumulators and knock-in, knock-out options that actually ended up increasing risk for the companies rather than protecting them against risk. Instead, we see companies more focused on executing plain forwards, plain vanilla options, 1x1 range forwards or risk reversals and, most often, window forwards to help manage currency delivery uncertainty.

Given the fact that forward points are at a premium, adding up to a full two paisa against the one-year forward, (at 48.41 as of this writing) Indian exporters seeking to hedge a weakening INR and recognize payment terms in a depressed global economy are widening, are extending delivery windows from 30 to 60 and 90 days without forward pricing penalties.

Corporate planning
With many companies in India, there tends to be no concept of a hedging cost budget. Companies still prefer “zero cost” option structures, as opposed to simple, plain vanilla options where the premium is paid up front. This is despite an implicit acknowledgement that zero cost” options are not really costless, because they actually provide much less risk coverage than plain vanilla options, largely because zero cost options put the strike prices far out of the money. The implication is that the company is far more exposed to spot INR risk for forward exposures and thus the underperformance of these hedges in some cases. Yet there is a huge preference for zero-cost options from the simple notion of no cash up front. The key is understanding the net performance of alternative options strategies.

Hedges still overshadow exposures
A still not too uncommon problem is that many companies think of a hedge as a “position” they have taken in the market. They do not see their exports and imports as intrinsic market positions that they have to either protect or close out at the earliest opportunity. An ongoing conflict at both corporates with VC-laden boards and the venture firms themselves is that management wants to see hedges generate profits as well as the underlying exposure. This condition is not possible in normal functioning markets as hedges act in opposite reaction to the underlying asset. The irony, though, is if a risk manager takes a conscious decision to leave an exposure unhedged because they see that INR or pertinent exchange rates are in favor of the unhedged exposure as it is, management is seldom willing to give credit for its vision and foresight. So, the adage, “What did you do for me today?” rings pretty loudly in risk manager’s ears!

There are several reasons for this anomaly. The biggest is that hedges are marked-to-market for accounting and reporting purposes. Exposures are not usually required to be marked-to-market and thus the immediate pain or gain is not necessarily felt in currency adjusted net income statement. The second reason is that treasurers and risk managers think they can get in and get out of, or trade, their hedges a number of times before an exposure matures and contribute to the cash flows of the company. As you can imagine, the latter activity has little to do with the core focus and business of the company and increases overall risk.


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