INR Volatility - Hedging Options & Effective Strategies

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1 INR Volatility - Hedging Options & Effective Strategies The purpose of the article is to draw attention on the recent volatility in Indian Rupee, various hedging options and effective hedging strategies. As we all know Indian economy is getting globalized and thanks to various initiatives taken by Indian Information Technology Industry (IT), Strategic M&A s done by Steel Industry, expansion of Cement industry and lots others. With the rising initiatives there is a great inflow of foreign exchange in Indian markets in the form of receivables or payables. Some of these payables are in the form of ECB, INR denominated working capital loans, Issuance of Certificate of Deposits (CD), Commercial papers and other money market instruments to fund working capital needs. In the last few years we have seen huge flow of USD, GBP, and EUR, Commodities currencies like Australian Dollar, New Zealand Dollar and Canadian Dollar in India. Such inflow of funds forced Treasurers to effectively implement respective hedging strategies depends upon their exporting models using derivatives instruments like Plain Vanilla forwards contracts (STFX/LTFX), Foreign exchange Options, Risk reversals, Zero Cost collars, Interest rates Swaps and Interest rate hedging strategies. These derivatives instruments are highly effective in nature and able to mitigate the impact of both exchange rates and Interest rates volatility at your bottom lines and also plays a significant role where in cost is in INR however invoicing happens in foreign currencies specially United States Dollar (USD) which in turn would create the need for effective hedging strategy. One interesting fact about globalization is the rising foreign currency loans in the books of Indian corporate due to expansion in various geographies, Capex funding and strategic M&A s. Such Foreign currency loans are subject to two types of risks - Revaluation risks and hedging risk. Corporate Treasurers are unable to mitigate the effects of revaluation on bottom lines however would be able to perform hedging risk via Interest rates products like Interest rate swaps which in turn covers Principal Only Swaps (POS), Coupon Only Swaps (COS), Principal and Coupon both, basis swaps, Constant Treasury Swaps and respective others. Majority of these foreign currency loans are taken in USD however realizations are invested in local currency to meet working capital needs hence forth there is a great risk due to volatility in Interest rate risks. Indian Foreign exchange markets are predominantly divided into two parts - Over the Counter (OTC) and Exchange Traded Derivatives (ETD). OTC is amongst the largest markets in the world with daily turnover of $5.3 Trillion in various plain vanillas and

2 cross currency pairs. There is no unique trading platform for OTC as majority of the trades happening either on phones or mails. OTC also have non zero counter party risk however ETD would be able to mitigate credit risk by having leverage structures (Margin Call, Variation Margins, daily based M2M). The biggest drawback with ETD is it is not very deep in nature hence forth Treasurers are unable to cover their exposures till 4 months only using derivatives instruments like Plain vanilla forwards contracts, Foreign exchange options contracts in USD, EUR, GBP and commodities currencies. Types of Derivatives & Hedging Options Financial Derivatives Basic Derivatives Financial derivatives are financial instruments that are linked to a specific financial Instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right. Transactions in financial derivatives should be treated as separate transactions rather than as integral parts of the value of underlying transactions to which they may be linked. Commodity Derivatives Complex Derivatives Plain vanilla Forwards Contracts (LTFX/STFX) Futures Contracts Swaps (Interest Rate Swaps, COS, POS) Exotics Contracts Option Contracts (Buy Put, Sell Call, Range Forward, Collars, Seagull) Warrants & Convertibles Swaps and other Exotics are used to hedge your Interest rate liability. Exotic contracts include Barrier Options, Knock in Knock out Options, Asian Options, Digital Options and structured products to hedge specific Interest rate liability along with Options known as Swaptions.

3 As on today Indian Rupee is facing huge volatility in the exchange rates sometimes due to internal factors like Current Account Deficit (CAD), Trade Deficit, Gold Imports, and Policy conundrum in India. The following is the currencies chart which do confirm that INR is the most volatile exchange pair in the world amongst Asian and G7 currencies. Currency MTD% 3M% 6M% YTD% INR 2.2% 2.14% 14.95% 14.51% PHP 0.76% -.59% 5.53% 6.12% SGD.41% -1.74%.05% 2.09% GBP.51% 3.08% 5.84% -.79% EUR -.64% 1.12% 4.73% 2.28% Source: - Thomson Reuters, 17 th Nov 2013 Note: - Positive ratios means depreciation and negative means appreciation of currencies vs. USD Call for Treasurers - Hedging of forecasted receivables & payables Considering the current volatility in the INR Treasurers should hedge their both receivables and payables using layering hedging strategy keeping their business model in mind. Treasurers having Information Technology business model should hedge their Cash flow hedge receivables using 6 months layered hedging program. Treasurers should also offset the revaluation impact using fair value hedging done at offshore locations in the form of Non Deliverable Forwards Contracts or Non Deliverable Options or Swaps contracts. Hedging of forecasted receivables using forwards contracts:- Considering the current volatility in INR Treasurers should hedge their forecasted receivables using both plain vanilla forwards contracts and exchange traded contracts like futures where in daily settlement is required. The hedging of forecasted receivables can be done at OTC levels or ETD where in exchange is involved. The only difference between an OTC and ETD contract is former is available till 20 Years in offshore market and the later market is available till near 6 months. Treasurers should hedge their forecasted receivables using both plain vanilla forwards contracts and ETD as later is having various strategies available at exchange level which is not available at OTC level.

4 There are various Information Technology and OIL companies in India which hedge their forecasted receivables and payables at both OTC and ETD level. Using this strategy Treasurer is able to play with various payoffs strategies and create an arbitrage between OTC and ETD at onshore levels. Hedging of forecasted receivables using Options contracts:- In this Treasurers should hedge their forecasted revenue via plain vanilla Options contracts wherein they are having three choices Plain Vanilla Buy Put Contracts, Collar Contracts (Export Side) Buy Put and Sell Call, Import Side Sell Put and Buy Call and Seagull Collar Contracts (Export side) + Buy Call or Collar Contracts (Imports side ) + Sell call. Option 1 (Conservative Treasury):- In this Treasurer would sell forecasted receivables using Plain vanilla Options contracts which is Buy Put and under this Treasurer would get a right however not an obligation to sell his receivables at an agreed rate. Example: - Treasurer sells $ 1 Mn as Buy Put contract wherein he is selling $ and buying INR at an agreed rate of INR /$. In this if at maturity exchange rate happened at INR 66/$ then Treasurer would let his contract worthless and sell his $ 1 Mn in market and in case exchange rate happened to be at INR /$ then he would execute his trade. To get this right Treasurer will get an upfront premium to bank and higher the strike price higher the upfront premium. Option 2 (Moderate Treasury):- In this Treasurer would sell forecasted receivables using exports collars which is Buy Put and Sell Call and under this Treasurer would get a right however not an obligation to sell his receivables at an agreed collar rates. Example: - Treasurer sells $ 1 Mn under collar as Buy Put and Sell Call contract wherein he is selling $ and buying INR at an agreed rate of INR /$ Buy Put and INR 67.00/$ Sell call. In this if at maturity exchange rate happened at INR 66/$ then Treasurer would let his contract worthless. If exchange rate happened to be INR then Treasurer would utilize Buy Put contract. IF exchange rate happened to be INR /$ then bank would but $ at INR from Treasurer and sell at INR 68.00/$ in the market and get a gain of INR 1 /$.

5 Option 3 (Aggressive Treasury):- In this Treasurer would sell forecasted receivables using exports collars + Buy Call which is Buy Put and Sell Call + Buy Call. Under this Treasurer would get a right however not an obligation to sell his receivables at an agreed collar rates + Buying $ contract. Example: - Treasurer sells $ 1 Mn under collar as Buy Put and Sell Call + Buy Call contract wherein he is selling $ and buying INR at an agreed rate of INR /$ Buy Put and INR 67.00/$ Sell call + Buy Call of INR / $. In this if at maturity exchange rate happened at INR 66/$ then Treasurer would do buy Call at INR 65.00/$ and sell in mkt. at INR 66.00/$ and his collar get worthless because the rate is falling under both Buy Put and Sell Call.

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