Hedging for Exporters An overview of concept and solutions

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1 Hedging for Exporters An overview of concept and solutions What is Hedging? How is it done? Hedging is a position established in one market in an attempt to offset exposure to currency fluctuations in some opposite position in another market. The goal is to minimize one's exposure to unwanted risk. It is done by taking a position in the futures market that is opposite to the one in the physical market. There are many specific financial vehicles to accomplish this, including forward contracts, swaps, options and perhaps most popularly, futures contracts. Why Hedge? Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates quantified in terms of exposure. Amongst the most important risk for exporters is forex exposure. There may be other kinds of exposure including commodity risk, Interest rate risk, wage inflation etc. Un-hedged exposures adversely affect bottom-line which in turn affects investor confidence and also creates operational hitches like cash flow requirements etc. Hedging reduces a firm s exposure to unwanted risk. This helps in sustaining profits, reducing volatility and ensuring smoother operations. Types of Exposures With a particular category (say currency) exposures can arise through various revenue or expense channels. Revenue Exposure Expense Exposure Expense Exposure (In foreign currency) (In foreign currency) (In local currency) FOB value of exports Overseas business expense Employee Salaries Consultancy revenue Overseas employee expense Inflow-outflow mismatch Interest income Foreign currency translation expense Variability of expneditures Other income Business associate expense Typically companies hedge revenues and make them fixed but expenses are still variable. Consequently companies are vulnerable to lower profits if expenses move against them. Difference between Hedging and Speculation Put simply, while hedgers are risk averse, speculators are risk seekers. Speculators make bet or guesses on where they believe markets are heading. Thus they are vulnerable to either upside or downside of the market. Hedgers however, attempt to eliminate this very vulnerability by making offsetting trade. Hedging is done to reduce potential losses not to make extra-ordinary profits. A trade is speculative if it adds to the already long or short position a company is carrying while the same trade is a hedge if by executing it the company s total open long / short position comes down from current levels.

2 Common myths about Hedging Hedging strategies are speculative Hedging strategies are complex and beyond reach Un-awareness/ wrong estimate of Forex exposure. Shareholder s value will not increase due to hedging. Only Large Multinational Corporations and Large Banks have a Purpose for Using Derivatives Common Hedging practices in India Although most small companies realize the importance of hedging, there are still some limitations when it comes to execution. Namely, Hedging on order arrival While this may hedge uncertainty in revenue, the uncertainty in expenses/liabilities has to be hedged with more planning. Hedging only when cash flows are expected Limitations of current hedging practice followed in companies Hedging only the revenues One of the most common practices. This leaves the expenses completely un-hedged hence the bottom line is still vulnerable to fluctuations in aforementioned factors. Moreover, this takes away the benefits of natural hedges. Incorrect choice of hedge tools Since they are not fully aware of the tools to use for hedging they may choose suboptimal hedging tools. Selection of wrong tools may also lock up crucial funds for a significant time. How much and what to hedge? Assume two competitors A and B (both exporters). A completely hedges its current expected revenue of $1000 from Rupee downside by buying USD/INR futures (say 1 lot). For this they pay approx Rs 2000 as margin. B does not take any position. If Rupee goes up (i.e. USD goes down) by 1%, company A loses on rupee upside, on their hedge and on any potential return they could have generated on the margin money involved. B only loses on rupee upside. Thus, to remain competitive company A will have to compete on margin. Hence, 100% hedging may reduce competitive advantage! Consider another scenario where a company is focused in say US markets and gets more projects from there than any other geography. As the revenues go up the company may be tempted to hedge only the revenues and not the expenses. However, rising revenues are indicators of prospering markets wherein wages and other expenses are also bound to rise. Hedging only revenues will result in a scenario where profits will not increase in proportion to the growth in revenues. To concur, the company also needs to account for expense volatility. Bank s role in hedging Banks provide a liquid market for currency trading. They make revenues when people trade. However, difference banks have different views on currency rates. Moreover, they offer exotic derivatives product which are often difficult to understand for non-experts. Banks make money not through advisory but when companies trade with them. As a result banks may push a company to participate in unwanted trades which may result in over-hedging (refer how much to hedge ).

3 Need for an Independent Consultant Neutral approach Independent consultants provide a neutral view towards when to hedge and the choice of hedging tools. Client is the sole focus of their policies. Proper identification of hedging policy Individual consultants design firm-specific solution after through interaction with the client. They identification of hedging policy is holistic and is based on the following pillars :- Company s current business mix Company s future growth projections Macro-economic trends Company s risk constraints Based on suite of Quantitative & probability models used by banks & insurance companies Deployment at Client side They can make themselves present at the client side during negotiations with the bank. At the same time, they can also provide end to end support during execution of hedges. Provide ongoing support For any required modifications in hedging strategy. Put simply, they provide an end-to-end support throughout the entire risk-management framework Forecast Riskestimation Benchmarking Hedging Stop Loss Reporting and review

4 About Finstream FinStream is a cutting edge financial consultancy company with strong expertise in Fixed Income, Risk, Derivatives and Quantitative Techniques. We are actively involved in consulting for big Institutions like NSE in derivatives space. High end technical expertise clubbed with nimbleness makes FinStream one of the preferred consultants in this space. We have created risk management software for companies to analyze hedge their Interest rate, FX and commodity price risks. We also advise banks on Asset Liability Management and run proprietary trading book in equity derivatives space. Our Approach Our approach can be broadly divided into two stages. 1) Long term strategy We arrive on the overall initial hedging policy of the company using the following inputs:- a. Business dynamics Nature of the company and the industry (in terms of profit margins, growth trends etc.) b. Objectives P&L expectations and factors affecting it. Growth target set by management. c. Risk profile of the company Asset conservation requirements using balance sheet analysis. Constraints like solvency and cash requirements d. Macro economic analysis current scenario and future trends. Output of above analysis is used to determine:- a) Quantity to hedge i.e. the Optimal Hedge Ratio b) Currencies to hedge currency combinations are chosen based on above factors and historical correlation analysis. c) Duration buckets Tenures of hedge instrument used. d) Products (or Instruments) to use for hedging 2) Monitoring and adjustments Post execution of phase I we continually monitor the following factors to make required adjustments in order to maintain an optimal hedge ratio. a. Changes in expected P&L b. Changing macro-economic situations and F/X movements. c. Revision of growth targets or capital requirements. d. Changes in revenues and expenses post execution of first leg of hedging. e. Hedge effectiveness

5 Current Clients/Projects FinStream advises NSE on a regular basis for its derivative product development. We train several big brokers on Fixed Income and derivatives markets. We are doing research projects with SEBI, RBI and WTC and have advised several corporate clients on hedging their FX and Commodity exposure. FinStream also conducts regular seminars on IR derivatives and risk management for various market participants. Core Team Gopi Suvanam - Gopi is an IIT Chennai Computer Science and PGDBA from IIM Ahmedabad. He has worked with Deustche bank in New York and London in FX and fixed income desks. He has advised some of the biggest funds and financial institutions in the world on investment ideas, trading strategies and risk management. Amit Trivedi - An Engineer and PGDBA from IIM Ahmedabad. Amit looks at the strategy & sales divisions of the company. Prior to starting FinStream, Amit has worked with institutions like Infosys Technologies, ICICI Bank, JM Morgan Stanley and EFG Bank in areas of software development and equity derivatives trading. Manoj Solanki - Manoj is the IT think tank at FinStream. The company leverages his profound experience in technology and finance. Manoj has worked with some of the biggest financial firms in the US like Countrywide, Merrill Lynch on algorithmic trading & reporting systems and market making models.