Hedging exports when premiums are falling | The Financial Express***

Clipped from: https://www.financialexpress.com/opinion/hedging-exports-when-premiums-are-falling/2909225/

With volatility up and premiums down (and sliding), the intuitive response is to shorten the hedging tenor—indeed, some exporters may stop hedging completely, which may not be sound at all

Hedging exports when premiums are fallingThe intuitive response is to shorten the hedging tenor—indeed, some exporters may stop hedging completely, which, to my mind, is not sound at all.

The forward premiums have been falling steadily since March 2021, with the decline getting more rapid this year; they have now reached just about 2% pa (at 12 months), the lowest level since 2010. The reason is, of course, the continuing decline in the difference between US and Indian interest rates as the Fed has been jacking up rates to contain inflation; RBI, too has been raising rates, but at a slower pace.

At least since 2014, the rupee forwards have followed the uncovered interest parity principle quite closely. The principle holds that in a free market, there should be no arbitrage between borrowing in different currencies; hence the forward premium should exactly equal the difference in interest rates of the two currencies. While the rupee is not freely convertible, the correlation between [the difference between the repo rate and the Fed funds rate] and the 12-month forward premium is very high (96%) suggesting that the FX market is pretty close to open despite certain regulatory/taxation constraints.

Also Read: Data drive: A public sector push

Clearly, all the action by the US Fed—cutting rates up until and through the pandemic and now raising them—is quite directly translating into domestic monetary policy and, as we see, into the FX forwards. RBI is expected to cut rates by 35 bps in its next (current) monetary policy meeting (December 5-7) and the Fed is expected to raise rates at its Dec 10 meeting by 50 bps—thus, the differential may fall a bit.

However, markets try to anticipate and, being ever-optimistic, market will want to believe that the Fed’s next move (after the December hike) will be to start cutting rates; my belief is that this hope is certain to be dashed and so, while we may see premiums tighten a bit, in a few months (or weeks), as it becomes more apparent that US inflation is going to remain elevated despite the economy slowing down, we will see the premiums fall again, and probably further.

This, of course, has significant implications for risk management. Historically, many exporting companies hedged out to 12-months, since that reflects the annual plan; indeed, companies in IT and pharma and some other industries often hedged even further out—say, to 24 months—since they had excellent visibility of their realisations, and one of the first principles of managing cash risk is to identify risk out to the longest meaningful tenor. However, with volatility up and premiums down (and sliding), the picture changes completely. The intuitive response is to shorten the hedging tenor—indeed, some exporters may stop hedging completely, which, to my mind, is not sound at all.

Also Read: A long & harsh winter 

As you would know by now, our approach is to always look for a structured solution. To address current market conditions, we have incorporated a toggle (into our classic hedge model, MHP 1.0) that signals when to switch to a different risk-controlled programme with a lower hedging intensity whenever the market momentum suggests the rupee may weaken. The new version, MHP 2.0, would have performed brilliantly—even better than MHP 1.0—over the past 5 years. Back-testing of the new model also suggests reducing the hedging tenor to 6/12 months from 12 or 24 months.

We tested the new version in a low premium environment and found, unsurprisingly, that a lower hedge tenor works best.

The accompanying graphic describes its performance and shows that over the period tested (and with the assumption that the premiums over the entire period were at today’s low level), there is:

  • Not a material difference in the cash realisation irrespective of the tenor to which you manage risk (although 6-months is the modest winner), but
  • A huge difference in the quarterly MTMs—the worst case in a 6-month risk identification is less than 1 rupee to the dollar, whereas at all other risk identification tenors, the worst MTM loss is around (and greater than) 4 rupees a dollar.

Of course, we don’t know that the premiums will remain low and, importantly, we don’t know how the spot rupee will move. If it weakens sharply, it would make sense to hedge even less but if it stays steady or appreciates we would need to increase the hedge ratio. The toggle that we have added to our structured programme can assist this process—in the meantime, reduce your hedge horizon and be sure to follow a process with a stop loss/risk limit.

The author is CEO, Mecklai Financial

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