Challenging Basic FX Risk Management Concepts
At a time when there has been a big jump in risk aversion in global financial markets, this article challenges two revered canons of foreign exchange (FX) risk management. First it builds a case that companies should actively manage currency risk, which is otherwise viewed as a ‘necessary evil’. Second, it argues that the concept of ‘natural hedge’ goes against the basic tenets of profit maximisation for companies and highlights an example where it was profitable for a company to shun a natural hedge even when it theoretically existed.
While preparing to write this article, I was assailed by a bit of self-doubt. Was I a fool, rushing in where angels feared to tread? It was heartening to find that mine was not the lone voice in the woods.
The article To Hedge or Not to Hedge in gtnews on 1 August 2006 quoted James Binny, executive director of ABN AMRO’s FX analytics and risk advisory, as saying: “It is accepted now that you can make money out of currency and it should be a useful part of the portfolio.” The article went on to conclude that “the idea that FX transactions will cancel themselves out over time is one that is antiquated, and few are still prepared to leave anything to chance and ignore this opportunity to trade.” (Italics added).
Let us go back to the beginning, to a time when there were no theories regarding FX risk management on Planet Earth. Let’s consider the example of a diamond company, domiciled in India, which imports uncut diamonds invoiced in US dollars. It cuts and polishes the diamonds and exports them back, invoicing the exports in US dollars.
As the charts above show, the company, as an importer, has an obligation to buy US dollars, which is the same as running a short position in US$-INR (Fig 1). As an exporter, it holds a long position in the export dollars that it needs to sell (Fig 2). This is the true picture of its FX exposures, shorn of any theories.
What should the diamond company do? Continuing to live in a world without theories, the company would attempt to buy its import dollars (or cover its original ‘short’ position) at a low rate and at the same time it would want to sell its export dollars (or cover its original ‘long’ position) at a higher rate. Suppose the company is indeed able to buy US dollars at 42.00 and to sell dollars at 44.00, then it would have captured a net export-import margin of INR 2.00 per US dollar, or 4.65% for itself from the FX market.
This 4.65% net margin is the result of judicious management of the FX rates that the company pays and receives, not from the core business of polishing uncut diamonds. Is there anything wrong in trying to capture this profit? In a competitive world, every variable that a business is exposed to needs to be managed with the intent of adding to shareholder value. FX is no exception.
Conventional wisdom says that FX trading is not the business of a manufacturing company. While one agrees that FX trading is not the core business of the company, it is an undeniable fact that the imports and exports undertaken in the course of its core business, forces the company to initiate trades in the FX market, as demonstrated by figures 1 and 2. This fact, as deduced by native logic, flies in the face of established convention that ‘FX is not my business’.
Figure 3: Framing a Hedging Process
| Questions that need to be answered: |
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Source: Kshitij Consultancy Services
A steel manufacturer, although not in the freighting business, tries its best to keep its freight costs down, both while transporting raw materials to its plants and while shipping finished goods out. A car manufacturer, although not a banker, makes all efforts possible to procure working capital at the cheapest possible rates. Thereafter, very legitimately, it tries to deploy any surplus funds that it might have available at the highest rates possible, of course, without exposing the company to risk. Variables such as freight, capital and labour costs are integral to each and every business, and it is the management’s duty to manage these variables efficiently, and if possible, profitably.
Similarly, although the diamond company might not have wished the FX trades on itself, it does have an obligation to profitably manage these trades.
The process of managing the trades is called hedging. It involves coming up with answers to the questions listed in the box and acting accordingly.
Let’s focus on the first two questions: “What to hedge?” and “How much to hedge?” Continuing in the same vein of a clean slate of ideas, the answer would have to be that both imports and exports should be hedged in their entirety (not necessarily all in one shot), because these are, after all, the company’s original FX trades and need to be covered.
Conventional wisdom, however, says that since the company has both imports, on the one hand, and exports on the other hand, it has a ‘natural hedge’ and needs to hedge only the residual net exposure, or excess of exports over imports. Say, the company imports diamonds worth US$100 and exports diamonds worth US$110. Conventional wisdom would ask the company to hedge/sell only US$10. Doing that, however, would mean that it should not try to earn an export-import margin from FX on US$100. At the most it may attempt to earn a FX margin on US$10. But that’s not really worth writing home about.
Thankfully, there is enough literature that agrees that a ‘natural hedge’ exists only in theory, given the realities of time and amount mismatches. Even if we assume a situation where the utopian concept does exist, a profit-seeking company would still want to buy US dollars for its imports at a lower rate and to sell its export dollars at a higher rate.
What would you think of a grocer who displays a rate list like the one shown in figure 4 below? Every grocer seeks to be compensated by the customer for taking the trouble of bringing the goods from the wholesaler to a well appointed store in the neighbourhood, for the convenience of the customer. Similarly, the diamond manufacturer would want to secure a reward (difference between its export-import rates) for the currency risk it carries on the entire US$110, not only on US$10.
Figure 4 : Jones Grocery Stores
| Item | Buy Price | Sell Price |
|---|---|---|
| Brown Bread | $3.00 | $3.00 |
| Rice (4 lb) | $6.00 | $6.00 |
| Burger | $3.50 | $3.50 |
| Milk (1 Gallon) | $4.50 | $4.50 |
| Curd (2 lbs) | $2.50 | $2.50 |
Source: Kshitij Consultancy Services
A bulk of the FX risk management theory in vogue and practice today dates back to the 1980s and early 1990s (a time when the FX market was no more than 15-20 years old) and emanates from bank dealing rooms. It was a time when there were a number of currencies in circulation in Europe, when bid-offer spreads used to be wide and volatility was high. Banks did indeed find some positive and negative flows cancelling each other out. While managing a mess of several currencies, the banks found it easier to deal with the residual currency amounts. It probably made sense at that time when computers, communication and information systems were less powerful than they are today.
When companies, which were completely new to tackling currency risk, turned to banks for guidance, the banks simply handed out a manual of what they did themselves to their clients. Here, it must be remembered that, by nature, banks are risk averse – they seek coverage and collateral at the very outset for the money they lend. Manufacturing companies, on the other hand, thrive by taking risks. “Fortune favours the brave” has been the mantra of all entrepreneurs across time and space.
Furthermore, the 80s and early 90s were times when globalisation and competition were not as fierce as they are today. Profits were easier to come by and companies could afford to leave a few stones unturned during their quest for profits.
Not so today. Times have changed and the textbooks need to be updated. Business competition has increased in general and also in the FX market. Bid-offer spreads are now down to a few ‘piplets’, even at the retail level. At the same time, currency volatility has reduced substantially and even George Soros might find it difficult to do an encore of his famous ‘broke the Bank of England’ trade. Information systems are more robust and real-time. In this new environment, there is both a possibility and a need for companies to try and work currencies into their bottom lines, rather than thrusting their heads into the sand like ostriches.
Can it really be worthwhile to go against an established belief, to do something radically different? Should the diamond company with a natural hedge really try to adopt a policy of ‘gross’ hedging, rather than ‘net’ hedging? Let the numbers do the talking.
We worked with one such company, using our proprietary concept of ‘dynamic benchmarks’. We did not go by the ‘natural hedge’ concept and, instead, hedged both imports and exports separately. We used only plain vanilla hedging tools, such as forwards and puts/calls. Most importantly, we did not expose the company to any additional risk. The average hedge ratio was in the region of 56%.
Over the period April 2006 to January 2008, even as the Indian rupee appreciated against the US dollar, exports were covered along the green line shown in figure 5. At the same time, imports were hedged along the red line, benefiting from the very same appreciation of the rupee. As a result, the company earned a very handsome export-import margin – from FX – over and above its normal business.
As seen in figure 6, net export realisations, after hedging costs/benefits, averaged INR 45.56 per US dollar in the financial year April 2006 to March 2007 and averaged 43.30 in FY 07-08. Net import costs, after hedging costs/benefits, averaged 45.28 in 06-07 and 40.96 in 07-08, leaving an export-import margin of 0.6% and 5.7% in FY 06-07 and 07-08 respectively. These are very satisfactory results – achieved by going against the grain of ‘natural hedge’ – without taking risks or speculating.
Figure 6: Benefits of Gross Hedging
| 2006-07 | 2007-08 | |
|---|---|---|
| Exports | 45.56 | 43.30 |
| Benchmarks | 45.24 | 42.76 |
| USD-INR | 45.19 | 4023 |
| Imports | 45.28 | 40.96 |
| Exp – Imp | 0.28 | 2.34 |
| % Gain | 0.6% | 5.7% |
Source: Kshitij Consultancy Services
As I finish writing this article, I have before me the views of some of the leading CFOs and corporate treasurers in India, as featured in the 6 September 2008 issue of Outlook Business. Mr NS Paramasivan, global treasury head of Essar Group, for instance, said: “Our mandate is to lower the cost of imports as much as possible and increase the realisation on exports as much as possible.”
And there’s nothing wrong with that, really, as long as it is done systematically and responsibly, without exposing the company to undue risk. When Mr YM Deosthalee, CFO of L&T, said: “We have the ability to convert our treasury to a profit centre. But we have no plans to do it yet”, it seems all that is needed now is for the academic intelligentsia to concede that trying to manage FX cost efficiently, perhaps profitably, is not a business crime. Indeed, it is just another avenue to be strenuously explored in the overall interests of creating shareholder value.