29 Oct 2017 16:42 IST

Wield the shield

Be it as exporters or importers, Indian businesses generally don’t hedge against rupee movement

“Chalta hai, yaar.” This is the attitude of Indian business when it comes to forex hedging.

Exporters appear to be harbouring the misconception that the rupee is in a structural downtrend and therefore they are unlikely to suffer losses for extended periods. Importers seem to be betting that phases of sharp depreciation will be few. This attitude has cost companies dear in phases when the rupee moved rapidly in one direction.

For instance, the rupee appreciated over 7 per cent from 68.85 in November 2016 to 64 in April and has remained resilient in a range between 64 and 66 since then. This sharp appreciation would have caught most exporters off guard as they would have expected a rupee depreciation , given the global and domestic conditions prevailing towards the end of 2016.

Likewise, the sharp depreciation in the rupee, from around 55 to 68 between May and August 2013 would have hit the importers hard. But few importers appear to be worrying about such eventualities.

Vulnerable sectors

Exports and imports get impacted, depending on whether the rupee is appreciating or depreciating against the US dollar. When the rupee appreciates, it is good news for importers as a strong currency brings down their import cost.

This is, however, negative for exporters as their forex revenue will take a hit. Similarly, when the rupee depreciates, forex revenue for exporters shoots up. But, the expenses go up for importers. Among the BSE 500 companies, IT and software, pharmaceuticals and automobiles are the major sectors that have higher forex earnings. These sectors are hurt by a strong rupee and benefit from a weak rupee. Similarly, import-oriented sectors such as oil and gas, metals, etc., come under pressure when the rupee depreciates.

Mostly unhedged

A report from India Ratings based on a study of top 100 Indian companies shows that in FY16, just 36 per cent of the overall forex exposures was hedged. The rest of the 64 per cent was left open to forex loss in the event of any sharp move in the rupee. In general, only about 30 to 35 per cent of Indian corporate’s forex exposure is hedged, the rest is left open.

Experts say that most of the big corporates have a risk management system in place and ensure that proper protection is taken on their forex exposure. But others, including the medium and small entities, do not have any risk management policies and are mostly unhedged.

There are several factors that prevent Indian corporates from hedging. Here’s taking a look at some of them.

High cost of hedging

The foremost concern of companies appears to be the hedging cost. Companies seem to think that the cost incurred for paying the premium while buying a hedge is unnecessary, and an avoidable expense. But numbers suggest that the hedging cost has actually come down over the last few years. Data from Kshitij Consultancy Services shows that the forward premium on USD-INR has come down from around 9 per cent in 2013 to about 4.4 per cent now.

The forward premium had stayed at a higher level of between 8 per cent and 9 per cent in 2013 and 2014 and has been coming down since then.

The premium is a function of the interest rate differential between the US and India. With room for just one more rate cut of 25 basis points over the medium term, the interest rate cycle in our country is more likely to turn around. However, since the Federal Reserve has also started hiking rates in the US, hedging cost could remain at current levels for some more time.

Stable rupee

Indian corporates largely believe that the Indian rupee is more stable and less volatile when compared to other currencies. However, this is not true.

Though the average monthly amplitude (difference between the monthly high and low) of rupee is ₹1.3 against the dollar, from a long-term perspective, the domestic currency has been weakening consistently year after year since 2011, barring the current year 2017.

Secondly, importers believe that the RBI would intervene in the market from time to time and arrest continuous depreciation in the rupee. But the RBI has reiterated several times that it will not intervene in the market unless there is excess and abnormal volatility. Therefore, it becomes exigent for both exporters and importers to forecast the currency move and hedge accordingly.

Natural hedge

Many companies, especially in the manufacturing segment, blindly believe in the concept of natural hedge. According to this concept, the normal business operations of a company generally provide a hedge. For instance, if a company exports to a country but also imports raw materials from the same country or has taken an overseas loan in the other currency, then the forex exposure of the revenue is partially neutralised.

This may work in theory but it may not be practical due to time mismatch. Soumyajit Niyogi, Associate Director, Core Analytical Group, India Ratings & Research, says, “The timing is a problem as the payment may not come exactly at the time of loan repayment period. This mismatch between the export flow and liability repayment becomes a problem.”

Lack of awareness

Many businesses are not aware of the different instruments used for hedging. The most prominent tool that has been used widely among Indian corporates for hedging is the forward contracts and, to some extent, the options contract. There are other instruments like swaps, futures and options contracts on the exchanges that can also be used for hedging.

Lack of transparency in terms of prices while taking a forward contract with a bank keeps many corporates away from hedging. That is, the bank that offers the forward contract marks up its margin while quoting the final price to the customer. Unless the business entity has a good relationship with the bank, it is unlikely to get good rates.


So what can importers or exporters do to shield themselves from exchange rate risk? Vikram Murarka, Chief Currency Strategist, Kshitij Consultancy Services, says that just as a business allocates a certain sum in its budget for small elements such as stationery, etc., it is necessary to allocate a certain sum for hedging expenses as well.

“The forward premium should be accounted as the cost of hedging. The budget for hedging cost should be 3 per cent to 4 per cent of your exposure in dollar-rupee,” says Vikram. He says that instead of hedging the entire amount at once, the exposure can be split into many parts and then hedged over time, coinciding with the payment schedule. He says this method can earn a net benefit of 1 per cent, after paying the hedging cost.

Other experts from corporate treasuries suggest that for small business entities with less forex exposure, the exchange traded derivatives contract can be used for hedging the short-term forex exposure as the pricing is transparent on the exchanges. They also insist that instruments like swaps, principal only swap and interest rate swaps can be used for covering long-term liabilities, like loans.

The weapons to protect against risk

Hedging can be done through two avenues. One, through the Over the Counter (OTC) market, that is through banks and two, through stock exchanges. Though various hedging instruments are available, only a couple of them are widely used.

They are forward contracts and options contract. Forward contracts are available only in the OTC market while options contracts are available both in OTC and on the exchanges.

Apart from these two, futures contracts on the exchanges and different swap agreements like currency swaps, interest rate swaps, etc., are the other instruments available for hedging.

Here’s a closer look at the most widely used hedging instruments, the forwards and options. According to market participants, forward contracts are the more popular of the two, with 80 to 90 per cent of overall hedges done with these instruments.

Forward contract

A forward contract can be obtained only in the OTC market. By definition, it is a contract between two parties (an exporter or an importer and a bank in this case) to buy or sell a specific quantity of asset (currency in this case) at a specified rate and a specified time.

Banks add their margin to the forward premium. This, along with the bank charges, becomes the cost for the hedger.

At the moment, USD-INR forward has a premium of around 4.5 per cent. If the spot price of rupee is 65 against the dollar, then the forward rate would be 67.93. The difference of 2.93 (67.93-65) per dollar is the forward premium. So the total hedge cost would be the premium (2.93) plus the bank’s margin added to the premium along with bank charges.

Exporters earn the forward premium while they hedge as they sell the dollar whereas importers pay this premium when they buy the dollar. Forwards protect the hedger from volatility whenever the currency price moves adversely, but do not give the flexibility to change the rates if needed.

That is, from the above example, if the rupee appreciates to 64 or 63 in the next six months, then taking forward contract today will give the exporter a better rate of 67.93 after six months when the spot rate would be 64 or 63.

But conversely, if the rupee depreciates to 70 in the next six months, then it is a loss as the exporter had locked the rate at 67.93.

Options contract

This is an agreement between a buyer and a seller where the buyer of the options contract gets the right but not an obligation to either buy or sell the asset at an agreed price (called the strike price) on a future date.

An option contract that gives the purchaser the right to buy is called a “Call Option” while the one that gives the right to sell is called the “Put Option”. Options are available both in OTC as well as the exchanges. Like forwards, a premium is charged in option contracts too. On the exchange, the brokerage and other exchange related charges mark up the hedge cost and are to be paid upfront.

For instance, an importer fears that the rupee could depreciate sharply below 70 against the dollar, say, by December. If an option contract is available at, say, 68.5 for December, the importer can buy a call at 68.5 and hedge himself against a sharp fall in the rupee.

In case the rupee appreciates to, say, 63 by December, which is contrary to the earlier expectation, the importer need not execute the option and instead buy from spot market to meet his obligation.

Futures contract

Four currency pairs (USD-INR, EUR-INR, JPY-INR, GBP-INR) are available as futures contract on the exchanges. There is a margin amount, that is, a certain per cent of the total contract value (generally between 3 and 6 per cent) that has to be deposited with the broker. Other charges like the brokerage, exchange charges, etc, add to the overall cost.

The major disadvantage here is the “margin calls”. That is, if your position exceeds a certain loss limit (mark to market) you will be asked to pay more margin amount. Since the mark-to-market is calculated on a daily basis, you may have to pay additional sums almost daily if the position moves into a loss.

Forwards or Options?

Your expectation regarding the currency movement will determine whether you should use forwards or options. In a trending market, when the currency is either falling or rising, taking a forward contract will work well. Say, if the trend in rupee is up, then an exporter can book a forward contract and lock the prices. At the same time the importer can keep the exposure open and cover at market rate whenever required.

On the other hand, whenever the rupee is depreciating, an importer should take a forward contract while the exporter can keep his exposure open and cover at market rate. Options can be used when the market is trading sideways. That is when the trend is not clear.

Vikram Murarka, Chief Currency Strategist, Kshitij Consultancy Services, says “When the trend is clear and if it is in your favour, then keep the exposure open. But hedge with forwards if it is not in your favour.”

He also adds that it is good to buy an option when the market is range-bound at which time the volatility is low and hence the option premium is low. “Conversely, when the market is trending, volatility tends to be high and so does the option premium. This will be the time when one should sell an option instead of buying an option,” adds Vikram.

Exchange vs OTC

Hedging on the OTC or through the exchange traded has its own pros and cons. The biggest advantage hedging on the exchange is the transparency in prices.

The exchange rate that you see on your computer or on the exchange website is applicable for all. There is no room for negotiation.

But OTC, the prices are opaque. The premium charged can vary from case to case depending on the relationship you have with the banks. Big players and a large hedge amount could fetch better rates when compared to small corporates with less hedge amount.

Apart from this factor, OTC scores better in comparison to the exchange. The exchange traded instruments are available only for a fixed maturity date towards the end of each month. So a perfect hedge, that is the actual time of hedge requirement and the contract expiry, may not match.

But OTC offers you the flexibility to hedge for any period, for any specific date on which the transaction is to take place. This results in a perfect hedge.

Limits are applicable if you want to take a position on the exchange. For the USD-INR contract, it is $15 million and for other contracts together (EUR-INR, GBP-INR and JPY-INR) it is $5 million.

Beyond this limit you will have to provide evidence of the underlying to take positions. In OTC, there is no such limitations and any quantum of amount can be hedged.

You will have to pay the hedge cost, that is, the premium, and other charges upfront on the exchange. Also, the risk of paying the mark-to-market (MTM) margin on a daily basis is present on the exchange if you use futures for hedging your position and the position goes against you. This would add to your hedge cost.

Such hassles can be avoided on the OTC if you have a good credit-line and the banks does not ask for any margin amount until the loss in the hedge position exceeds 80 or 90 per cent of the credit line.

There is no liquidity problem in OTC. On the exchanges, the liquidity is good only on the near-month contracts, especially the one month. Cancellation of the contract is possible in OTC whereas on the exchange it is not possible.

Broadly taking into consideration the flexibility on the OTC and the limitations on the exchanges, hedging through the OTC could be ideal for corporates.

(The article first appeared in The Hindu BusinessLine.)