Forex Hedging - Walking on the edge? It’s time to hedge your bets March 2018 issue

With central banks resorting to desperate moves, like Bank of Russia’s recent 650 bps rate hike or Swiss National Bank’s move to peg Franc to Euro in 2012, unhedged forex exposure is like a time bomb, which can explode and ruin everything, without an

Forex Hedging - Walking on the edge? It’s time to hedge your bets

On the 16th of last month, Bank of Russia did the unthinkable. In order to stem the slide in the ruble, it hiked interest rates by 650 bps! The result was an immediate four handle crash in USDRUB, followed by a maniacal 30% surge. While this was a once in a lifetime of event, it, once again, brought back to fore the need to immunise businesses from forex volatility by hedging

Shakti Shankar Patra | The Dollar Business

In a world of free-floating currencies and ultra aggressive central banks, it has become very important to not only regularly assess one’s forex exposure, but also aggressively hedge it


At the end of FY2012, India’s most valuable company – Tata Consultancy Services (TCS) – had foreign currency hedges worth a notional Rs.8,506.37 crore, other than hedges worth a notional $2.64 billion in options and $308.53 million in forwards, which TCS categorised as Cash Flow Hedges. At the 30th March 2012 RBI USDINR reference rate of 51.1565, these added up to Rs.23,602.77 crore. And if one goes by TCS’ FY2013 consolidated operational revenue of Rs.62,989.48 crore, it means even before the start of FY2013, TCS had got almost 37.5% of its forward earnings hedged. Despite this, the company made a net forex gain of Rs.49.27 crore in FY2013. How? The answer is in the fact that on the last day of FY2013, RBI USDINR reference rate had risen to 54.3893, thereby benefitting TCS’ unhedged revenue.

How did TCS tweak its strategy in response? It simply, reduced its hedges! For, at the end of FY2013, TCS had foreign currency hedges worth a notional Rs.10,665.98 crore, other than hedges worth a notional $1.37 billion in options and $26.28 million in forwards, categorised as Cash Flow Hedges. This means while at the beginning of FY2013, TCS had got 37.5% of its forward earnings hedged, at the beginning of FY2014, TCS had got just 22.3% of its forward earnings hedged!

On thin ice

If you thought hedging just 22.3% of your earnings is too risky, you haven’t seen anything yet. For example, at the end of FY2013, Infosys Technologies had foreign currency hedges of Rs.5,985 crore – just 11.9% of its FY2014 earnings! While such adventures have been not so dangerous for Indian exporters, given the secular decline in the value of the rupee, history is evident to the fact that, in the long run, they don’t work out. Just pick up any report from before 2008 and you will find how Indian IT companies were scrambling for cover as the rupee moved from strength to strength. For example, the same TCS had increased its foreign currency hedges by more than 250% between FY2006 and FY2007 – from $566 million notional to $1.43 billion notional – as the rupee appeared to be in a bull run.

On the other hand, finding themselves on the wrong side of the secular decline in the rupee are Indian importers. In fact, the rapid decline in the rupee in the summer of 2013 had made matters so dire that the RBI had to open a Special Swap Window for oil marketing PSUs, to help them meet their crude oil payment related dollar obligations. Despite this the largest among Indian oil PSUs and India’s largest company by sales – Indian Oil Corporation Ltd. (IOC) – had Rs.81,823.5 crore worth of unhedged foreign currency obligations at the end of FY2014, against Rs.52,120.1 crore of foreign currency loans!

Indian rupee and MCX futures - The Dollar Business


Why hedge

Let’s go back to India’s most valuable company – TCS. Being in the IT outsourcing and consultancy business, TCS earns majority of its revenue from US and Europe – 81.7% in FY2014. But most of its expenditure is done in India, in Indian rupees. So, let’s say TCS wins an order valued at $1 million, to implement which it figures out it will have to spend Rs.5 crore. Looking at USDINR at 62 (say), it goes ahead and spends Rs.5 crore on implementing the project, expecting to pocket a profit of Rs.1.2 crore. But by the time the project is delivered and the payment for it is received, USDINR has moved to 45 (say). This means when TCS presents the $1 million cheque to its banker, the latter gives it only Rs.4.5 crore, resulting in TCS making a loss of Rs.50 lakh on the project, instead of a profit of Rs.1.2 crore. This, only because of unfavourable foreign exchange movement.


"At the end of FY2014, TCS had reduced its US Dollar Cash flow hedges by over 65% (YoY)"


TCS and millions of other exporters, all around the world, avoid such situations by hedging their foreign exchange exposures (at least partly, as we have seen earlier) by using derivative contracts like futures, forwards, options and swaps. So, in the above example, the moment TCS signed the deal, it could have hedged its $1 million worth of foreign exchange exposure, by selling an USDINR forward contract, which would have been quoting around the spot price of 62. This would have meant in case of any strengthening of the rupee (fall in USDINR) in the interim, TCS’s ‘short forward’ position would have compensated for the loss in translation. Going back to the same example, assuming USDINR had fallen to 45 at the time of payment, the forward position would have given TCS Rs.1.7 crore of profit (assuming the forward was shorted at par), which would have compensated for the translation loss.

It’s not that hedging is important to negate operational foreign exchange headwinds only, it is also key to mitigate balance sheet risks. For example, let’s assume an Indian company avails a $1 million loan from an American bank, to benefit from lower interest rates in US. Since the company needs the money in India, it immediately converts the dollars into rupees at the prevailing USDINR rate of 62 (say), thereby, getting Rs.6.2 crore. Let’s assume at the time of paying the loan back, USDINR has risen to 72. In such a situation, the company ends up coughing up Rs.7.2 crore (of course, interest as well) to get its hands on $1 million because the American bank would demand being paid back only in dollars. Even in this case, the company could have hedged its foreign exchange exposure by buying an USDINR forward contract, the moment the loan is sanctioned. The ‘long forward’ position, in return, would have negated all translational loss at the time of paying the loan back.

rupee volatility-The Dollar Business
A bit of lull in rupee volatility, in the last few months, seems to have made a lot of Indian exporters and importers complacent about their hedging requirements – a phenomenon that hasn’t gone unnoticed by even the RBI, which feels Indian corporates are grossly under-hedged


Why not hedge

The only reason for not hedging one’s foreign currency exposure is the lure of favourable currency movement. Going back to the above TCS example, let’s say by the time TCS received the $1 million payment, USDINR, instead of moving lower from 62 to 45, had moved higher to 72. In such a situation, TCS’ short forward position would have incurred a loss of Rs.1 crore, although it would have been compensated by translational gain. Instead, if TCS had not opted for hedges at all, it would have gained that extra Rs.1 crore at the time of conversion.

Another reason for not opting for hedging is the cost of it, because while derivatives like forwards, futures and swaps don’t cost much (other than transaction cost), derivative instruments like options involve the payment of a premium, which, at times, can be a very dissuading factor, particularly when a forex pair is not very volatile.


"In 2013, the RBI opened a special swap window to help OMCs meet their dollar requirements"


Even when it comes to forwards and futures, since an efficient market ensures that all risks and factors are discounted (at least reasonably), they (forwards and futures) often trade at significant discounts or premiums, in the direction of future prices. And given the massive interest rate differential between US and India, USDINR forward contracts are, today, quoting at massive premiums and in a contango. For example, with USDINR at 62 (say), if three-month USDINR futures and forwards are trading at 64, six-month contracts are trading at 66, one-year contacts are trading at 68 and so on. So, for a company, which is scheduled to payback a foreign-currency loan a year later, fully hedging its foreign exchange exposure would mean buying an USDINR forward at 68 – a very dissuading factor, given where the spot is trading.

Indian Oil Corporation Ltd-TheDollarBusiness


Who’s job

While exporters and importers have their own reason/logic/strategy to whether completely hedge, partially hedge or not at all hedge their forex exposure, RBI has started taking note of the fact that corporate India is massively under-hedged. And while it, probably, doesn’t have the mandate to force companies to hedge their forex exposures, it certainly is trying to warn one and all. Trying to put across this message, RBI Deputy Governor, a couple of months back, said, “It is absolutely essential that corporates should continue to be guided by sound hedging policies and the financing banks factor the risk of unhedged exposures in their credit assessment framework.” He went on to add that Indian companies’ hedge ratio for overseas loans and foreign convertible debt was ‘very low’. 

How to hedge

Having established the need and importance of ensuring your forex exposure is hedged, the question is how one goes about it. And the answer lies with your friendly banker. With the world getting increasingly integrated; ever increasing volumes and value of trade; and currency moves like what the ruble did recently, every bank worth its salt, today, has an active risk management and treasury department. What these banks essentially do is act as a bridge between exporters and importers – those who would be inversely affected by the movement in a currency pair – and hence, are trying to find someone to take the opposite side of the trade. Banks also, very often, act as counterparties themselves. And given that a bank acts as a counterparty to both exporters and importers, its own risk gets negated, at least partially.

Going back to the above mentioned example, if TCS goes to XYZ Bank (say) the moment it receives the $1 million order and tries to hedge its forex exposure, XYZ Bank would be, typically, ready with quotes for various periods. So, with spot USDINR at 62, it might be ready to act as the counterparty for a one-month period at 63, three-month period at 64, and so on. What about XYZ Bank’s risk if USDINR falls to 45 (say)? The bank would typically try to negate this loss by acting as the counterparty for an importer. So, the moment a three-month forward is traded at 64 between TCS and XYZ Bank (here XYZ Bank is acting as a buyer), it would try to find another company, most likely an importer, who is looking to buy a three-month forward at 64.5 (here XYZ bank is a seller), thereby making itself immune from forex risks, and at the same time, pocketing a small profit of 0.5.

Today, we also have organised exchanges like MCX, NSE and BSE, where standardised future and option contracts of various currency pairs like USDINR, EURINR, GBPINR etc. are traded, enabling even the smallest of exporter/importer to hedge its forex exposure, without worrying about counterparty risks. At the same time, for those who want to hedge their forex risk, but also want to profit from favourable currency movement, there are slightly more complex derivative products like options, which come at a slight cost.

In fact, interestingly options are increasingly becoming the instrument of choice for India Inc. as can be seen from TCS’ FY2014 Annual Report, which reveals that all of the company’s outstanding positions under Cash Flow Hedges are option contracts!


"Companies don’t hedge all their forex exposures to benefit from favourable forex movement"


Hedge for an edge

The reason for a company to exist in a business is because it thinks the business model is profitable; it’s because it offers great goods and services; it’s because there is enough demand for its goods and services at the price at which it is offering them; and the price at which it is offering its goods and services, allows it to make profits. It’s not in business to speculate in the forex market. Given all this, forex exposure related risk is, at best, a nuisance, which is best avoided. And the only way to avoid it, is by, what else, but hedging. You hedged yet?


“We are sitting on a time bomb, people are very under-hedged” - Saurabh Sarkar, Managing Director & CEO, MCX Stock Exchange

Saurabh Sarkar, Managing Director & CEO, MCX Stock Exchange


TDB: Can you give us a rough estimate of the breakup of currency derivative traders at MCX, in terms of real hedgers and speculators?

Saurabh Sarkar (SS): If you compare the volume-outstanding open interest ratio in each of the exchanges, you will find that ours is the lowest. This means that the percentage of hedgers is the highest at MCX. Typically, volume is driven by speculation and open interest by hedgers. So, wherever you find volume as a percentage of open interest very high, you know there is a lot of speculation. In our case, while open interest is, generally, about $800 million, volume is about $500-$600 million. This means that more hedging activity is going on.

On the other hand, at BSE the volume would be about 3x of open interest! Even at NSE, the ratio is very high. So, even though there has been a lot of speculative activity at MCX in the past, a lot of the volume, today, is because of hedging. If you want me to put a number, I think at least 30% to 35%, maybe even 40% of the volume at MCX is, today, is accounted for by hedgers. We recognise if this business has to grow, we need the participation of more corporates. So, we have started reaching out to them directly.

TDB: Despite a rise in currency derivative turnover, there is a feeling that not a lot of small and medium sized exporters/importers hedge their forex risk. What’s your take on this? What is MCX doing to raise awareness?

SS: Obviously, it is difficult for small and medium sized exporters and importers…firstly, awareness is very low and secondly, banks have a lot of control over them. Most of them have only one or two banks, on whom, they are dependent on for financing. Many also feel that once they start dealing in exchanges, they have to deal with daily mark to market (MTM) margins and other processes. They don’t realise this could, actually, be beneficial for them, if they compare this with the margins they pay to their banks. At the same time, banks are also moving to the Basel III regime, which means they will have to charge much higher for such activity. So, the key thing is to make traders realise that dealing directly on an exchange platform is far more beneficial than dealing with a bank.


"Our marketing efforts are focussed on reaching out to corporate India"


A lot of awareness still needs to be created in this area. As I said, all our marketing efforts are focused on reaching out to corporates and bringing them to our platform. The only trouble is it doesn’t give us easy rewards because when a hedger hedges his/her exports, he/she won’t be trading every day. So, the reward for exchanges is not high, but we are progressing on this path because we feel, things will be very different in the next five-seven years.

TDB: China is the top source of Indian imports. But, despite the yuan being a lot more volatile in recent years, we don’t have CNYINR contracts. When do you think we can have the same?

SS: I think it’s a very good idea. Today, everyone, including Indian exporters/importers, is exposed to the Chinese currency, because China is such a big manufacturing powerhouse. Every Indian manufacturer and exporter/importer faces yuan risk, without even realising it. So, we should also have yuan hedging on our platform. But for that, we need to approach the regulators.

TDB: Most large corporations prefer the OTC market to hedge their forex exposure. Is it only the lack of liquidity or is there something else that makes them go to the OTC market?

SS: I don’t think it’s a case of lack of liquidity. In the OTC market, large corporations are subsidised by the smaller guys. For, usually, large guys don’t pay any margin, while smaller players end up paying a very high margin. But as I said, even banks will soon start charging margins to large corporations. That’s when it will make some sense for them to come to an exchange, which treats everyone – be it a large corporation or a small time trader – equally.

TDB: Currency markets should be open 24/7, which is not the case in India. Have you tried to make a case for this with the RBI? Do you think RBI will allow this in the near future?

SS: By definition, the currency market should never be closed. It should be open 24/7. I hope they will (allow it). I guess both the SEBI and the RBI have had discussions on this this matter and there is some talk of increasing it up to 7.30 pm in near term future. But it all, ultimately, depends on the regulators. Once the market is allowed to stay open till 7.30 pm, it might get further extended till 11.30 pm. We have been saying this to the SEBI for some time for now and we hope to get some positive news soon because, I feel, an important event might take place even at night and one need not wait through the entire night to trade in currencies.

TDB: In 2008, lots of importers burnt their fingers due to the sudden rupee depreciation. How have things changed since? Did the 2012/2013 rupee volatility see increased participation?

SS: I think so, because if you see the volumes, they were very high in 2012 and 2013. In fact, they were 10x of what they are now. That’s when regulators came in with lot of restrictions and clamped down on exchanges, which dried up volumes. Now many such restrictions are gone but because there is not a lot of volatility, you don’t see much participation. But again, I feel we are sitting on a time bomb – people are very under-hedged. They are assuming the rupee will be where it is forever. In case there is any big move, importers will again burn their fingers. Unfortunately, smaller companies come to hedge only after the key event has happened. I think they should have a policy, wherein a certain percentage is always hedged, regardless of volatility. Even the RBI has expressed concerns about Indian companies being under-hedged.

TDB: How are you dealing with competition? Tell us why an exporter/importer should use your platform and not that of your peers.

SS: We are trying to carve a niche. Our business model is geared towards corporate India. We are spending money on increasing awareness. We are not chasing volumes at this point in time because that comes with its own sets of problems. We are keen on building up open interest. We are keen on associating with more corporate. I think, we already have around 11,000 corporates registered with us. And our aim is to increase this to around 2.5 lakh in next five years. We are reaching out to every exporter, importer and small trader in India.

TDB: Do you think the fact that large Indian corporations opt for structured products and not necessarily plain vanilla futures/forwards a reason for their lack of participation in Indian exchanges?

SS: The structured products’ market is not very active right now because RBI has intervened and brought in a lot of restrictions for banks too. So, that cannot be a reason. I also think for a smaller guy, structured products are not a good option because there is no transparency. At the same time, today, all sorts of options are available on currency exchange platforms as well. So, if someone wants to do strategies, instead of simply hedging, that can always be replicated through options. I would like to think what is available with banks, is also available with us.

TDB: How has your personal experience been in handling MCX?

SS: It has been a very challenging one because we have gone through some very tough times due to our past promoters’ involvements. But now things have stabilised and the future looks quite optimistic.

 Forex Hedging - Walking on the edge? It’s time to hedge your bets

Derivative Contracts Decoded




A futures contract is an agreement between two parties to respectively buy and sell a particular asset, at a pre-decided price, on a future date. Futures contracts are standardised and traded on recognised exchanges.

For example, an USDINR January futures contract (of lot size 1,000) bought by A and sold by B at Rs.64 means B has agreed to handover $1,000 to A, in exchange of Rs.64,000, on the settlement day. Since all futures contracts in India are cash settled, this essentially means A and B will simply exchange the difference between 64 and RBI’s reference rate on the expiry day.


Forwards are just like futures contracts, but with a few key differences. Unlike futures, forwards are non-standardised and are not traded on exchanges. These are over-the-counter (OTC) contracts that can be customised as per the need and hence, are very popular among large corporations. However, because of being OTC products, they don’t have centralised clearing houses, making them more susceptible to default.

Call option

A call option is a contract that gives its buyer the right, but not the obligation, to buy a certain underlying, at/within a certain time, at a pre-decided price. On the other hand, the seller of the option contract takes up the obligation to sell the underlying at/within a certain time, at the pre-decided price. The price that the option seller charges the option buyer to take up the obligation/sell the right is called the option premium and the pre-decided price is called the strike price. Since, the call option buyer has a right, its potential upside is unlimited and downside is limited. On the other hand, for an option seller, the potential upside is limited, but downside is unlimited.

For example, if a USDINR January 65 call is bought by A from B at Re.1, it means B has agreed to sell USDINR to A at Rs.65 and to do this, B is charging Re.1. If at the time of expiry, USDINR is at Rs.70, B ends up making Rs.4 of loss, while if at the time of expiry, USDINR is at Rs.65, it pockets Re.1 of profit. Similarly, while at USDINR Rs.70, A makes Rs.4 profit, the maximum potential loss for it is Re.1, if at the time of expiry, USDINR is at Rs.65 or lower.

Put option

A put option is a contract that gives its buyer the right, but not the obligation, to sell a certain underlying, at/within a certain time, at a pre-decided price. On the other hand, the seller of the option contract takes up the obligation to buy the underlying at/within a certain time, at the pre-decided price. The price that the option seller charges the option buyer to take up the obligation/sell the right is called the option premium and the pre-decided price is called the strike price. Since, the put option buyer has a right, its potential upside is unlimited and downside is limited. On the other hand, for a put option seller, the potential upside is limited, but downside is unlimited.

For example, if a USDINR January 65 put is bought by A from B at Re.1, it means B has agreed to buy USDINR from A at Rs.65 and to do this, B is charging Re.1. If at the time of expiry, USDINR is at Rs.60, B ends up making Rs.4 of loss, while if at the time of expiry, USDINR is at Rs.65, it pockets Re.1 of profit. Similarly, while at USDINR Rs.60, A makes Rs.4 profit, the maximum potential loss for it is Re.1, if at the time of expiry, USDINR is at Rs.65 or higher since that would mean A won’t be exercising his/her right.


“Some hedge only to negate the accounting impact of FX moves” - Jamal Mecklai, CEO, Mecklai Financial

Jamal Mecklai, CEO, Mecklai Financial


TDB: How actively do you think mid-size corporates and large SMEs hedge their forex exposure? Do you think there is enough awareness about hedging in India?

Jamal Mecklai (JM): I actually believe mid-sized companies in India are more aware of risk-management than similar sized companies in most other countries, including the ones in developed markets. And one of the reasons for this, and I am probably blowing my own trumpet, is Mecklai Financial. For the last 30 years, we have been educating companies about risk because the most important thing is awareness. The ability to do something about it comes much later.

TDB: In that case, what about large corporations?

JM: For large companies, a very crucial aspect of forex gain/loss is the accounting impact it. In a survey we had done 10 years ago, one of the questions was, “Do you have problems in accounting forex gain/loss, when there’s a lot of volatility in it?” 85% of the respondents said it was an issue. When we did the same survey three years back, only about 15% said it was an issue! But now, because of the crazy volatility in the last two years, even large professional companies are, once again, saying they want to manage the volatility in forex gain/loss. Let me cite an example of a very large company, which was dealing with us. It wanted to minimise volatility in forex gain/loss, irrespective of the cost involved, just because it felt that’s what its investors wanted. So, here we have a company, which fully understands the ins and outs of forex fluctuation, but all it wanted to do is please its investors. So, today, many very large companies hedge only because they are frightened of the accounting impact of forex fluctuation in their quarterly P&L.


"A company’s P&L hedging need might be different from that of its Balance Sheet"


Let’s take the example of a company, which is into both exports and imports. Let’s say it does $10 million worth of exports and $5 million worth of imports a month. Now, buyer’s credit, typically, runs for 180 days. This means the company has six months of imports sitting on its books. Let’s also assume it has export credit for 60 days, which means it has two months of exports sitting on its books. So, the company, actually, has to pay more than what it is supposed to receive. In such a situation, how it wants to hedge boils down to what its priority is. In this case, what needs to be done from a P&L perspective and what needs to be done from a balance sheet perspective are opposite to each other. Even in these kind of situations, many companies are more worried about the P&L, rather than the overall business.

TDB: Would you agree with the view that even large exporters and importers get complacent when there’s not a lot of volatility and look at risk management only after volatility picks up?

JM: It’s all a matter of education and learning. I would say a lot of Indian companies have gone through the learning curve. They understand risk management much better than what the case was many years back. They are also more open to outsourcing their risk management activities. At the same time, while most Indian companies try to manage risk, they also want to keep a bit of the upside open.

Keeping the upside is important for companies that are competing with a lot of small guys. Since these small companies don’t use risk management at all, in case of a sudden move on the upside, they would be in a position to offer their products lot more competitively. So, keeping the upside open is very important in certain sectors.

TDB: What regulatory changes do you think will help Indian companies manage their forex risk better?

JM: There are two things here. Firstly, we need to get rid of a lot of unnecessary hurdles. For example, companies only above a certain net worth are allowed to hedge using spreads. There are several similar rules and regulations that we should do away with. Secondly, we should do all we can to get different varieties of players in to the market, which I think will only be possible if we make our capital account convertible.