Friday, April 11, 2008

Hedging Foreign Currency Risks

Shyam Ponappa / New Delhi May 3, 2007

How to tackle the risks of a rising and falling rupee.

Until recently, Indian exporters profited from the gradual depreciation of the rupee against the dollar, euro, or yen. With currency inflows and a fluctuating rupee, there is a need to consider hedging foreign currency receivables/payables. Indian companies hedge rupee receivables or payables through banks with forward contracts or tailored options for limited durations, usually not beyond some months. Cross-currency instruments are available abroad for other currencies, e.g. using futures or options in Tokyo, the Chicago Mercantile Exchange or the Philadelphia Stock Exchange, but no rupee-denominated hedging instruments are traded in markets.

This will change with the Dubai Gold & Commodities Exchange announcing the launch of rupee-dollar futures in June 2007, and the RBI permitting currency futures and options, although with many caveats and constraints. How should companies deal with these developments?


Importers and exporters need products such as rupee futures and options in addition to forwards to manage their currency exposure cost-effectively, with the institutional infrastructure of exchanges where these are traded. With volumes, competition and liquidity, prices are likely to fall significantly. Such developments will give Indian companies access to reasonably priced hedging alternatives, adding to their competitive strength.

For such institutional development, the finance ministry, the RBI, banks, and specialised service providers will have to all pull together. Orchestrating participation from skilled commodities specialists and institutions in commercial centres such as Mumbai would greatly facilitate development, much as currency futures originated in the commodities trading centre of Chicago, and currency options in the specialised securities centre of Philadelphia.

The key will be to design and implement an end-to-end system, with a collaborative (public-private), goal-oriented approach. What could hamper outcomes is moralistic disapproval and proscription of speculation—i.e. the attitude that “speculation, like liquor, is bad”. Some speculation is essential for the development of depth and resilience in such markets. This is why we should simultaneously try to get the Chicago Mercantile Exchange and/or Philadelphia to introduce rupee futures and options. In short, a bypass strategy like the SEZs, with all its costs and implications, until we can unfetter ourselves.

Evaluating hedging alternatives

Companies with foreign currency receivables can choose to maintain their exposure, or hedge it to protect against a strengthening/weakening rupee. The simplest way to evaluate hedging alternatives is to use the average forecast (Expected Value point estimate) of the spot exchange rate. For large, non-routine exposure of cash flows as well as event-oriented accounting exposure with external effects (e.g. annual earnings if stock prices reflect accounting profits more than cash flows), companies can do a systematic evaluation using decision analysis, aside from intuitive assessments. This can include probabilities associated with a range of estimated spot rates, and the risk preferences or utility of a company, i.e. the tradeoff between risk and reward. Such evaluations may suggest a partial hedge of a given exposure, instead of all or nothing.

Applying decision analysis

Systematic assessment requires thinking through the following “decision tree” process: To hedge or not? If no, the receivable is converted at maturity to rupees at the prevailing spot rate. If yes, then:

a) Estimate likely spot rate values at maturity with associated probabilities, as a probability distribution.

b) Specify management’s risk preferences (utility curve) for the range of probable outcomes.*

c) Estimate and factor in the cost of hedging different amounts of exposure with forward contracts, futures, or options.

d) Simulate likely outcomes of the risk-adjusted return to the company from hedging different levels of exposure.

e) Select the method (a forward contract, futures, or options) that is likely to yield the preferred results.

Be aware throughout that none of this accounts for unforeseen spikes (the collapse of Enron, or the run-up of real estate).


Items a-d are explained below.a) Estimate Exchange Rates & Probabilities: Forecasts of spot rates for the rupee against the currency can be graphed with spline functions or other curve-tracing tools, to obtain a probability density function (curve) of any desired shape. For instance, a proprietary system I helped to design years ago in San Francisco used three point-estimates with their associated probabilities—the minimum, maximum, and median (most likely point)—to draw the probability distribution. The degree of uncertainty — thickness of tails and of the bulge at the centre or to any one side of the distribution—could also be specified, so that the curve can reflect management’s rate forecast.

Figure 1 has two examples of estimated rates:

b) Management’s Risk Preferences (Utility): Management must specify its preferences (utilities) and its maximum tolerable loss (loss-limit) in the context of the currency exposure. This can be done using a curve that conforms to the two-piece von Neumann-Morgenstern utility function.* This curve combines loss-aversion with risk seeking for gains. The curve at the lower bound near the maximum tolerable loss should be asymptotic to the loss limit
(near vertical in Figure 2), to avoid breaching the loss-limit

c) Hedging Instruments: Forwards, Futures, or Options—As mentioned above, there has to be considerable institutional development to offer these choices in rupee-denominated exposure management, either locally or by access to markets abroad. Then, the cost of hedging different percentages of the exposure in different ways will be feasible and can be factored into the decision.

d) Simulating Outcomes: Risk Profile Of Returns: Spreadsheets readily allow for simulations of different combinations of exposure, currency rates, probabilities, and preferences to yield a “risk profile” of likely returns for any given level of exposure (implying that the remainder is hedged). The highest value of the preference-adjusted returns for increasing amounts hedged indicates the preferred hedging position. The risk profile for a given hedge with the probable gains/losses is shown in Figure 3.

To conclude, let us understand that efficient hedging alternatives add to India's competitiveness, as do efficient financial services overall. Indian companies have to compete with others who have such facilities. In essence, financial services are a form of enabling infrastructure at the next level beyond "basic infrastructure".

* Kahneman, D, & Tversky, A (1982): 'The psychology of preferences', Scientific American, 246, 160-173.

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