With the rupee suddenly/again seeming like it will remain strong indefinitely, many exporters are sitting on disappointing lost opportunities and wondering what to do in the future.

Some companies are looking to extend their hedging horizons; others, remembering 2008/09, are unwilling to go down that road.

Some companies are sticking to their historic approach of hedging 50 per cent, praying for a sudden bout of weakness; others are just frozen in the market, glassy-eyed. But even if there is a sudden tumble, it is very difficult to act because what if what if what if….

Once more, most companies’ risk management policies are exposed as not really managing risk at all.

To be fair, risk is a funny business. Nobody really knows what it means. And if you try to measure risk, it becomes even more of a joke — I mean, how can you measure something that, by definition, is unmeasurable? But, on the other hand, there is the truism that goes, if you don’t/can’t measure something (for example, risk), there is no way you can really manage it.

VaR best used defensively Thus, measuring risk is a critical first step. The problem is that the standard analytic measure — VaR or value at risk — is hampered by a fundamental definition problem. When you say the VaR of an exposure is, say, 3 per cent to a 95 per cent confidence, the normal English interpretation is that there is a 5 per cent chance that you could lose 3 per cent. The actual meaning is quite different — it means that there is a 5 per cent chance that the market will move against your exposure by more than 3 per cent, and the loss could be significantly higher than 3 per cent.

Once you understand this correctly, you also recognise that VaR is best used defensively — as a tool to compare the riskiness of different strategies, or, in combination with a stop loss, as an early warning signal.

Let us turn to a company with six-month exports who runs a 50 per cent hedge strategy, believing it to be a reasonable approach since, if the rupee suddenly depreciates, as it does from time to time, it will be able to capture that value on its open exposures.

Given that over the past 15 years (2003 to 2017), on a six-month basis, the worst (or best, in this case) rupee depreciation was a huge 25.7 per cent, it would seem that these possible gains are worth waiting for.

The flip side of opportunity gains is, of course, risk. The worst six-month appreciation of the rupee over this period was 9.6 per cent. Now, this would have been the worst loss on an unhedged six-month exposure; however, risk, as measured by VaR, would be somewhat different. Running a calculation to a 95 per cent confidence level for the six-month daily returns of USD/INR shows the VaR to be 6.1 per cent — this means that there is a 5 per cent chance that the losses on the open exposure would exceed 6.1 per cent. Since the portfolio is 50 per cent hedged, the risk on the exposure is 3.05 per cent, or about INR 1.80 (on the underlying forward rate of, say, 66.20). This means the risk-adjusted rate for the six-month export which is 50 per cent hedged at 66.20 is 64.40.

How to go about it The point is that, in comparing strategies, you need to look at the VaR-adjusted values. Thus a 100 per cent hedge with no opportunity would be valued at the forward rate (66.20); a 50 per cent hedge, with some opportunity, would be valued at 64.40; and a zero hedge, with infinite opportunity, would be valued at 62.60.

Let us say the company had a budget rate of 65 for the exposure (about 2 per cent below the forward rate). As a first cut, the company could hedge 2/3 of the exposure, since the overall risk would then come down to 2 per cent. However, even this will not protect the benchmark definitively, since, as already explained, this is not the worst that can happen — as already pointed out, the worst appreciation historically was nearly 10 per cent and there is no prima facie reason why it can’t be even worse than that.

The only way to ensure that the budget rate is not breached is to set a stop loss at 65 and manage the exposure dynamically with an initial hedge (say, 30-40 per cent) followed by lock-in hedges whenever the market moved favourably by a pre-set amount. The stop loss should be further tightened by using a VaR-based early warning trigger — thus, if the market moved adversely, the exposure would be hedged out before it hit 65.

This kind of approach, provided it is followed with discipline, will not only ensure 100 per cent protection of the benchmark, but also enable the company to stay alive to capture some of the mouth-watering opportunity, if it shows itself.

The writer is CEO, Mecklai Financial Services

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