The Hindu Business Line : A primer on corporate hedging

Without hedging, a company is exposed to the vagaries of the markets and finds it difficult to predict revenues and incomes. Quoting instances, RAGHUVIR MUKHERJI explains how the different risks to a company arise and highlights the importance of having a clear and coherent policy framework for corporate hedging.

In recent times, there have been a number of incidents of companies getting caught on the wrong side of market movements and making losses on hedging.

Hexaware Systems booked a loss of Rs 10.3 crore ($2.6 million) on exotic foreign exchange options contracts. Very recently L&T was in the news for booking a Rs 200-crore ($51 million) loss on commodity futures on the London Metals Exchange.

At the same time, without hedging, a company is exposed to the vagaries of the markets and finds it difficult to predict revenues and incomes.

Many IT companies were badly hit by the sharp depreciation in the dollar in 2007 due to inadequate hedging.

These incidents bring to light the importance of having a clear and coherent policy frame-work for corporate hedging.

These situations should be distinguished from losses that banks (such as ICICI Bank and bulge-bracket US investment banks) have incurred from taking speculative positions in financial markets.

The fundamental principle behind hedging is that it is preventive activity taken to reduce losses in a possible adverse situation. The etymology of the word probably comes from the fact that hedges protect gardens from destructive visitors like stray dogs.

It is a myth that all hedging is financial; for example, constituting a ‘bench strength’ in an IT company to ensure availability of talent when required; diversification to reduce reliance on one market or one client and decentralisation and creation of back-ups to reduce reliance on a few key employees are all examples of non-financial or strategic hedging.

Typically, the level of financial hedging is more in companies whose main activity is trading (such as investment banks and hedge funds) vis-À-vis ‘brick-and-mortar’ companies that produce something.

The rules that the top management should frame around corporate hedging are given below.

Risk management unit

Setting up an independent, sound risk-management unit which works closely with the Treasury or principal trading unit (for example, in companies like British Petroleum) will identify a group of people who are responsible for all the hedging and risk management in the company. This group should not only have financial whiz-kids, but also people who have a thorough understanding of the business.

The risk management unit will have to work with various departments to mitigate risks (e.g. with corporate Finance and Treasury to hedge interest rate risks and financial investments, with Sales and Marketing to hedge sales-related cash flows, and with Purchases for hedging purchase prices).

They should be the in-house consultants who advise other departments on what to hedge for and how. There should be circulation between the risk management unit and the operational units.

Identify the Risks

It is almost axiomatic that for hedging to be effective, the risks that the company faces should be identified first. Risks can be broadly classified into credit, market, liquidity and operational risks.

Credit risk arises from the possibility of customers and counter-parties going bust before fulfilling their commitments.

Market risks arise from adverse movements in markets (for instance, interest rates, commodities and foreign exchange).

Liquidity risks crop up when there is a sudden cash crunch that affects the working of the organisation.

Operational risks stem from operational processes failing, like machine break-downs, quality failures, regulatory non-compliance, etc. However, within these broad categories, different organisations face different risks.

The magnitude of the same risk might differ from organisation to organisation. For example, a low debt, export-dependent organisation such as Infosys will not be directly affected by interest rate changes vis-À-vis a leveraged company but is greatly affected by an adverse movement in foreign exchange rates. However, to the extent interest rates affect foreign exchange markets, they will be affected.

Hedging Policy

Once the risks have been identified, a ‘hedging policy’ on how they can be mitigated must be formulated by the Corporate Treasury. This must be approved by the top management, particularly the ‘Finance Committee’ of the Board.

The hedging policy must list out the risks that the company usually faces and guidelines on what hedges can be adopted to mitigate these risks. Some of these will be general guidelines, and some will be specific to certain risks.

Financial hedges (those that work through insurance or market activity) should only be entered into with the approval of the risk management unit, and preferably, only by the Treasury.

Wherever possible, the Treasury should enter into simple contracts where the risk is clear, instead of exotic contracts (e.g. combination of options, cross-currency swaps) where risks are complex or opaque.

Losses/gains on the hedging instrument and the hedged item should be reported as per Indian Accounting Standards AS -30 (Financial Instruments: Recognition and Measurement) and AS 31 (Financial Instruments: Presentation) or IFRS - IAS -39 (Financial Instruments: Recognition and Measurement) or US GAAP – FAS 133 (Hedge Accounting).

When engaging in trading activity, the close relationship between credit, market and liquidity risks should be taken into account.

A losing counter-party (profitable situation for the company) runs credit risk. A big market loss might pose liquidity risks as margin calls will strain liquidity.

some specific guidelines

The best way to reduce credit risk on clients is to get letters of credit from a well-known bank at the inception of the relationship. Only where the company has already entered into a contractual relationship, credit derivatives (like credit default swaps) should be used.

It Costs Money to Be Safe

Everybody should understand that hedging, like any insurance, has a cost, and may lead to potential losses. However, as long as this can be compensated by other profits, the company is safe.

As per the RBI Guidelines on risk management and hedging issued in July 2007, banks should ensure board level overview of the risk management policy and ensure that the quantum of the hedge should not be more than the underlying exports or imports.

For example, in the case of L&T, it bought futures in certain metals contracts. The prices fell, and it had to incur a loss (having bought at a higher price). However, as long as it has contracts to sell these at higher prices, or can use the metal as inputs to products or projects which it can sell profitably, the company should be alright, albeit less profitable than it could have been.

Keep Pruning the Hedge

It is said that ‘In the real world, the only perfect hedge exists in a Japanese garden’. And even there, they need a lot of tending. Market-based hedges have to be closely watched and reviewed regularly for effectiveness, because they can go horribly wrong.

Long Term Capital Management (LTCM) is a case in the point. They had a nice little business model (with two Nobel laureates on their board), making money from pricing inefficiencies in international bonds and other interest rate products. They were short on interest rate swaps (they paid floating) and short on US government bonds — so, when market yields went up, they made money on the government bonds (which have an inverse relationship with yields), and when yields went down, they made money on the swaps.

After the Russian default of 1998, there was a global credit squeeze quite like the one we witnessed in late 2007. Interest rates rocketed. LTCM lost a lot of money on the swaps. In parallel, there was a ‘flight to safety’ (actually it was more of a mad scamper) to US sovereign bonds, so US sovereign bond prices also rose. So, LTCM’s hedges began to compound their losses. They were bailed out by the Fed, and had to close down.

(The author is a Chartered Accountant and a certified Financial Risk Manager from the Global Association of Risk Professionals (GARP). He is currently Vice-President, HSBC Securities Services. The views expressed are personal.)

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