The Hindu Business Line : To hedge or not to hedge

Wilma Ribeiro fiddled with her note pad as she waited for the group to assemble in the conference room. Being the MD’s secretary she had to arrive in advance to ensure that everything was in order. The boss was a stickler for perfection and had no tolerance for sloppiness.

“Morning Wilma”, said Goatee as he walked in. Goatee was the new Vice-President Treasury. His real name was Rahul but he was known as Goatee since high school because of his trademark French beard.

Following Goatee was Sundararajan, the Vice-President Finance. Wilma had nicknamed him Curd Rice because that was what he invariably brought for lunch everyday. Curd Rice was followed by Ganguly who was the Vice-President Operations and Balaji the Chief Accountant. The last to arrive was the MD himself.

MD’s worry

“Gentlemen” the MD began right away in his clipped public school accent. “As you are all aware the rupee has been appreciating steadily against the dollar. Our export revenues which were forecasted at Rs 400 crore have materialised as a cash inflow of Rs 325 crores due to the strengthening rupee. This state of affairs cannot continue. We need to take active steps right away.”

“Sir! How come we have not faced this problem earlier” asked Ganguly. “After all we have been in this business for the past 20 years.”

“There are a number of reasons,” said Goatee. “First, ever since the rupee was made convertible on the current account, it has been steadily weakening against the dollar. This state of affairs was perfect for us since our exports are invoiced in dollars. However, for the past few months the rupee has been steadily strengthening and the post-conversion value of our export earnings has been steadily declining.

“Second, export revenues which used to constitute barely 2-3 per cent of our top line, are now more than 10 per cent of our sales revenues.”

“But if the rising rupee has hit our export earnings it will also reduce our import bill, would it not,” asked Ganguly, who was always quick on the uptake, a fact that even Goatee who was from a rival business school had to concede.

“You are absolutely right,” said Goatee. “But the problem is that for the past three years we have been implementing our import substitution strategies, as a consequence of which imports now constitute a relatively insignificant portion of our expenditure.”

Rupee invoicing

“Rahul can we not invoice in rupees. I read an article recently where the author talked about it as a strategy to counter declining export earnings,” said the MD.

“Must be a business school product,” muttered Curd Rice to himself. “Only they are capable of such hair-brained ideas.”

“What was that Sunder?” asked the MD.

“I was just saying that it is an excellent idea,” said Curd Rice. He was a chartered accountant with 35 years of experience and had an opinion bordering on contempt for business school graduates. Their whole curriculum needed to be re-worked in his opinion. Nothing could, according to him, be an alternative to the rigour underwent by a chartered accountant. This was an opinion that was shared by his blue-eyed boy Balaji. However, the new MD was an MBA himself and they could not be vocal about such opinions.

“Sir, rupee invoicing is feasible for large corporations which enjoy sufficient bargaining power with their buyers. We have not yet reached a stage where we can dictate terms to our buyers,” said Goatee.

What about derivatives?

“So what do you propose,” asked the MD.

“Sir I think that we need to look at derivative products such as forward contracts and options to hedge our foreign exchange exposure.”

“What is hedging,” asked Balaji. “Ignoramus” muttered Goatee to himself. “These guys are not fit for modern day financial management,” he had once told his girlfriend, sharing his opinion about accountants.

“Hedging is risk mitigation by taking a position in the derivatives market that counters the risk exposure in the spot market,” said Goatee.

“I have been reading that derivatives can lead to catastrophic losses. Recently, the Agriculture Minister has imposed a ban on forward trading in certain commodities,” said Curd Rice.

“Will hedging help us to improve our bottom line under all circumstances,” asked Curd Rice. “That is, can we be certain that our revenues will be more if we hedge as compared to a situation where we leave our risk exposure open.”

“Nobody can guarantee that the outcome with hedging will be better than the outcome of an unhedged position,” said Goatee.

“Then why should we hedge,” asked Balaji.

“Gentlemen a decision to hedge is taken because the parties concerned want to mitigate their risk exposure. Nobody can however be certain that things could not turn out to be better if the decision to hedge is not taken. Treasury managers are not prescient, and if they were they certainly would not need hedging tools,” said an exasperated Goatee.

Forward contracts

“You talked about entering into forward contracts Rahul,” said Ganguly.

“But sometimes we end up shipping earlier than scheduled whereas on other occasions our counterparties end up delaying their payments. Can we use derivative products given such vagaries?”

“Forward contracts can always be modified to take into account factors such as early delivery and late delivery,” said Goatee.

“They can also be cancelled. We also have option forwards which permit us to transact at any point in time during a specified time period.”

“I suggest that you prepare a note on this Rahul,” said the MD. “We need to have more clarity on the concept of hedging itself and how it works. Besides, you talked about forward contracts and options. I am not exactly aware of how these products work and the differences in their mechanics. I suggest that we meet again next Friday with the necessary inputs to take a decision.”

With that the MD picked up his papers and rose.

“Wilma please ensure that the minutes are sent to everyone by Monday.”

Racy@TheHindu.co.in http://Racycases.blogspot.com

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