How much are you really paying?

You find yourself tracking a number of rates while managing forex risk. You normally keep a watch on the Spot Rate, the Forward Rate, maybe even option prices. In your weekly/ monthly forex MIS reports you calculate your hedge ratios and do mark-to-market calculations on your hedges. Besides all this, you also keep abreast of the global stock, commodity and money markets.

This is good and necessary for prudent risk management. It needs to and should be done.

Net Rate

However, is it possible that you are missing that one vital variable that you really need to track? If you are an importer, do you know your Net Purchase Rate for Dollars? If you are an exporter, do you know your Net Sale Rate? Do you know how much you really paid for the Dollars you bought for your imports, or how much you really got for the Dollars you sold against your exports in the last month/ quarter/ year?

What is the Use?

Your actual net purchase / sale rate will give you the true account of the effectiveness of your forex risk management policies and practices in clear and unambiguous terms. It is that one number which really matters because it directly impacts the CASH profit/ loss of your company.

There is a 99.99 per cent chance that the rate at which your exposure (imports/ exports) is retired/ realised is going to be different from the rate at the time you recognised your exposures in your accounts, or the book rate. If you do not hedge at all, your import payment/ export realisation will happen at the Spot Rate on the date of import payment/ export realisation. This is simple enough.

But, we all hedge in order to avoid the danger of a rise (or fall) in the Dollar as the case may be. We employ various techniques, tactics and tools to hedge. We rely on various forecasts. We spend a lot of time and effort on hedging. Some people believe in hedging 100% through Forwards on Day One. Some others do not hedge at all. Some people believe they can optimise their rate by trading in/ out of the market. Some people have a firm hedging policy that they stick to. Others keep experimenting with many different strategies. There are many approaches to risk management, each with its own advantages and disadvantages. An earlier article in this series had dealt with the drawbacks of common hedging methods.

Effectiveness

Whatever be your chosen policy, you can say your hedging has been effective/ profitable if, as an importer, your Net Purchase Rate (NPR) happens to be less than the Average Spot Rate (ASR). If you are an exporter, your Net Sale Rate (NSR) should be more than the Average Spot Rate (ASR).

In formulae terms:

Gain for an Importer = ASR – NPR

Gain for an Exporter = NSR – ASR

We suggest the above measure of hedging effectiveness or profitability, because if you had not hedged, you would have got the Spot Rate on payment/ receipt date in any case. By hedging you should either pay less or receive more than that Spot Rate.

NPR/NRR

Say you are an Importer. Over a period of time, you might have hedged as follows:

1) You would have hedged some part of your exposures using Forwards. Simple enough. And you might have the wise policy of utilising your hedges for actual payments, to the extent possible. Good.

2) Some part of your imports might have been hedged using Call Options. At maturity, some of them would have been exercised if the Spot on maturity was greater than the Strike. The others would not have been exercised and you would have paid for your imports at the prevailing Spot rate.

3) A part of your exposures might have remained intentionally unhedged, because you should neither hedge 0% nor 100%, and you would have paid off those imports also at the Spot rate.

4) During this period, you might have also engaged in some in-out-in-out forex trading on the Major currencies. Not necessary, but possible.

Given the above, you would calculate your Net Purchase Rate as shown in Example 1. As an Exporter, you can calculate your Net Sale Rate as shown in Example 2.

So, start tracking your Net Purchase/Sale Rate. You might be surprised by the results. Only those who are really keen to do well in forex hedging, who understand why forex is their business, will take up the challenge. The others will not know what they are really doing.

(The author is Chief Currency Strategist at kshitij.com. The views are personal. He can be reached at > vikram@kshitij.com )

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