Ashima Goyal

Dealing with currency volatility

ASHIMA GOYAL | Updated on March 12, 2018

Tame the volatility bull by the horns.

A well-planned hedging strategy should become part of Indian firms’ business plans. Incentives to hedge will certainly help.

In volatile times, such as in the last one year or more, currency risk looms large in all foreign exchange transactions.

One way to minimise exposure to exchange rate fluctuations and its potential impact on cash flow and balance-sheets is through hedging. When exposures are large and short-term — as they were for East Asian firms during the 1997 currency crisis — illiquidity in terms of cash flows turns into insolvency.

In India too, currency volatility has led to adverse impacts on firms and banks that have lent to them. But short-term foreign currency debts have generally been smaller, since external commercial borrowings were permitted only for long-term debt.


One reason why firms try not to hedge is perceived opportunity loss: Hedged exporters lose profits in the event the currency depreciates, just as hedged importers fail to cash in on lower import costs from currency appreciation.

But no hedging would be tantamount to speculation. It means aiming to profit by betting on a predicted one-way exchange rate movement. The exporter who does not hedge his future foreign currency receipts because he expects the rupee to depreciate is indirectly a speculator, unless his position is part of a planned risk management strategy. That amounts to deliberate incomplete hedging.

It is the company board’s task to set a risk strategy that protects cash flows, and in the light of that strategy, accept any opportunity losses that follow. The treasury heads shouldn’t be grilled on such losses that may arise. Risk mitigation must become part of board strategy/ethics, imposing standards through the company.

But hedging is expensive. Hence, it should be undertaken to meet specific objectives at minimum cost.

For example, keeping in mind the time profile of expected outflows and inflows of foreign exchange, short-term currency volatility affecting cash flows could be hedged. On the other hand, perceived longer-term trend changes in ‘real’ exchange rates should be allowed to affect export and import decisions.

Second, only currency movements in a 10-15 per cent band need to be covered through hedging; larger movements are very often due to overshooting that should reverse and stabilise to a given ‘real’ exchange rate. This is what we have probably seen in the case of the rupee as the steep depreciation corrects. By all indications, it has settled to an equilibrium level that corrects for inflation differentials.

Third, companies can also rely on natural hedges. For example, rising export incomes can help an exporter offset enhanced repayment burden on a foreign currency loan due to depreciation. Writing an insurance contract with someone having the opposite currency position can be potentially costless. In short, incomplete hedging based on a clear risk mitigation strategy is not speculation.


Hedging involves a small but sure loss, which is the cost of hedging. As against this, there is a small probability of a large gain without hedging. The reason for not hedging is precisely that we generally prefer an uncertain outcome with a small probability of a gain to a sure loss.

Therefore, framing the problem correctly — in terms of an investment in stronger balance sheets — can counter the psychological tendency among firms to neglect hedging. A well-planned hedging strategy should become part of robust systems and standards that Indian firms adopt. Incentives to hedge can help it become a settled norm.

Hedging seems a waste of money also because intra-day volatility in currency markets in India is often less than hedging costs. But we have seen that volatility can increase sharply –for example, with global shocks. The majority then want to carry forward short dollar positions waiting for markets to calm — then, costs of hedging shoot up.

So policy needs to ensure two-way movements or, perhaps, even create volatility if it is low. Volatility is a problem only with disorderly market conditions.

Creditors normally set interest rates to cover expected default under bankruptcy. A fully-hedged firm can then get loans at lower rates. But if the policy environment does not allow creditors to recover loans, firms do not internalise bankruptcy risk. As a result, the incentive to hedge disappears.

Firms should not be allowed to escape the consequences of systemic externalities caused by their risk-taking. But policymaking should, however, protect them from external systemic shocks that sharply raise volatility and, in turn, hedging costs.


Forex markets have huge turnover, with trades dominated by inter-bank or dealer transactions, including on proprietary accounts. Some of this provides liquidity that enables hedging and is also necessary to adjust portfolios or net off exposure due to clients.

Derivatives, to that extent, facilitate flexible risk management. Currency futures provide competition to customised bank products, thereby giving better rates (lower hedging costs) to the small exporter. However, they also create leverage since there are no upfront payments involved.

By banning these instruments and markets, not only do hedging costs go up, but they also end up migrating offshore. Such offshore derivative markets become more difficult to influence, even as positions there are less transparent.

So the answer is to monitor, regulate, and create correct incentives rather than to ban. At the same time, better accounting standards, more data and transparency can increase regulatory comfort.


Large exchange rate movements also raise hedging costs. Overshooting from fundamental currency values and one-way feedback trading hurts markets as well. What is needed is a variety of tools suited to the current stage of market development that maintains neither a fixed nor wholly market-determined exchange rate.

Large markets players try to make profits at the expense of the central bank. Variation of a managed float in a band not less than ten per cent can help prevent riskless “puts” against the central bank, since there would be substantial risk of loss here if the expected movement does not materialise.

The larger band-approach worked well in case of the European exchange rate mechanism. The central value (around which the currency float happens) need not be announced. It can also change with inflation differentials to prevent real over- or under-valuation.

When large outflows take place, the central bank should intervene after the market bottoms out, so that portfolio investors share currency risk. The band (10 per cent or so) may then occasionally even be breached, but will soon revert to the ‘equilibrium’ rate. A variety of signals (including published data on real effective exchange rates) can be used here. The central bank’s intervention should also not be one-sided and has to be strategic. Buying and selling from its reserves can be based on market intelligence pertaining to net open positions, order flow, bid-ask spreads (when one-sided positions dominate, dealers withdraw from supplying liquidity and spreads rise), turnover, and share of inter-bank trades.

(The author is Professor of Economics, IGIDR, Mumbai. The article benefited from discussions as part of a Forex Association of India panel.)

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Published on September 18, 2013
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