A key feature of financial markets, across the world, in the past couple of years has been the high level of volatility.

The Indian rupee has exemplified this feature well. Between June 2011 and now, the rupee has moved in a wide range — between Rs 45 and Rs 69 — a difference of more than 50 per cent.

Importantly, this movement has not happened in a straight line; there have been considerable ups and downs. Given India’s significant macro-economic and financial imbalances — high inflation and external trade deficits, large external repayment commitments among others — a clear downtrend for the rupee can be well established.

Also, importantly, the large fluctuations have happened well within the 60-90-day credit period that exporters/importers normally work with. Equally significant, financial markets seem like they will continue to experience a similar degree of volatility in the ensuing period, too.

For instance, the dollar/rupee market currently indicates a volatility (or dispersion measure) of something like 4.5 per cent a month, with the current spot rate being Rs 62.30.

This roughly means that in the next one-two months, the rupee can potentially move in the range of 57-70. ( There is a 5 per cent chance of even larger moves!).

Forex challenges

This level of volatility poses severe challenges in foreign exchange risk management.

Large movements on either side can render the conventional forward contract quite unequal to the task of optimal hedging. While the forward contract may give price certainty, it will generate opportunity losses most of the time in volatile markets.

That is very well being proven by the large number of companies reporting “hedging losses” in their financial results of the past several quarters.

Quantifying the losses in margin terms may be more relevant.

If an exporter is working on a 10 per cent profit margin, a 3 per cent (adverse) move shaves off 30 per cent of his profits — assuming the exporter remains un-hedged, hoping for rupee depreciation.

Equally, opportunity losses can be as high as 30 per cent, if he has hedged with conventional forward contracts; but the rupee then moves in his favour.

Similarly for an importer, a 3 per cent move can mean a significant savings in costs in these high-cost times. In conventional hedging, with the rupee at a forward discount, you contract to pay more rupees (per dollar) for a specific forward date. But, if the rupee appreciates after the hedge is initiated, the importer generates opportunity losses.

There are also a large number of “importer” cases in the past two years, where companies have remained un-hedged in the “hope” of rupee appreciation. But, with the rupee continuously plumbing new lows, can you visualise the state of those company balance-sheets now?

In this environment, there is a need for a hedging product that can provide the manager with downside protection as well as enable him to participate in any favourable market movement. That is, price certainty combined with the ability to avoid, or at least minimise, the opportunity losses.

That is the currency option.

Currency Options

Currency options traded on the NSE — currency derivatives segment — represent a growing and useful platform for mid-tier/small companies to hedge their currency risks. Currency options are one step higher than the plain forward contract. They permit the buyer to deal (buy or sell foreign exchange) at the rate contracted in the option itself or the prevailing market rate, whichever is beneficial to him.

For instance, an exporter can buy a “dollar put” option at a contract rate of, say, Rs 64, perhaps, for a one-month maturity. This will give him the right to sell his export dollars at Rs 64. But, he is not obligated to sell his dollars at Rs 64. He will do that only if the dollar is below Rs 64 at maturity.

On the contrary, if the dollar is higher, say, Rs 66, the exporter can very well sell his dollars at the higher market rate.

A similar argument works, in the reverse direction, for an importer. An importer can buy a “dollar call” option at a contract rate of Rs 64 for a one-month maturity.

This will give him the right to buy his import dollars at Rs 64. But, he is not obligated to buy those dollars at Rs 64. If the dollar has weakened in the interim period, the importer can very well take the lower market rate and make the payment.

This flexibility to either deal at the contract rate or the market rate, whichever is better, comes at some price. This is called the option premium.

Insurance premium

The option premium is like insurance premium. The company is insured (protected) at a particular rate. Therefore, when the insured event does not take place, the premium paid is a sunk-cost. And, it is only natural that the premium is critically dependent on the probability (chance) of the insured event occurring. (The volatility we mentioned earlier proxies the probability).

The final effective exchange rate realised by the company (for exports) and paid (for imports) then will have to be adjusted for the premium paid.

Companies in the SME universe have to seriously look at this product which enables them to manage their forex risks in a far more advanced and beneficial manner. Dealing on a recognised exchange is also recommended for a host of reasons:

Banks do not/cannot do options with their SME customers (for regulatory reasons — though SMEs are the ones which probably require it the most);

Prices are transparent, real-time on the exchange;

Ease of dealing (like net-banking or on-line trading in stocks);

No paperwork required for prospective exposures (and generally when buying/selling options contracts);

Hedging on the exchange but spot-transacting with the bank brings clarity in risk management;

Ability to deal even in small amounts — minimum being $1,000 on the exchange.

(The author is a Chennai-based financial consultant.)

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