Forex risk and ‘options’ for exporters

The rupee’s recent plunge against the US dollar did not help most garment exporters in Tirupur. They had booked a lot of orders around the 66.50 levels in the previous months, says a media report. The President of the Tirupur Exporters’ Association (TEA), which represents the $3-billion industry, said that they would benefit only if the rupee’s depreciation were sustained.

One can understand the predicament of the Tirupur exporters. On November 9, the rupee closed at 66.50. In the previous three months, its range against the dollar was a narrow 66.50/67. So, export orders would have been booked and the resultant (expected) dollar inflows would have been covered in the forward foreign exchange market on a base rate of around 66.70 to the dollar.

But, when the base rate itself moved by ₹2 to the dollar — with the rupee falling to the 68.50 levels by end November, the exporters were understandably upset at the loss of the opportunity to realise an additional ₹2 per US dollar. A move of ₹2 on a base of ₹66.50 is nearly 3 per cent. On the export order margin of say 5 per cent, that is an opportunity lost to increase profits by 60 per cent.

The rupee has since clawed back some of its losses. Nevertheless the problem of missed opportunities would keep recurring for exporters.

Identifying the opportunity loss in absolute money terms would better highlight the problem exporters face. If a medium-sized exporter (about $10-12 million), which constitutes the bulk of the TEA’s membership, had forward sold, say, $3 million (that’s his three months’ sales) on a base rate of ₹66.70, he has lost the opportunity to realise extra profits of ₹60 lakh.

But why should he be bothered about enhancing his profits as long as he has earned his 5 per cent? What could be the benefits if the exporter had been able to avoid this opportunity loss or at least minimise it?

Each lakh of profits or avoided opportunity loss would enhance the exporter’s competitiveness. In a buyers’ market, the ability to avoid opportunity loss would enable the exporter to bid aggressively for orders. A garment initially quoted at $10 apiece could be offered at a lower price if one has the confidence that opportunity loss will be avoided. This is all the more critical when exporters’ face weak buyer demand in the major western markets.

The exporter would also be able to better match prospective buyer demand for low(er) prices. This typically happens when buyers wrongly assume that the exporter has benefited from local currency (rupee) depreciation and therefore demand lower prices. But, of course, as the TEA President’s observation shows, the Indian exporter suffers a double whammy — no benefit from rupee falling while being forced to cut prices for future orders.

It is obvious from the above numbers — as well as reactions of TEA — that avoiding or minimising the opportunity loss occasioned by rupee depreciation is extremely important for exporters. Repeated opportunity losses can potentially seriously undermine the economic health of the firm.

But should one really bother so much? Indian exporters went through such a phase during 2011-13 as well, when they endured large opportunity losses. They are still operating. Rupee fell nearly 50 per cent then — from 45 to the 65 levels. Well, the standard disclaimer in the securities markets – that past performance need not necessarily be indicative of future performance — applies here also.

So, how to go about the task of avoiding or minimising opportunity losses? The first step is to understand the nature of volatility in the domestic foreign exchange market vis-à-vis that in global markets.

As is clear from the charts, volatility in the Euro/dollar currency pair is almost continuous. The pair keeps going up and down – by something like 3 or 4 per cent — every month. Therefore, it is commonplace for the Euro/dollar pair to start a year at one level and end the year at almost the same level — in the interim though, it would have moved all over the place. This keeps corporate finance managers on their toes almost continuously.

This is very different from what we have in the dollar/rupee market. As the rupee chart shows, volatility is peculiarly sporadic in our markets. The rupee was stuck in a narrow 66.50-67 band for much of 2016, but we have had significant moves in two discrete time periods — beginning and end of 2016. This has happened earlier — the most recent being when the rupee was stuck around the 45-46 levels in the 2009-2011 period but subsequently fell 50 per cent to the 65 levels by mid-2013.

Long periods of stability breed complacency among financial managers. It is almost like risk management has been outsourced to India’s RBI. But such outsourcing is no substitute for structured risk management. Indian companies have to adapt to newer techniques and instruments in risk management. They have to look beyond the traditional forward contract (and its exchange-traded cousin, the futures contract) and employ the most simple foreign exchange insurance contracts — termed options. Simple options will be more than enough to navigate the oddities of the rupee market. Complex options that add risk and are speculative are completely unnecessary.

The writer is a Chennai-based financial consultant