Market Maniac

Benchmarking Treasury Performance
Aug 02, 2011

While most companies have developed their treasury processes sufficiently to where they are generally able to protect their business targets, many companies still struggle with defining the best benchmark against which to measure treasury performance.

A large number of companies assess the paid/realized rate against the rate prevailing at the time the exposure is paid or realized – to my mind, this is absolutely the wrong benchmark, since it implies that the default mode for the company is to keep all exposures fully unhedged, which is extremely high risk. An alternate method used by some companies is to compare the achieved rate against the Day 1 forward rate; while this is somewhat better than the zero hedge benchmark, I believe it is still inadequate since it implies that the company always hedges all its exposures on Day 1, which means it is willing to forego any opportunity – there are few companies who would honestly accept this.

The best via media is to use a 50% hedge as the benchmark for measuring treasury performance. A 50% hedge is not a bad strategy since it (a) acknowledges the uncertainty in the market, (b) can be implemented without virtually zero cost, and (c) generally provides a reasonable performance. The only downside to this strategy is that it does not provide strong predictability of cash flows, since the 50% unhedged portion could close out at any value.

Since this performance can be achieved at very little cost, since you don’t have to invest time and resources thinking about the market, it provides a good benchmark from which to assess how well (or badly) the treasury has performed. Say, for a company with 100 cr of annual exports, the treasury realizes a rate that is 0.8% better than the 50% benchmark, it readily translates to a value add of 80 lakh for the year. If the treasury realizes a rate worse than the 50% benchmark, it has actually lost value for the company. Of course, this sort of benchmarking exercise is only meaningful if the company’s other treasury processes are well developed – in particular, the treasury needs to have full authority to take and implement hedging decisions.

As part of our effort at helping companies improve their performance in managing risk, we have focused on consistently beating the 50% hedge benchmark, and have been quite successful, certainly over the last 5 years, as shown in the table above.

I believe this is an excellent performance, particularly since over this period the rupee was generally quite volatile and moved between 39 and 52, changing direction as many as eight times. Rupee volatility, too, bounced around from a low of sub-2% to as high as 17% during the 2008-09 crisis. Forward costs moved increasingly in tandem with RBI’s repo rate, and ranged between 1.5% and 7%.

We used a hybrid approach to achieve these results, primarily following a structured analytic framework that is designed to (a) ensure that the benchmark rate is never breached whatever happens to the market, and (b) enable capture of some part of market opportunity. The framework, which provides hedge signals whenever certain levels are triggered, requires setting an initial hedge and defining certain processes to take lock-in hedges when the market moves favorably; we build in our market views to set these parameters and processes.

Rather than trying to forecast specific rupee values for future dates, we build in our market view by trying to judge the broad market environment – will it be range-bound, trending (up or down), or choppy. In other words, we use much softer assumptions, as compared to a straight forecast. Depending on our judgment of how the market will behave over the next, say, 6 or 9 months, we select the kind of instrument to be used as an initial hedge (forwards, plain vanilla options, call spreads, put spreads, etc.) as well as the amount of initial hedge. The market view also helps determine the kind of lock-in process we would use, although, in general, we find a high water mark approach works best. We revisit the settings at the start of each month.

Analysing the table shows that performance for both imports and exports is best in trending markets, irrespective of direction of trend. Choppy markets with high volatility are the most difficult, which is hardly surprising. Another interesting finding is that even when premiums are quite high, the performance remains respectable.

What is also rather interesting is that the approach has worked only marginally better for exports (average 1.37% improvement over a 50% hedge) than for imports (1.25%, on average). Given that you have to pay to hedge imports whereas you earn premium when you hedge exports, the parallel performance confirms the robustness of the approach.

Thus, for every 100 cr of imports or exports, using this approach would have saved (on average) 1.25 cr or 1.37 cr, respectively; the worst performance would have been in 2009, when the savings in both cases would have been of the order of 40 lakh.

The other benefits of following this approach are that it

enables the company to have a definitive picture of its cash flows, since the program is structured to ensure that the benchmark rate is never breached – indeed, the benchmark was never breached over the past 5 years
generally carries much less risk than a 50% hedge – the average hedge ratio for the hybrid hedge program over the 5 years was more than 70%, with the lowest year average at 45%; and
like a 50% hedge, can be managed with very limited investment of management time and bandwidth.

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