10 April 2006

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Most readers of this column are probably tired of my constantly talking about managing risk - don't buy exotic derivatives, don't take a position unless you are sure your benchmark is protected, don't do this, don't do that. In fact, some people within our organization have started calling me Dr. No, as opposed to Dr. Risk, who is quoted elsewhere in this report.

Rankling under this negative portrait, I thought let me turn over a new leaf, and instead of talking about risk, let me talk about opportunity, which, after all, is simply the flip side of risk. But, of course, you can't make a leopard change his spots, so I will talk about how to capture opportunity while ensuring that you protect your risk. How's that for something new?
To illustrate the approach I am speaking of, I'd like to report on a portfolio I am managing for a client - a mid-sized exporter with flat sales of USD 10 million a month. We began working on this approach on January 31 this year. First off - and sorry about that - we set a "target value" for the portfolio by discounting the forward rates for each month (till July) by the at-the-money option premium. Thus, the target value for the portfolio was set at Rs.264.49 cr for an average realization of 44.08 (as compared with the notional value of Rs.266.86 cr at the average forward rate prevailing on January 31 of 44.48).

The point of doing this, of course, was because we both - the client and myself - had a view that the rupee would weaken in the near term. Being conservative, we decided to start hedging when the spot rate, which was 44.08 at the time, crossed 44.35. Further, we decided that rather than leave it all to our judgment, we would add in a process whereby we would move the target rate up whenever the market moved favorably - thus, on February 1, when the market moved up to a MTM of 266.92 cr (a gain of 6 lakh), we took 3 lakhs of profit by adjusting the target value upwards to 264.52 cr; this took the average target rate to 44.085. [We decided to capture only 50% of every upward move in this exercise - theoretically, you could set the opportunity capture at any ratio from 0 to 100%.] This would enable us to get some value out of the market even if our view proved wrong and/or we were hit with high volatility. Thus, at the start of each trading day, we calculated the MTM of a fully open book and, if it had moved favorably, we captured 50% of this move into our target value; if the MTM moved adversely, however, we didn't shift the target value - thus, all positive moves in the market were fed into our portfolio.

We followed this process each day, overlaying this opportunity capture with (a) our view, and (b) our risk management tool, which uses VaR as an early warning signal. We were, of course, open to change our views as time went on - that is the nature of the market. However, to enforce some discipline, we documented our view at each point in time. On the other hand, if and when the VaR signal suggested that the target value (enhanced by our opportunity capture process) was under threat, we HAD to cover enough risk to eliminate this threat.

The results, which are shown in the table, were quite interesting. Using the approach described above, the portfolio was fully hedged out by April 7, and was valued at 268.22 cr. This was 1.37 cr (0.5%) better than having hedged everything at the start, and 75 lakh (0.3%) better on a risk-adjusted basis than having stayed completely unhedged. [The equivalent average rates were 44.70 (actual), 44.48 (hedge on Day 1), and 44.58 (risk-adjusted fully open).] Further, on an absolute basis, the approach captured 63.5% of the opportunity in the market - i.e., 63.5% of the difference between the very best and very worst rates that prevailed.

A pretty good performance, wouldn't you agree?

Interestingly, a closer look at this performance shows that we sold February at 44.3050, whereas the spot rate on Feb 27 was 44.52, and March at 44.5575, whereas the spot rate on Mar 31 was 44.705. Clearly, our subsequent covers (April at 44.6425, May at 44.905, June at 44.9150 and July at 44.90) more than made up for these losses, at least up to today.
And therein lies the tale, and the lesson. An excellent portfolio performance could well include certain losing transactions. [It is important to note that we were managing the portfolio purely from a cash flow standpoint; if we were to build in accounting issues, the hedging process would doubtless have been different.]

Another interesting finding from the study was that we could have achieved pretty much the same results even without having a view. The table shows that the "benchmark" hedged portfolio, which was created by simply tracking the (moving) target value and hedging whenever it was threatened, and which was also fully hedged by April 5, produced almost exactly the same value as the one incorporating our market view. Of course, the rates at which the exposures were hedged were quite a bit different - February 44.52 (as opposed to 44.3050), March 44.50 (44.5575), April 44.55 (44.6425), May 44.65 (44.9050), June 44.90 (44.9150), July 45.0375 (44.90).

There's many ways to skin a cat and many ways to capture opportunity from the market. But it you wish to have nine lives, you need to temper your view (and your process) with a sound risk management undercarriage.

Currency Markets - Rupee and Majors

USD/INR

Fortnightly movement: O-44.6000 H-44.7400 L-44.5600 C-44.6850.
Sentiment: With liquidity returning to normal, rupee's intrinsic strength may reassert
Expected range for 1 Month: 44.25-45.00
Expected range for 3 Months: 43.75-45.00

RBI continued to intervene heavily in the forex market as part of its liquidity management process, pushing the rupee to its lowest level since early January. However, with liquidity easing, the intervention will likely let up, which could see the rupee recover some of its losses - in fact, it ended the week about 6 paise stronger than its lowest level and is trending a bit firmer this morning.

Of course, with the dollar building up some strength on the crosses overseas, we may yet see a market-driven dip in the rupee, but with fundamental sentiment on India still bullish, we would bet on continuing inflows and the excellent trade performance pushing the rupee stronger over the next few months.

Of course, volatility will continue high, with the important monetary policy meeting on April 18, with many participants convinced of a 1% CRR, and others focused on the Rs. 8,000 cr of auctions.

EUR

Fortnightly movement: O-1.2030 H- 1.2332 L-1.1980 C-1.2093
Sentiment - neutral but may worsen
Expected range for 1 Month: 1.1825 -1.2325
Expected range for 3 Months: in abeyance for now

The euro's impressive rally from 1.20 to 1.23 began on March 30 on speculation of the UAE and several other central banks diversifying their forex reserves into euros as also rumours of the impending resignation of US Treasury Secretary, John Snow. However, the 'clincher' was the US ISM manufacturing index falling below its Eurozone counterpart for the first time in 3 years leading to strong expectations that the dollar's interest rate advantage over the euro would hereafter keep on eroding for the rest of the year. And then, the market got 2 shocks. ECB President put cold water on market expectations of a rate hike next month. This was follwed by an upbeat US employment report. And, the euro finished last Friday over 2 cents down from its 3-month high seen just a day before.

The euro has been trading between 1.1825 and 1.2325 since the beginning of this year. A sustained breakout clearly requires supportive data when the euro is very near either end of this 5-cent range. Hopefully, this will happen sooner than later but till then it seems best to play the range.

GBP

Fortnightly movement: O-1.7428 H- 1.7614 L-1.7247 C-1.7428
Sentiment: negative and may worsen
Expected range for 1 Month: 1.7225 -1.7625
Expected range for 3 Months: in abeyance for now

Since early February 2006, sterling too has been moving in a narrow range between 1.7225 and 1.7625. With the markets all the time trying to guess the likelihood and timing of the next Bank of England rate cut, an upside sterling breakout depends for now only on the Fed running out of ammunition i.e. hawkish US data. So a downside breakout appears more likely but even that has eluded so far firstly due to flip-flops in US data and secondly due to the same 8-1 majority at the BoE MPC meetings for leaving the benchmark rate unchanged at 4.5%.

The technical bias appears to favour a downside breakout but better stick to the range till fundamentals overwhelmingly point that way.

JPY

Fortnightly movement: O-117.54 H- 118.79 L-116.26 C-118.28
Sentiment: neutral but may improve
Expected range for 1 Month: 115.50 -119.50
Expected range for 3 Months: in abeyance for now

At the beginning of last fortnight, the yen firmed as far as about 116.25 on talk of Japanese fiscal year-end repatriations but thereafter it slid as far as 118.80 thanks to an upbeat policy statement from the Fed accompanying its widely expected rate hike on March 28 and then a disappointing Japanese Tankan report last Monday. Japanese core CPI rose 0.5% y/y in February and was in positive territory for the 4th consecutive month but to no avail since PM Koizumi shrugged off this data saying that it may not be possible to declare the end of deflation till the end of September 2006.

Since the last week of January 2006, the yen has been trading between 115.50 and 119.50 and it appears this range will hold for a while. The yen could strengthen from another yuan revaluation or widening of the yuan's daily trading band against the dollar. There are market expectations of a token gesture around the Chinese President's Washington visit this week. In that event, the yen could again move towards 115.50 but a move beyond that may probably require timely dollar-negative US data or effective monetary tightening by the Bank of Japan with or without PM Koizumi's blessing.

Dr Risk's prescription

Is the Euro out or just retired hurt?

The fortnight began well for the euro with the German IFO business confidence rising to a 15-year high but the euro couldn't hold on to its gains thanks to a unexpected rise in US consumer confidence and upbeat policy statement from the Fed after the rate hike on March 28. The euro's sustained rally began on March 30 on speculation about UAE and Asian central banks diversifying their forex reserves into euros as also rumours of impending resignation of the US Treasury Secretary John Snow. The euro rose to about 1.2175 but again dropped to the low 1.20s last Monday before the 'clincher' in the form of the US manufacturing ISM index falling below its Eurozone counterpart for the first time in 3 years.

Last Tuesday, when the euro rose and closed above 1.22 on follow-through buying, a rise to 1.25 or higher seemed a near certainty. That's how it looked like even last Thursday till the ECB President Trichet indicated during his press conference that the market expectations of a May rate hike were not consistent with the current ECB sentiment. After reaching a multi-month high of 1.2332 the euro fell by over a cent and closed the New York session marginally over 1.22. Friday morning, the euro still appeared to have the power rally to 1.25 but that prospect appeared just a little less certain. It seemed obvious that only a stronger than expected US employment report may keep the euro in check but to reverse its recently established uptrend the data that followed next week would also have to favour the dollar. Indeed, a market that took so long to decide - rightly or wrongly - that the dollar's interest rate advantage over the euro would keep on narrowing for the rest of this year may need a lot of force to reverse its sentiment.

Yesterday's US employment data appeared mixed with a higher than expected payrolls number, lower than forecast unemployment rate and lower than expected average earnings growth. The euro initially ticked up on expectations of tame inflation but then slid sharply on the possible inflationary impact of the low unemployment rate and the higher payrolls number. Interest rate futures suggest that while Fed rate hike on May 10 is certain, the chances of another hike on June 28 have gone up to 46% from 36% before the release of the US employment report yesterday. The chances of a June 28 Fed rate hike could well come down if the US data next week and thereafter are not supportive.

Since the beginning of this year, the euro has moved in a 5-cent range between 1.1825 and 1.2325. For now, it does appear that the euro will probably move to the lower end of this range but making a guess as to the direction of the eventual breakout seems a futile exercise considering the frequent flip-flops in data and market sentiment. Clearly, what has been missing is news that favours a breakout when the euro is near either of the range boundaries.
From a technical perspective, an upside breakout may target the 1.26-1.28 area while a downside breakout may target 1.11or thereabout!