27 March 2006

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With market volatility already high, and certain to continue to rise, as capital account convertibility becomes a reality, companies need to substantially increase their focus on their forex risk management processes.

Given that treasury skills are hard to come by, and, trust me, even harder to retain, I believe that, over the next few years fast growing companies - which means most companies in India - will begin to look at outsourcing certain aspects of their forex risk management. In particular, companies in the IT sector will need to look at this, since HR is a major management focus in such companies, and creating and retaining an effective treasury team could threaten to destabilize the bigger HR picture of attracting and retaining software talent.

Again, it hardly makes sense for a company with a modest forex turnover to invest in the infrastructure needed - viz., Reuters screens, valuation tools, etc. - to run an effective treasury. However, probably the most important reason that will drive companies to look for professional services in this area is the cost of maintaining a continuous focus on risk.
A well run treasury has three components - the front office, which is market facing and takes hedging/trading decisions and implements them, the back office, which keeps track of the company's exposures, transfer price to business divisions, bank limits, etc., and the middle office, which "sees" the company's exposures as a risk profile, sets a target value for the risk profile, tracks the risk to ensure that the target value is never threatened, and provides risk-based signals to the front office and the CFO.

All three of these pieces are critical, and it is important that they be housed and operated separately for effective risk management. In particular, the middle office should report directly to the CFO, independent of the front office (which is usually seen as the treasury). The back office needs to be sensitized to the importance of timely information flow. Effectively staffing these functions independently is a tall order for most mid-sized corporates.

In an effort to understand how we could effectively assist companies to outsource certain aspects of treasury, we have been working with selected clients to assess the functioning of their treasury operations. Unsurprisingly, we found that while there are several differences between operations of different companies, there are certain common threads that can be distinguished. My sense is that companies may lose as much as 1 to 1.5% of their top line due to leakages between the different nodes of the treasury function - and this is without counting possible losses on the market. Outsourcing certain aspects of the operation could help preventing some of these losses.

As part of this exercise, we conducted a "live" simulation for a client, who has a simple and conservative policy - they keep 75% of their export receivables hedged at all times. We compared their approach with our benchmark approach which used at-the-money option pricing to fix the target value for its set of risk exposures and used value at risk (VaR) as an early warning signal to ensure that the target value was never breached.

In addition, we ran a second simulation using another approach we have developed. Here, we began (again) by setting the target value for the portfolio, as before. However, in this case, as we went forward, we adjusted the target value by 50% of any favorable movements delivered by the market. In my view, this is quite sensible - take part of what the market gives you today rather than depending on the skills of your treasury to capture them tomorrow. It is also very conservative, since as the target value keeps rising, it is likely to get hedged out quite early on any dip in the market.

We ran the simulation on a sample of USD 5 mio receivable per month from November 2005 to date. [We selected this period for the simulation since the rupee first fell then strengthened and remained quite volatile throughout.] The results are shown in the table below:

As the table shows, staying unhedged was a poor choice - the portfolio lost value and even fell below the target value by 1.2 cr (nearly 0.5%).

The approach actually followed (of covering 75% of exposures) performed quite well, showing a risk adjusted gain of over 1 cr (about 0.4%) from the target value and about 2.5 cr (nearly 1%) from staying unhedged. This approach also performed better than the benchmark, which was created by simply hedging part of the risk whenever the VaR signaled that the target value was threatened. The benchmark approach resulted in the portfolio being fully hedged out by January at the target value - this means that all the gains (1.17 cr) from the approach actually followed could be attributed to the hedging policy, since if it had been simply left to the market, it would have hedged out at a value 269.70 cr (the target value). [Of course, this performance was directly a result of how the market moved during the period under test; it is quite easy to construct a market scenario where this approach would have lost money relative to staying open and with respect to the benchmark.]

The new approach we have developed, however, is another kettle of fish, since it captures positive market movements while staying extremely conservative. In the current simulation, the entire portfolio was hedged out by December. The portfolio performed hugely better, adding about 4.8 cr (or 1.75%) to the top line. Importantly, this approach would also perform better in a contrary environment. Of course, this approach has its limitations as well - where there is high volatility in their business forecasts, for instance, or where the company has a strong risk appetite - but the process can be modified to build in certain constraints, as necessary.

This study makes it quite clear that having a structured approach can not only add value to the company's portfolio, but, importantly, can add a necessary measure of control. With markets getting more volatile and regulators getting more [appropriately] demanding, it is time to build processes, so that you can take a meaningful call on whether it is sensible for your to outsource some aspects of your risk management.

Currency Markets View - Rupee and Majors

USD/INR

Fortnightly movement: O-44.5000 H-44.6900 L-44.3300 C-44.6500.
Sentiment: Clearly, strong on inflows, pushed back vigorously by RBI
Expected range for 1 Month: 44.25-45.25
Expected range for 3 Months: 44.25-45.50

The domestic unit witnessed yet another week of depreciation as RBI bought dollars aggressively both to absorb flows that came into the stock markets and to ease the year-end liquidity pressure. Look for a CRR cut in the April 18 credit policy, since further rises in interest rates may be counter-productive to growth.

RBI's activity, buttressed by the volatile dollar overseas, helped the dollar rise to its highest level since January 6. With RBI protecting exporters interest the rupee is poised to move with a weaker bias. With the dollar likely to remain volatile, any sudden dollar weakness (say, if the FOMC softens its hawkish tone) could see the rupee threaten 45.00. However, with underlying strength and central bank driven weakness, sudden upward spurts cannot be ruled out - options would be a good bet.

Premiums, which had been rising on the central bank's liquidity play, may ease in coming weeks if liquidity eases.

EUR

Fortnightly movement: O-1.1913 H- 1.2208 L-1.1913 C-1.2034
Sentiment - neutral but may worsen
Expected range for 1 Month: 1.1600 -1.2150
Expected range for 3 Months: 1.1300 -1.2150

Another fortnight has gone by and the euro is still stuck in a trading range. Initially, the euro rose smartly all the way to just over 1.22 thanks to larger-than-expected drops in US retail sales and the Philly Fed index, very benign core CPI and a 2nd consecutive monthly shortfall in the net capital inflows into the US vis-à-vis the trade deficit. However, the euro made a sharp U-turn and slid to about 1.1950 after the Fed Chairman Bernanke hinted at the need for higher short term rates, US core PPI rose more than expected and existing home sales unexpectedly jumped over 5%. Last Friday's 10.5% drop in new home sales was a shocker and the euro recovered to close above 1.20. The recovery seems feeble but a stronger rally could ensue if the Fed's statement accompanying its decision tomorrow is perceived to point to an early end to its rate hikes.

The technical picture appears ambiguous but may hopefully get resolved soon. If by early next week the euro is unable to vault over 1.2150, a downside resolution of the trading range may appear more likely. A decisive break below 1.18 will most likely confirm the onset of the medium term downtrend.

GBP

Fortnightly movement: O-1.7272 H- 1.7593 L-1.7232 C-1.7417
Sentiment: negative and may worsen
Expected range for 1 Month: 1.7000 -1.7600
Expected range for 3 Months: 1.6500 -1.7600

After rising to just under 1.76, sterling fell as far as 1.7325 after Bernanke's hawkish comments on the one hand and a Bank of England MPC member saying on the other hand that the risk of UK CPI falling below 2% was greater than what the MPC thought. However, an actual uptick in UK inflation to 2% last month from 1.9% in January as also the MPC minutes showing a 8-1 vote to leave rates unchanged helped sterling recover.
With the widely expected Fed rate hike on March 28, the Fed funds rate now at 4.5% will, after a long time, again rise above BoE's benchmark rate. This could perhaps prove to be psychologically negative for sterling.

If sterling is unable to get past 1.76 in a week's time, a downside breakout will seem more probable. A decisive break below 1.72 will very likely point to the resumption of the medium term downtrend.

JPY

Fortnightly movement: O-119.02 H- 119.18 L-115.51 C-117.43
Sentiment: neutral but may improve
Expected range for 1 Month: 113.00 -119.50
Expected range for 3 Months: 110.00 -119.50

The dollar negative data and the warning from the US Tsy. Undersecretary to Japan not to prevent yen strength pushed the dollar down to 115.50 yen. However, Bernanke's comments and US existing home sales data propelled the dollar to 118.50 yen before slumping again on the shocking new home sales numbers.

After last July's yuan revaluation, periodical speculation of another yuan revaluation has led to some yen strength. However, the yuan's snail-pace realignment since then could perhaps mean that any further meaningful yuan revaluation may need to be preceded by yen strength and hence, the warning from the US Treasury. And, yen strength will need monetary tightening from Bank of Japan leading to eventual rate hike/s and/or end of Fed's monetary tightening.

With Japan's CPI data and BoJ policy-setting meeting looming on the horizon i.e. early April, dollar's upside may be limited to 119.50 yen. If Japan's annual core CPI again turns out to be positive, BoJ may be more prepared to start draining excess market liquidity. A break below 115.50 would then seem more likely paving the way for 113 and 110, if not lower.