Why companies dont hedge

While more and more companies have documented foreign exchange risk management policies, their implementation is often severely constrained because their boards have not effectively internalised the reality that ensuring that margins are protected sometimes – and possibly, often  – results in opportunity losses.

The recent sharp movements in the rupee have again brought this problem to the fore. This is unfortunate and a step backwards — over the years, most companies had moved away from worrying about foreign exchange losses, with fewer and fewer companies even reporting this as a separate line item in their summary accounts. This renewed concern confirms my sense that, in too many cases, policy documents are simply words on pages rather than a deeply understood set of processes for risk management.

As a result of this, treasury managers (and oftentimes chief financial officers) cringe to hedge even if the policy lays down specific guidelines. In these dramatically volatile times, the threat of huge opportunity loss freezes action, even though inaction can lead to huge cash loss. Lack of 100 per cent understanding – and, hence, support – from the board drives this indecision; leading, often, to a substantial waste of management time debating whether the rupee will fall as much as the premiums. What compounds things is that there is plenty of evidence to satisfy both sides of this question.

The table – rather obviously – shows that during different two-year periods over the past 10 years, it has sometimes been profitable to hedge imports forward and sometimes to hedge exports. Interestingly, and unsurprisingly (given that premiums merely discount interest rate differentials rather than provide any sense of how the rupee is going to move), the level of the forward premiums does not provide any consistent clue of which side of market will turn out to be more attractive.

Overall, buying forward for imports has lost an average of about 34 paise (around 0.7 per cent) as compared to staying unhedged; correspondingly, selling exports forward has, on average, been more profitable than staying open.

While 0.7 per cent is 0.7 per cent and money is money, what is worse is that the average hides huge variations. The worst loss on open imports was a horrendous 9.23 (around 25 per cent) back in April 2008; the corresponding number for open exports was a whopping 5.18 (about 12 per cent) in November 2006. These are terrifying numbers that can sink any cash flow. Of course, on the other side – if you do hedge – the worst opportunity losses have been of similar orders of magnitude and, indeed, identical for hedged exports in 2008 and hedged imports in 2006.

So, how do you take the call?

Well, the purpose of risk management is to protect the company’s cash flows; thus, not hedging (which leaves you open to cash loss) is by definition worse than hedging (which leaves you open “only” to opportunity loss and tears and gnashing of teeth at the board).

So, clearly, the first step to getting to sensible implementation of your risk management policy is to protect the operating team from fireworks from management. This requires acknowledging the possibility – nay, likelihood – of opportunity loss front and centre in its risk management policies.

Most companies set their objectives of risk management as something like: to ensure that our business margins are completely protected from loss as a result of foreign exchange fluctuations. To make the policy more implementable, the objective itself needs to be further qualified: … explicitly acknowledging that this effort may result, from time to time, in opportunity loss.

And, of course, to prevent this, too, from simply ending up as (more) words on pages, board members need to be continually re-educated on managing risk in financial markets.

Another critical requirement is to have a senior executive – who is, ideally, on the board as well – who plays the role of Head of Risk. S/he may not need to be so designated, but needs to be someone who understands both sides (purchase and sales) of the business, enjoys and understands markets, and is able to knock heads together to keep things moving.

I have seen several mid-sized companies build their risk management operations in this way to where it has become a tool to drive competitiveness. Unfortunately, I have seen many more that are still floundering in the trenches between different operating power centers and the board.

jamal@mecklai.com