Thursday, February 11, 2016

Companies opt for complex strategy as covering forex risk through forward deals becomes expensive

MUMBAI: Rattled by choppy markets, companies with cheap dollar loans are knocking on the doors of banks to cut derivative deals to protect their books. Volatile equity prices coupled with rumours of high-street European banks imploding and China considering a devaluation, is driving companies, including some of the state-owned firms, to look for inexpensive ways to avert a hit on their foreign currency loans if the rupee moves further south.

The simple, customary practice of covering forex[2] risk through forward deals — a transaction where a bank agrees to sell dollars to a corporate on a future date at a preagreed price — has become too expensive. Instead, companies are preferring a little more complex strategy known as "call spread". Here, companies, with long-term dollar loans are taking a bet that the rupee would not cross 83 against the dollar at the end of five years when it has to repay the principal amount of the loan.

So, a call spread of 68 and 83 would mean that as long as the rupee trades in the range of 68 to 83, a company that has entered into such a deal would be able to buy dollar at Rs 68. The company even benefits, if the rupee gains unexpectedly to go above 68: in a situation where the local currency strengthens to 66, or 65, the company is free to ride the upside by buying cheaper dollar to repay its forex loan. But if the rupee weakens beyond 83, the company is exposed to the spot rate plus difference.

For instance, if the currency touches 88, it has to buy dollars at 73 (which is 68 plus the difference b etween 88 and 83). Though technically such structures are not entirely risk-less, it's certainly less expensive than an outright forward cover where a single rate is frozen. In today's market, a forward rate, based on the five-year forward premium, would be close to 89 or even a little more. In other words, in an outright forward deal a corporate fully hedging its five-year dollar loan[3], will have to agree to buy dollar at 89 at the end of five years; as against this a company entering into a call spread is not tying itself up into such an obligation.

Confirming the development, Sidharth Rath, President and Head Treasury-Transaction Banking at Axis Bank[4], said, "Some corporates are taking bets on a range the rupee is expected to move. Based on it, they are discussing to hedge their foreign currency exposures for longer period (three-five years) through call - spread as the premium is lower than forward contracts."

According to Keta Kurkute, AVP, Forex Risk Advisory at Mecklai Financial, "In today's uncertain market, corporate having large external commercial borrowings can consider hedging partially through such products rather than not hedging at all...A call spread of 68 to 83 levels for 5 years is costing around 3% per year as against a cost of 5.15% in case of a traditional forward deal."

On Thursday, the rupee lost about 0.66% or 45 paise to close at 68 .30 a dollar, the lowest level since August 28, 2013, despite the Reserve Bank of India intervention in the spot as well as futures market, said a dealer. In recent times, banks have asked corporates with unhedged forex loans to fork out margins - a development that among other things may have prompted many companies to look for cheaper hedging tools. In a call spread (in the above range), a corporate buys a call at 68 and sells a call 83.

"Under call option structures, corporate losses are limited to the total premium outgo of the structure... many large corporates (importers) don't want to be locked in forward contract prices," said Anindya Banerjee, currency analyst at Kotak Securities. Some corporates are, however, unsure whether call spread deals would qualify as "full hedges" in the eye of auditors who insist that companies should provide for mark to market losses (MTM) in their books on account of foreign forex liabilities like dollar loans and import bills.

[1]

References

  1. ^ rupee (economictimes.indiatimes.com)
  2. ^ forex (economictimes.indiatimes.com)
  3. ^ loan (economictimes.indiatimes.com)
  4. ^ Axis Bank (economictimes.indiatimes.com)

Companies opt for complex strategy as covering forex risk through forward deals becomes expensive Rating: 4.5 Posted by: Unknown

0 comments:

Post a Comment

Blog Archive