cases for managers

ISSUES IN CORPORATE RISK MANAGEMENT The need to define proper Objectives

Case 2 - Keep the objective in mind - It pays. Case 3 - Focus on objectives; Learn from your mistakes.

This is an issue not usually dwelt upon in market literature or forums and chat rooms, but success in Corporate FX Risk Management, or even speculative trading for that matter, often hinges upon Defining your objective(s) Devising a plan or strategy to achieve the objective(s) Executing the strategy and Very importantly, remaining focused on the objective Devising of a plan/ strategy and execution thereof are matters of expertise in market reading and dealing and are usually the more enchanting part of Risk Management or Trading. Rarely is adequate attention paid to the need to define proper Objectives for the risk management exercise. Even if the objectives have been properly defined, they are often forgotten in the heat of market activity. This leads to failure or underperformance in the big picture. We shall try and illustrate this through some case studies in the context of Corporate FX Risk Management.

The Case of a Swiss Franc Loan A company with a Rupee Balance Sheet (take it as a USD Balance Sheet, if you please), contracts a Swiss Franc Loan at a USDCHF rate near 1.25 towards the end of 1996, after which the Swiss Franc weakens to 1.45 by early 1997 and then trades in a range of 1.45-1.55 through the greater part of 1997-1998. It strengthens to about 1.35 by end of 1998. The company accounts for the Loan in its books at 1.50 and wants to “earn back” the “loss between 1.50 and 1.35” through “Hedging Operations” which call upon it to sell USDCHF in the Forward Market and earn Cash Profits on such Hedges, which will be booked in its Profit and Loss accounts. Note, that the focus is on CASH Profits/ Losses generated through “Hedges” and not on the VALUE of the Loan, which is a Balance Sheet item.

The company starts its “Hedging Operations” near the epochal birth of the Euro. As we all remember, 1999 was the year in which the Euro was born near 1.17against the Dollar and caused much anguish in the market by weakening throughout the year to end just above Parity. In the process it dragged the Swiss Franc down against the Dollar. The company, to its dismay, found itself making Cash Losses on its “Sell USDCHF” hedges. To make up the initial losses, it sold more USDCHF in ever increasing larger amounts right through the year, trying to earn Cash Profits on interim bouts of Dollar weakness against the Swiss Franc. Huge Sell USDCHF trades were daily entered into for making a few pips profits, not realizing that the trades were all against the larger Trend. Its focus on the Cash Profit/ Loss made the company overlook the fact that the ongoing weakness in the Swiss Franc was decreasing the value of the Loan on its Balance Sheet. In an attempt to first earn “hedging profits” and then to cover losses against the trend, it ended up with a USD 1 million loss, negating, to a large extent, the real Valuation Gain on its Balance Sheet.Had its focus been on the Balance Sheet, the company would have stopped its “Hedging Operations” after the first few hedges made Cash Losses and proved that the market was actually reducing the value of its primary Loan exposure! Sounds incredible? The moral of the story is that a lot of thought and deliberation should go into deciding upon correct objectives before commencing market operations.In a subsequent issue we shall take up the case of a company, which started out with the correct objectives, but lost its focus and underperformed as a result.

ISSUES IN CORPORATE RISK MANAGEMENT Keep the Objective in mind. It pays

Case 1 - The need to define proper objectives Case 3 - Focus on objectives; Learn from your mistakes.

The definition of proper Objectives is the first step in effective Corporate FX Risk Management. Get your objectives wrong and you are most likely courting trouble. We had taken this up in the Issue dated 28-Mar-04. Having set the correct objectives, the Risk Manager needs to keep them in mind after the Hedge Strategy has been implemented, so as to not be led astray by the market. It pays immensely. A conglomerate with a Rupee Balance Sheet had a large foreign currency loan book, 85% of which was denominated in US Dollars. The balance was in D-Marks, Yen and Sterling. Circa 1994-95, the Risk Manager decided to reduce the currency concentration risk and rebalance the loan basket using Currency Swaps. The Objective was clearly defined as Risk Diversification. It was decided to swap 10% of the Dollar loans into Yen. The Yen was chosen because interest rates were close to zero as compared to 6.50-6.75% on the USD 6-month Libor, giving a huge interest benefit. Further, the Yen was expected to weaken over a 3 year time frame. The Swap took place in Jan-95 near 100 on the USDJPY Spot.
	Almost immediately thereafter, the Dollar dived against the Yen, to hit an all time low of 79.80 in April 1995. There were 3 months of intense agony. The company had never undertaken such a large forex deal. The Board was on the edge. Had the deal gone horribly wrong? The Risk Manager reminded the Board that the objective was Risk Diversification and only 10% of the loan book had been put on the line. Further, the deal had a 3 year tenor. The market eventually turned around and the danger passed. The Swap came back into money. Now the Board was tempted to square off the trade and book whatever small profit was available. Again the Risk Manager stuck to his guns, saying the Objective was long term Currency Diversification, not short term Trading Profits. The Board backed down and the Swap was allowed to run its course.
The Yen eventually touched 120 in 1997. The company booked a huge currency and interest rate gain of almost $17 million. Those who have been in the market through that period would appreciate how difficult it must have been to steer such a trade through to its end. It is immensely commendable that the Risk Manager did not waver from the Objective, neither in bad times nor in good times. The gains from the deal (which in itself was well conceptualized), was realized by remaining focused on the Objective.

ISSUES IN CORPORATE RISK MANAGEMENT
Focus on Objectives; Learn from your mistakes

Case 1 - The need to define proper objectives
Case 2 - Keep the objective in mind - It pays.

In the issue dated 25-Aug-04 we presented the case of a corporate that stuck to its long term objective even in bad times on a currency swap that went very bad initially; but ultimately booked handsome gains at the end of three years. We now present the case of a corporate that initially failed to realise profits because it lost focus of its objectives. But it learnt from its mistake and made good the next time the same opportunity presented itself.

Business Exposure: An Indian Importer, having all imports invoiced in US Dollars.
Objective: To diversify a part of the exposure into another currency to reduce Currency Concentration Risk, through off-balance-sheet transactions.
Forecast on 26-Feb-04: While below 1.30, there were chances of EURUSD falling to 1.18 (5.2%) over 2-3 months.

Strategy adopted: Bought a EURUSD Put at a strike of 1.2425 on a small part of its total exposure. The Put served as a proxy for currency diversification
Option Price Paid: 2.02%

The corporate created a synthetic Euro Payable, where it would gain if the Euro fell. But, the Euro fell only slightly and then started trading sideways.
The Option was losing time value and the Corporate was concerned that it had paid the 2.02% Premium in vain. Its focus shifted from its objective of Currency Diversification to minimizing the cost of hedging. So, in order to recoup part of the premium paid, it squared the Option. There was a sigh of relief. But, the Euro started falling almost immediately thereafter and went on to meet its target of 1.1850.

Had the Corporate stuck to its objective of reducing its Currency Concentration Risk, it would have retained the Hedge and made good money thereby. Nevertheless, it learnt from its mistake and replicated the deal in 2005 when a similar opportunity presented itself.
No mistake the second time:
In the first quarter of 2005, EUR-USD had fallen from its post introduction high of 1.3665 and had traced a classic Double Top (refer below). The forecast was bearish, targeting 1.20.

Recognising the opportunity, the Corporate again bought EUR Put/ USD Call Options with the same objective of diversifying the currency composition of its Imports as also of lowering the cost of Imports.
The market again hesitated for a while after the deal was done, causing some anxiety to the Corporate. But remembering the experience of 2004, it stood its ground. Finally the Euro fell and the Corporate made a very decent amount of money on expiry of the Option. This success has now given the Corporate enough confidence to be more proactive in managing its Currency Exposures.

Moral of the story: Its alright to make mistakes. But learn from it and do better next time. Do not give up on Forex Risk Management as "speculation" if things don't work out the first time. And, things do work out if the objective is well thought out, the hedge strategy is well laid out and you work according to plan.