Market Maniac

Using FX as a strategic management tool
Oct 27, 2014

The FX gain/loss entry in financial accounts is pretty well understood by most companies, although I believe that there are still too many companies that focus inordinately on this purely accounting entry in taking hedging decisions. however, to my mind, very few companies focus on FX to the same extent in management accounts. As a result, many companies are sometimes unaware of opportunities that could actually improve the underlying profitability of their businesses.

The most obvious area, of course, is where companies use cheaper foreign currency borrowings for, say, post-shipment credit in exports, resulting in both a lower EBIDTA and lower interest costs. The true EBIDTA picture – comparing with domestic sales – would be obtained by calculating interest at the domestic interest rate and revenue at the forward rate. This would result in a higher EBIDTA and higher interest cost; the savings on using foreign currency credit (if any) should correctly be allocated to treasury gain. This would give a more accurate picture of the relative profitability of exports versus domestic sales.

Another often completely unseen gain/loss resulting from FX fluctuations is due to variations in business forecasts. While companies know this at a high level, particularly if they have oversold exports and have to cancel the forward contracts at a loss, the actual impact can only be correctly captured if the company follows a very strict risk management regime with a clearly defined hedge strategy. Some work we have done with a client may prove instructive.

The company is a large textile player with estimated monthly receivables of $ 25 million and forecast imports of $ 10 million a month. The business is reasonably mature and visibility is strong out to at least 12 months; business forecasts get tightened about 4 to 5 months before maturity. The company has a policy to identify risk as net estimated exposures on a rolling 12-month basis and to hedge it following a structured process with pre-set levels for hedging specific percentages. The natural hedge, too, is managed in a very well defined way.

Following this process, by September 1 this year, the monthly net realizations for September were expected to be $ 13.75 million ($ 25 million of exports and $ 8.25 million of imports, reduced from the forecast $ 10 million). This net portfolio was 85% hedged at an average rate of 63.54. The forward rate for the rest of the month (on Sep 1) was 60.89, providing an average MTM of 63.09, which was 70 paise better than the benchmark rate of 62.39.

As the month unfolded, actual exports turned out to be $ 27.5 million (about 10% higher than forecasted at the start of the month), but imports paid were just $ 5.5 million, only two-thirds of those expected at the start of the month. As a result the net portfolio was around 35% higher at $ 22 million, and a much larger amount had to be realized at spot. Since the rupee had strengthened over the entire risk period, the average realized rate turned out to be 62.71, better than the benchmark but only by 32 paise, reflecting a net gain of INR 65 lakh.

If the forecasting were better – assume it was 100% accurate – the actual net portfolio (of $ 22 million) could have been realized at the September 1 MTM (of 63.09), reflecting a gain of INR 1.54 crore! Thus, the glitches in forecasts cost the company nearly INR 90 lakh in September alone.

Of course, the rupee could have moved the other way – weakened – during September, which would have resulted in the gap amount ($ 22 minus $ 13.75 = $ 8.25 million) being realized at a higher rate. However, the primary focus of managing any business should be to ensure that non-business risks – e.g., FX – do not reduce the profitability. And, in any case, nobody could argue that more accurate forecasting is not a good thing.

At a management level, if it turned out that this pattern was repeated – say, over a year, resulting in lost potential of around 10 cr – it would provide a definitive signal to invest some part of this lost amount in improving forecasting ability and, indeed, internal communications where these gaps most frequently lie.

Another plus from using a tightly analytic approach is that it can provide signals for business negotiation. The same company found that its unexpired portfolio (October 2014 to September 2015) was marked-to-market at 64.02, nearly 2 rupees better than its benchmark of 62.18. With the portfolio about 55% hedged, the gain from benchmark of the hedged amount was nearly INR 15 crore, part of which amount the company could – and will – use to provide discounts to increase sales.

While hardly a surprise, running tighter and more analytic FX processes, while a little painful to set up at first and extremely difficult to follow with discipline, can often lead to substantially improved business outcomes



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