Hedging Your Bets: A Closer Look at Investment Strategies

In 1991, India opened its economy to the world. Economic reforms initiated by the Indian government came with enormous opportunities for the Indian economy and the same has helped Indian companies in opening trade opportunities with global companies, but everything comes at a cost which is huge volatility of Indian Rupee (INR) against various foreign currencies. The purpose of this research paper is to study why and how companies hedge their currency exposure; risk minimization is one reason.

1. Understanding Corporate Risk and Hedging

1.1 Hedging

Hedging is according to Investopedia (2006), “Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.”

Hedging is not a new phenomenon; companies have hedged for quite some time. The globalization of goods and capital markets has led to an increasing number of firms that have to make hedging decisions.

1.2 Types of Risks in the corporate world

In the corporate world, companies face various types of risks that can impact their financial performance and overall stability. These risks can arise from both internal and external factors. Understanding and managing these risks is crucial for effective decision-making and long-term sustainability. Let’s discuss mainly two types of risks in the corporate world that relate to hedging:

1. Commodity Price Risk:

Commodity price risk refers to the exposure a company has to fluctuations in the prices of raw materials and commodities that are essential for its operations. This risk is particularly significant for industries such as agriculture, manufacturing, energy, and mining, where the cost of inputs is directly influenced by commodity prices. Sudden and unpredictable changes in commodity prices can lead to increased production costs, reduced profit margins, and potential inventory-related losses.

1. Currency Risk (Exchange Rate Risk):

Currency risk arises when a company has exposure to foreign exchange rate fluctuations due to international trade, foreign investments, or foreign subsidiaries. Exchange rate movements can impact a company’s revenue, expenses, and profitability when transactions are denominated in foreign currencies. A strengthening or weakening of the local currency relative to foreign currencies can lead to gains or losses in translated earnings.

1.3 Benefits of hedging in reducing financial volatility

1. Risk Mitigation: Hedging strategies offset potential losses from price fluctuations in commodities or currencies, reducing financial risk and uncertainty, during scenarios like Russia-Ukraine War.
2. Price Stability: Companies can lock in future prices using hedging instruments like futures or options contracts, providing stability in budgeting and financial planning.
3. Cash Flow Protection: Cash flows determine the value of the company.

Company’s Value = Net present value of all the expected future cash flows (NCF)

Currency risk can therefore be defined as the variance of the expected cash flows, which arises from unexpected changes in the exchange rate. (Fig 1)

Figure 1: Hedged vs Unhedged Value of Firm

1. Profit Protection and Competitive Advantage: Hedging minimizes the impact of adverse market movements, safeguarding overall profitability. Effective hedging allows companies to maintain stable prices, enhancing their competitiveness.
2. Investor Confidence and Reduction in Financial Distress: A robust hedging program boosts investor confidence in a company’s financial performance and risk management capabilities, as hedging reduces the likelihood of financial distress during economic uncertainty, ensuring financial health.

2. Hedging Commodities

2.1 Commodity Price Risk Management

The commodity price risk management approach is crucial for companies heavily reliant on commodities as inputs involved in the production and sale of commodities. Such factors are supply and demand dynamics, with changes in production levels, geopolitical events, and weather conditions directly impacting commodity prices. Additionally, currency fluctuations influence commodity prices, as many commodities are traded and priced in foreign currencies, making them sensitive to exchange rate changes. Economic indicators, such as GDP growth and inflation rates, also influence commodity demand and prices. (Fig 2)

Figure 2: Bloomberg Commodity Index (BCOM)

For industries heavily reliant on commodities as inputs, such as manufacturing and agriculture, price fluctuations can lead to volatility in production costs, affecting profit margins and pricing decisions. Supply chain disruptions may arise due to price changes, impacting inventory management and supplier relationships.

Russia-Ukraine War: Real Commodity Prices

Following the start of the war, Coal, natural gas, and wheat prices have all reached historic highs in nominal terms. However, in real terms, only the European natural gas price has reached an all-time high, and it is substantially above its previous peak in 2008. Coal prices are close to their 2008 peak, while oil prices remain some way below. In the case of wheat, prices are far lower today compared to their peak in the 1970s, but close to their 2008 level. War and Sanctions have caused commodities chaos.

Figure 3: Real Commodity Prices- Russian-Ukraine War

2.2 Methods of Hedging Commodity Price Risk

1. Futures Contracts: Futures contracts are standardized agreements to buy or sell a specific commodity at a predetermined price and date in the future. By using futures contracts, companies can lock in future commodity prices, providing price certainty and protecting against adverse price movements.
2. Options Contracts: Options contracts provide the right, but not the obligation, to buy (call option) or sell (put option) a commodity at a specified price within a given time frame. Companies can use call options to protect against rising commodity prices, while put options can safeguard against falling prices. Options offer more flexibility compared to futures contracts, as they allow companies to benefit from favorable price movements without being obligated to execute the trade if market conditions change.
3. Forward Contracts: Similar to futures contracts, forward contracts enable companies to lock in commodity prices for future delivery. However, forward contracts are customized agreements between two parties, making them more flexible than standardized futures contracts. This customization allows companies to tailor the terms of the contract to meet their specific needs.

2.3 Case Study of Effective Commodity Hedging

Figure 4

Essar Group is an Indian multinational conglomerate company that owns a variety of assets in the core sectors of energy, infrastructure & logistics, metals & mining, technology, and retail, and hedge key inputs like zinc, graphite, lead, natural gas, etc. “Having seen the volatile commodity markets over the past few years, we are now experimenting to find out the effectiveness of hedging,” says N.S. Paramasivam, Head (Global Treasury), Essar Group.

Dabur hedges key inputs that go into the making of Amla, Chyawanprash, Glucose D, toothpaste, etc. “We were among the first FMCG companies to try out hedging as a tool to protect ourselves from volatile input prices,” says Jude Magima, Executive Director, Dabur India. (Fig 4)

3. Hedging Currency

3.1 Currency Risk Management

Exchange rate fluctuations are influenced by a combination of economic, political, and market factors. Some key determinants include interest rates set by central banks, inflation rates, economic growth (GDP), and trade balances. Geopolitical events, political stability, and international trade dynamics also play a significant role. Market sentiment, investor confidence, and capital flows contribute to short-term volatility. Additionally, monetary policy decisions, fiscal policies, and global economic trends influence exchange rates, impacting international trade and investment flows.

Currency risk may lead to unpredictable revenues and increased costs for international operations, affecting profitability. It can also result in losses on foreign investments and hamper cash flow management. Multinational corporations need to adopt effective hedging strategies to mitigate currency risk and ensure stability in their global business operations.

3.2 Methods of Hedging Currency Risk

1. Forward Contracts: Forward contracts allow companies to lock in an exchange rate for a future transaction. That way, a company can eliminate the uncertainty of future exchange rate movements.
2. Currency Options: Currency options give companies the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of currency at a predetermined exchange rate on or before a specified date.
3. Currency Swaps: Currency swaps involve exchanging cash flows denominated in one currency for cash flows in another currency. Companies use currency swaps to exchange different currencies temporarily, avoiding the need to buy or sell currencies in the foreign exchange market. This way, they can manage their currency exposure and reduce the risks associated with fluctuations in exchange rates.
4. Leading and Lagging: Leading refers to accelerating payment collection from foreign customers, while lagging involves delaying payment to foreign suppliers. By adjusting payment terms strategically, companies can respond to anticipated exchange rate movements.

3.3 Case Studies of Effective Currency Hedging

The IT sector in India, which includes companies like Infosys, TCS, Wipro, and others, used hedging primarily to manage currency risk. Being major exporters of IT services and software products, these companies generate a significant portion of their revenues in foreign currencies, especially the US dollar, Euro, and British Pound.

Indian IT companies used currency hedging instruments such as forward contracts and currency options to mitigate the impact of exchange rate fluctuations on their financial performance. By entering into forward contracts, these companies locked in favorable exchange rates for future revenue inflows, providing greater predictability in their earnings. Currency options allowed them to protect against adverse currency movements while also benefiting from favorable fluctuations. (Fig 5)

Figure 5: Rupee vs Dollar

4. Best Practices and Challenges

4.1 Developing Effective Hedging Strategies

Over the last two to three years, the biggest dilemma in corner suites across India Inc. has been: how do we control our input costs? Raw material prices — of metals, edible oils, crude and refined oil, vegetables, cereals, coal, etc. — have risen exponentially during this period. Says H. Shah, Associate Director (Risk Advisory Services), E&Y: “Any abnormal rise in the prices of inputs not only squeezes margins but also impacts the cash flows of a company.” So, some of the best hedging strategies that are being adopted by India Inc. are: -

1. Diversification: Avoid overreliance on a single hedging instrument or strategy. Diversify hedging approaches to spread risk and increase flexibility.
2. Professional Expertise: Seek advice from financial experts or risk management professionals who understand the complexities of hedging and can provide tailored solutions.
3. Hedge only a portion of your future requirements of raw materials: Test the waters by hedging only 15–20 % of your requirements. “We normally hedge only about 30–35 % of our input requirements at a time with a clear stop loss/gain mandate,” says Dabur’s Magima.
4. Done well, it should be a no-profit-no-loss game: If, however, one exceeds the brief and enters the speculative zone, there is every possibility of making huge gains or equally large losses.

4.2 Challenges and Limitations of Hedging

Hedging is still perceived by many as akin to speculation. L&T recently shocked the market by declaring a Rs 200-crore hedging loss in zinc. That is the flip side of the hedging mechanism. Companies have to be very careful in drawing a line between hedging and speculation. RBI regulations stipulate that they must have proper risk management policies, like MIS and margining systems, and board approvals in place. That’s because hedging can cause large financial losses if the bets go wrong.

5. Technological Advancements in Corporate Hedging

1. Advanced Data Analytics: Companies will increasingly leverage big data and advanced analytics to gain deeper insights into market trends, risk exposures, and correlations.
2. AI: Automation and AI-powered tools will streamline hedging processes, reducing manual interventions, improving accuracy, and enhancing efficiency. Companies will rely on algorithms and machine learning to identify market signals and optimize hedging positions in real time.
3. Fintech Startups: For example, Chatham Financial provides risk management advisory and technology solutions, including hedging services for interest rate, currency, and commodity risks. Their fintech solutions offer sophisticated risk analysis and hedging strategies tailored to businesses' specific needs.

6. Conclusion

Corporate hedging is an essential risk management tool in the dynamic business environment. Fueled by technological advancements and supported by fintech startups, companies can now adopt sophisticated and flexible hedging strategies to navigate currency, commodity, and other risks effectively, safeguarding their financial stability and improving long-term competitiveness.