As explained before, hedging means protection. It is like Insurance, in the sense that it protects your wealth (or reduces your Risk) rather than maximizes (your wealth). It is trading ($, Gold, Silver, Re, equities, etc.) to ensure that you get ADEQUATE (i.e. the Budgeted) realization on (say) your $ exports. It takes a satisficing approach rather than a maximizing approach, i.e. it sacrifices maximizing (upside) in favor of assuring a minimum.
Declaimer: This article written was originally in October 2013, and some of the data points may be outdated.
Static hedging is the taking of views on the value of (say) a currency, NOT to maximize the realization from the currency, but to ensure an adequate realization for your business. So an exporter may sell his $ at Rs.65 because he is making an adequate 15% margin over his costs, NOT because he thinks that is the maximum realization he can get from the $. So he takes a view that “this is a good price” and sells his $ in the Forward market, whenever he gets such a price.
Dynamic hedging is much more complex than that. It tries to ensure that the average $ realization from the same export $ is determined by the movement of $ on the chart, and remains in (say) the top 10 percentile, i.e. if the Dollar moves from 63-70 during the period, the exporter can realize>69; if the $ moves between 60-65, the exporter can realize>64.
In dynamic hedging, the methods of managing the average realization from the Dollar have nothing to do with the profits available in the business. The objective of Dynamic Hedging is to be a differential factor against the competition, with the objective that the average realization (from the $) must be higher than what the competition can get, and this target is determined by the $ chart itself.
In low-margin businesses, static hedging does not guarantee survival. High-margin businesses may sometimes choose to opt for static hedging, simply because it is easier. But dynamic hedging is what a business needs to protect its competitiveness vis-a-vis other businesses; it is difficult, no doubt, and needs specialized skills…..just like heart surgery is difficult, but the only other option is a heart attack!
Static hedging means selling all your Dollars at a given price “which looks good”; dynamic hedging is much more humble, it is a statistical method of selling your Dollars and buying them back, to make sure that the AVERAGE realization on your net Dollars sold is at or above the top of the price chart.
Hedge Ratio: explain the principle of Hedge Ratio and its relevance to the Physical Business.
The proportion of the flows in a business that is proposed to be hedged, i.e. if an exporter chooses to hedge 50% of his annual turnover, he is running a Hedge Ratio of 50%.
A business has ‘flows’, i.e. it gets Re/ $ as Sales receivables, and pays out Re/ $/ commodity costs (like cotton, steel, aluminum) as flows. The ‘Hedge Ratio’ is the proportion of future flows (of currency receivables or payables) that you have bought/ sold. When you are discussing a ‘corpus’, you can be pretty clear about what the corpus is. For example, when you put money into the equity market, you are giving a corpus to your Mutual Fund/ Broker/ Trader, but when you are talking about a ‘flow’, you need to think differently.
A FLOW is a series of ‘pots’. One pot is a corpus, but think of it as many pots one after the other, in serial
The correct way to think about this is like you think of your factory. The VaR is your investment, whether invested yet or not. The dehadi is your return, realized in cash. The period taken to recover enough dehadi to cover your VaR is the only variable you need to monitor.
It has to be understood clearly that you CANNOT lose money if you are managing a flow. That is because the loss in one pot is made up That is why this is called a Hedge Ratio, NOT a Risk Ratio. What proportion of your ‘portfolio’ you are carrying as inventory, will decide your VaR, but REMEMBER, if you are ‘doing nothing’ in your Physical Business, the dehadi booked in the Treasury will always reduce Risk/ increase profits for the Physical Business. That is why it is called a Hedge AGAINST the risk you are running in the Physical Business.
What is the concept of dehadi?
The concept of dehadi comes from ‘part’, i.e. cash accounting. The Birlas (or Marwaris in general) use Parta Accounting, which treats all assets as ‘liabilities’ (i.e. Fixed Assets will depreciate, Inventory will deteriorate and be written off, Debtors will default, and only Cash will be mine…). There is, therefore, a sharp focus on Cash to the exclusion of EVERYTHING ELSE.
Profit, then, is only what is CONVERTED into cash. In English Accounting, this is the point of “Free Cash Flow”, i.e. after Interest, depreciation, Capex, and even Investment into WC, the Operating Profit RECOVERED in cash is ONLY counted as Free Cash Flow.
In the Treasury (which runs the Dynamic Hedging operation), everything is marked to market EVERY DAY. Conceptually, if you buy Reliance at Rs.800, and make Rs.1 dehadi every day (i.e. profit on CLOSED TRADES), then this dehadi has to pay for the VaR. If we believe that Reliance might (even if for ONE DAY) go down to Rs.600, then the VaR per share is Rs.200 * no. of shares held as inventory. If the dehadi is calculated per share, and it comes to Rs.1 per day, then it will take us (maybe) 200 days to recover the VaR. These are the profits to be recycled into the Treasury, to be kept as Reserve to finance the dehadi stream. These profits are, therefore, ‘written off’.
Once the VaR is now funded by Treasury profits, the dehadi stream is now ‘free’, i.e. without any Capital from the co. The objective of the Treasury is to get to this point; in the Physical Business, this can take 7-10 years, while the Treasury does this over a much, much shorter time, i.e. usually below 1 year.
All Inventory in the Treasury is then marked down at Rs.600 and the loss is calculated. The Budgeted Inventory is multiplied by Rs.200 and this is the VaR. It is now assumed that this money is lost, regardless of whether the MTM has happened or not. This VaR has to recover from the market, by booking dehadi.
What is VaR and how is it different from MTM?
As explained above, VaR is the MTM at the lowest possible value that the stock may reach, or has reached over the last 5 years (we use the lesser of the 2 bottoms, 2008/ 2011 to set the lowest possible price the stock can reach). The inventory we hold carries the Risk of being marked down to these levels, which would be Max Possible Loss (MPL)…..a.k.a. Value At Risk on the portfolio. This is the VaR, and it must be recovered by dehadi (i.e. make the market pay for your portfolio Risk) before we start to take home our earnings.
MTM, meanwhile, is just the loss/ profit for the day.