The global economic landscape has experienced a notable shift with the emergence of rising inflation and increased interest rates from major Central Banks. This shift has led to a consequential decline in interest rate differentials, particularly seen in the case of the United States, which has raised its fund rates to a range of 5.25% to 5.50%. As a result, the interest rate differential between the US and India, which is typically priced through forward premia, has steadily decreased over the past few months. Forward premia, or discounts, represent the variance in interest rates between two economies.
Since April 2022, the US Federal Reserve has implemented a 500 basis points hike in its fund rates, while the Reserve Bank of India (RBI) has raised its repo rate by 250 basis points. Consequently, the Forward Premia has contracted from 3.40 (4.56%) to 1.43 (1.73%). This development has created a favourable environment for importers, who benefit from reduced hedging costs. However, the situation poses challenges for exporters, who find it increasingly difficult to hedge their export receivables due to the diminished premia.
Exporters are now actively seeking alternative hedging solutions, looking beyond the conventional strategies they have traditionally relied upon. Plain vanilla forwards, which were once the go-to avenue for hedging, are no longer preferred options. Instead, exporters either avoid them altogether or employ them to hedge only a portion of their unhedged exposure. While plain vanilla forwards are straightforward and appealing due to the absence of upfront payment requirements, the minimal premiums received by exporters have compelled them to explore alternative options, even if it means incurring additional costs.
In response to the current low forward premia scenarios, exporters are exploring alternative investment avenues and hedging strategies to effectively manage their risks.
Notably, derivative structures such as options and structured products have gained prominence, primarily due to their reduced pricing in the prevailing low premium environment and lower volatility levels. These instruments historically required upfront payment of premiums, which deterred exporters. However, with the current market conditions, the pricing of option structures and exotic options has significantly decreased, making them increasingly popular as alternative hedging mechanisms among exporters.
Let’s delve into the details of each alternative hedging strategy mentioned:
1.Plain Vanilla Puts: A plain vanilla put option gives exporters the right, but not the obligation, to sell a foreign currency at a predetermined strike price on the due date. The rationale behind using plain vanilla puts is that the cost of these options has decreased over time. For instance, a 3-month At-The-Money-Forward (ATMF) Put option that previously cost 95 paise (Indian currency) has seen its cost reduced to 60 paise. This means that exporters can now purchase a 3-month ATMF Put option at a much cheaper price compared to the pricing from a year ago. The decreased cost makes it an attractive alternative for hedging against potential currency depreciation.
2.Put Spread: A put spread involves the combination of two options: a put option to sell a foreign currency at a predefined strike price and a sell put option with a lower strike price. The inclusion of the sell call leg within the structure helps reduce the overall cost. The rationale for using put spreads is that their cost has also decreased over time. For example, a 3-month ATMF Put Spread that previously cost 50 paise has seen its cost reduced to 40 paise. This decreased cost makes put spreads a more affordable option for exporters looking to hedge their currency risk.
3.Seagull: A seagull is a three-legged option structure that consists of a buy put option, a sell put option, and a sell call option. In a seagull, the strike price of the sell call option is placed higher than the buy put option, while the strike price of the sell put option is placed below the buy put option. The rationale for using a seagull structure is the significant decrease in its cost over time. For example, a 3-month seagull structure that previously cost 42 paise now has a cost of only 15 paise. It’s important to note that a seagull structure exposes the client to unlimited loss if the spot price of the currency trades below the strike price of the sell put option.
Apart from regular option strategies, there are also exotic and structured derivatives gaining popularity:
1.Barriers: Barriers are used to either knock out or knock in a specific leg of an option structure, such as a put spread or seagull. A knock-out barrier causes the option to cease its existence once the barrier strike is reached, while a knock-in barrier activates a specific leg of an option to become exercisable once the knock-in strike is reached. The rationale for using barriers in option structures is to reduce the cost significantly. By adding out-of-the-money knock-in or knock-out barriers, the overall cost of the structure can be substantially reduced.
2.Forward-Forward Swap: A forward-forward swap involves undertaking a swap between a near-leg and a far-leg forward contract to either pay or receive premia. This swap allows the client to fix their premia while keeping the spot position open. In other words, it provides the flexibility to benefit from potential spot price movements while locking in the current premia levels. The client covers their spot position on the maturity of the first leg by net settling the transaction. The rationale for using a forward-forward swap is to manage the hedging costs effectively and maintain a desired premia position.
3.Target Redemption Forwards (TARFs): TARFs are structured products composed of a Buy call (BC) and a Sell Put (SP), with leverage applied to the SP leg. TARFs aim to deliver a higher forward rate for a series of maturing forwards over a specific period. One unique feature of TARFs is the inclusion of a profit cap. As the series of maturities progress, the client has the option to exercise the strike to convert their foreign currency while benefiting from gains due to the difference between the spot price and the strike price. Once the accumulated gains reach the capped limit, the structure gets knocked out. The rationale for using TARFs is to achieve a higher rate than traditional par forwards, but it’s important to note that TARFs involve leverage, which can lead to substantial losses in case of adverse movements. It’s worth mentioning that structures with leverage are not allowed in Indian markets.
4.Instalment/Compound Options: Instalment or compound options are like plain vanilla options, but they provide the buyer with the flexibility to make instalment payments for the option premium throughout the option’s tenor. If the client fails to make subsequent instalment payments, the option ceases to exist. However, if the option is in the money, the buyer can make the premium payment and book the profit on the due date. This structure provides the buyer with more control over their premium payments and potential profit-taking.
It is crucial to consider that the availability of these alternative investment avenues and hedging strategies may vary based on client eligibility (Retail/Non-retail), regulatory approvals, and prevailing market conditions. Exporters should exercise caution and seek guidance from financial professionals to determine the most appropriate hedging approach tailored to their specific circumstances.