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Option Structures for Indian IT and ITES Exporters
Option Structures for Indian IT and ITES Exporters

January 30, 2024

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Background

  • Generally, exporters use forward contracts to hedge foreign currency receivables to hedge against the spot rate risk and to benefit from the forward premium.
  • Hedging using forwards has historically been beneficial as the Rupee depreciation has generally been lower than implied in the forward rate. 
  • But, in the prevalent scenario, two primary issues make forward hedging sub-optimal.
  • Low forward premium from a historical perspective and
  • The tail risk of a sharp depreciation in the Rupee.
  • Currently, USD INR is around 83.25 and the 1y forward rate is around 84.65. The 1.4 INR buffer might not be sufficient to cover a potential depreciation move from hereon. We are at such a point that USDINR might see a partial repeat of the 2021/22 move. 
  • While short term stability can be expected because of the Dovish Fed and Intervening RBI, In 1 year's time natural depreciation would be needed as an emerging currency and INR may move towards 86.00.

Low forward premium makes the Option attractive

  • Decade-low forward premium discourages export hedging because the potential gains from the forward premium may not outweigh the depreciation. 
  • The low forward premium is making long-term hedgers in India reconsider their decisions of strategic hedge.
  • One potential alternative for the company to consider is to use options for USDINR instead of forwards for hedging.
  • Options can provide more flexibility in terms of managing risk, as they offer the ability to limit potential losses while still allowing for upside potential. 
  • We recommend that Options like Seagull and Range Forwards be considered for long-term hedging now as they provide a buffer in case of large depreciation of the Rupee.
  • These Options protect the forward rate while allowing benefits if INR depreciates more than the forward

 

Tail Risks Prevalent in the Market

 

  • China's economic slowdown signals wider global risks; Europe also shaky.
  • US recession fears could lead to falling currencies in emerging markets.
  • Germany, France nearing recession; may drag global economy down.
  • US high interest rates above 5% limit credit, hindering growth.
  • If the US economy doesn't land softly, global markets could suffer.
  • Fed pulling $100B monthly from the market; risky for financial stability.
  • 2024 elections in Taiwan, India, US may stir geopolitical tensions.

 

Hedging using Option Structures

  • Tail risk hedging entails using such instruments, which outperform forwards in the scenario of INR depreciation beyond the forward rate. Options, as hedge instruments, can enable such structures. The enhanced opportunity benefit compared to a forward can be achieved by:
  • Protecting an acceptable minimum rate lower than forward - using Range Forwards
  • Providing a partial protection against INR appreciation – using Seagull
  • These strategies help exporters during times of low forward premiums and a depreciating INR outlook, which has been the case right now.
  • Both the option strategy structures have been one of the best strategies to hedge exports recently. Some of the option structures have been shown in the scenario analysis given above.

Hedging using Seagull

  • Hedging through Seagull structures is initiated by buying an At-the-money put option, selling an Out-of-the-money put option at a lower strike, and selling an Out-of-the-money call option at a higher strike. 
  • Example: a seagull structure with a buy Put strike at forward, 84, sell put strike at 81, and sell Call strike of 86.00 would protect against any potential depreciation of USDINR till 81  while also allowing the company to benefit from potential INR depreciation till 86.00. 
  • Here, unlike a forward contract, the protection would be limited to 81 but it will not lock you at 84 even if at maturity spot is hovering around 86.00 or so.
  • The payoff diagram table  shows the effective rate under forward and seagull structure
  • Seagull structures have been one of the best strategies used internationally by companies to hedge exports. 

 

Hedging using Range Forward

  • Hedging through Range forward structures is initiated by buying an At-the-money put option, selling an Out-of-the-money put option at a lower strike, and selling an Out-of-the-money call option at a higher strike. 
  • For example, a range forward option with a buy Put strike of 84.00 and sell Call strike of 86.00 would protect against any potential depreciation of USDINR below the 84.00 level, while also allowing the company to benefit from potential INR depreciation till 86.00. 
  • Here, unlike a forward contract, it will not lock you at 84 even if at maturity spot is hovering around 86.00 or so. The payoff diagram table shows effective rate under forward and range forward. 
  • Range forward is one of the safest strategies that is being used internationally by conservative companies to hedge. This has worst-case protection and at no point hedge become naked and there is no leverage in range forward as well. 

 

Historical Analysis: 
Forward Vs Options- 2022-23

  • If a Range Forward or a Seagull had been used in the previous 2 years, the hedging strategy would have been materially more effective than a forward hedge. It is prudent to prepare for a depreciation event and adjust the hedging strategy. 
  • As an illustration, when USDINR was around 75.25 on Feb 2022, hedging through forwards for 1 year gave a rate of around 78.35.  On the other hand, the premium paid Range forward with Buy Put at forward and Sell Call at 81 protected the forward rate and benefitted the companies from INR depreciation till 81.
  • Similarly, premium paid Seagull Structure with Buy Put at forward, Sell Put at forward-4 and SC at 81, protected the forward rate up to 74.35 and benefitted the companies from INR depreciation till 81. 
  • Since INR depreciated sharply towards 82-83, exporters that hedged through options were able to get a better realization rate than forwards.
  • As shown in the table, the Range Forwards gave 178 paise a better effective rate than forwards. Similarly, Seagull gave 220 paise better effective rate than forwards.

Back-testing USDINR Strategies

*Green means best in that year and Red is worst in that year

*Assumed 6% cost of fund.

  • Spot- 83; Fwd rate 1yr- 84.70;
  • RF 1: Buy Put forward less 4%, Sell Call forward +4.5%, zero cost, Example Buy Put 81.30 Sell, Call 88.50, Zero cost
  • RF 2: Buy Put at spot, Sell Call at Forward + premium, Zero cost, Example Buy Put 83.00, Sell Call 86.40, Zero cost
  • RF 3: Buy Put Forward + 1%, Sell Call Forward + 6%, Cost 2.00%, Example Buy Put 85.50 Sell, Call 89.75, cost 170 paisa/ USD

    We backtested different range forward strategies against forward for the past 20 years and observed the following:

    • No Clear winner strategy.  There is no formula which makes a hedging rule a winner always
    • 10 out of 20 years,  Hedging through Forwards has not been the best strategy
    • Human Judgement is needed to anticipate what’s likely to be important for improved performance. 
    • RF-3 is the best kind of Range forward clearly.
    • During 2003-2009, the Forward premium for 1yr was less than 3%, similar to today. In these years, forwards were best in 

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