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Research:
Was paying Forward Premium profitable for Importers?

15th February, 2014

BACKGROUND

Forward Premia increased sharply in June-July 2013 and retain an overall uptrend currently. In the bigger picture, Forward Premia have been increasing steadily since May 2004. It is common knowledge that most Importers prefer not to hedge as Forward Premia are perceived to be too high. The question we ask is "Would it have been advisable for Importers to pay these high and rising Forward Premia in order to hedge themselves? Would it have been profitable?"

FINDINGS IN BRIEF

Profit/Loss in Rupees Table We found that
  1. Paying 1-month Forward Premium has been profitable on whole since May 1996 and
  2. Since October 2007, Paying Forward Premium has been profitable across most tenors.

WHAT WE EXAMINED

  • We examined the 1, 3, 6 and 12 month tenors.
  • We calculated Daily Profit as Profit = Spot after relevant period (say Spot after 1-month) minus the Forward Rate (Spot + Premium) at the beginning of the period (say 1-month).
  • This Daily profit has been calculated for every day since May 1996, going as far back as possible in each given time frame.
  • Total Profit (given in the Findings table above) has been calculated as a Sum of the Daily Profits.
There is an implicit assumption in the above analysis that a Forward Cover transaction has been done daily since May 1996. While this is certainly not the case in real life, we are ready to live with the assumption because
  1. It is necessary for the purposes of analysis because it eliminates the question that would otherwise arise as to "When was the Forward Cover taken?"
  2. Keeping the assumption does not compromise the results of the research into the question at hand. In fact, the elimination of choice actually makes the results more reliable as it examines only the impact of market movements. Otherwise, any other result would have been unacceptable from a purely analytical point of view as it would have included human discretion, which can always work to either improve or worsen the profit/ loss available in a given market situation.
  3. Keeping the assumption also highlights how things work when we undertake Systematic (as opposed to discretionary) Hedging. In fact, it encourages the practice of Systematic Hedging.

WHAT WE COULD HAVE EXAMINED

  • We could have studied a longer period, going back to say 1995 (or even 1993 and 1991) but we did not have data before May 1996.
  • It would have been, perhaps, more interesting to break up the findings into 3 periods, viz. (a) May '96 to Jun '02, when the Rupee depreciated from 35.14 to 49.09 (b) Jun '02 to Dec '07, when the Rupee appreciated from 49.09 to 39.16 and (c) Dec '07 to current, during which Rupee depreciated from 39.16 to 68.81. But, that would have increased the element of hindsight.

MAIN POLICY IMPLICATION

Given that forecasts are not 100% reliable (our own forecasts have a reliability of 64%-72%, please see www.72pct.com) it is advisable for Importers to hedge at least a portion of their Exposures in a Systematic manner.

The detailed results of the research, and some additional findings, are presented below.

PAYING 1-Month FORWARD

PAYING 3-Months FORWARD

(Take mouse over the thumbnail images for a full preview)
Profit/Loss Table2

PAYING 6-Months FORWARD

(Take mouse over the thumbnail images for a full preview)
Profit/Loss Table2

PAYING 12-Months FORWARD

(Take mouse over the thumbnail images for a full preview)
Profit/Loss Table2

ADDITIONAL FINDINGS

The Spot tends to rise after a certain level of Loss
Examining the data, we can surmise that once the Loss on a Forward Contract reaches a certain level, there are good chances of a recovery, even if temporary. The average of such "maximum loss" levels is given below:

The policy implication is that IF you happen to be deep "out-of-money" on a Forward Contract (that you should not be in such a scary situation in the first place is another issue), it might not be the best time to panic and exit the Forward Contract and book a loss. A recovery is possible, even if temporary, which might give you a better opportunity to exit the Forward Contract.

Also, once a Forward Contract reaches a certain "out-of-money" level, it could be used as a technical indicator of a possible rise in the Spot of anywhere between 130-340 paise.

Paying Forward has been Profitable post Oct-07 despite higher Forward Premia
That it has been profitable to Pay Forward Premium post-Oct '07 is evident from the data. What we have to appreciate is that Premia have risen steadily after Oct-07 from very low levels close to Zero (does anyone remember 1-month actually going into Discount?) to the current high levels close to 9% p.a. The current levels are close to those that prevailed in 1996-97. Despite this, paying Forward Premia has been profitable.

The obvious conclusion is that the rate of Rupee depreciation has been greater than the prevailing and rising Forward Premia.

This serves as an eye-opener for Importers, prompting them to base their hedging decisions on expected Spot movement rather than on the "high cost of hedging" and to realize that Rupee weakness can be more than prevailing Forward Premia.

Fix a Hedging Cost Budget
Lastly, this research reinforces our long-standing policy recommendation to Corporates - it is imperative to fix a Hedging Cost Budget. Successful and effective hedging is not possible without that.

A vast number of Importers who were hit by the sharp Rupee depreciation of 2013 could have mitigated their losses if they had had a budget that allowed them to pay a Hedging Cost - whether on Forwards or on Call Options. It is indeed paradoxical that Importers tend not to PAY Forward Premia (in order to avoid a cost) and Exporters tend to RECEIVE Forward Premia (in order to earn revenue). In the process, both lose. It is time now to put a stop to avoidable loss.

To read more on the crucial factor needed for successful hedging, please read: FIRST STEP TO SUCCESS IN HEDGING: Sanction a Hedging Cost Budget



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