This concluding part of our series on hedging will talk about different types of hedging
22-Nov-2013 •Sanjeev Pandiya
In this third and concluding part we will talk about different types of hedging and its relationship with trading entities
What is static hedging? And how is it different from dynamic hedging?
As explained before, hedging means protection. It is like insurance, in the sense that it protects your wealth (or reduces your risk) rather than maximises (your wealth). It is trading ($, gold, silver, Re, equities, etc) for the purpose of ensuring that you get adequate (i.e. the budgeted) realisation on (say) your dollar exports. It takes a satisficing approach rather than a maximising approach, i.e., it sacrifices maximising (upside) in favour of assuring a minimum.
Static hedging is the taking of views on the value of (say) a currency, not with a view to maximising the realisation from the currency, but with a view to ensuring an adequate realisation for your business. So an exporter may sell his dollar at Rs 65, because he is making an adequate 15 per cent margin over his costs, not because he thinks that is the maximum realisation he can get from the dollar. So he takes a view that “this is a good price” and sells his dollar 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 dollar realisation from the same export dollar is determined by the movement of dollar 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 is able to realise >69; if the dollar moves between 60-65, the exporter is able to realise >64.
In dynamic hedging, the methods of managing the average realisation 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 competition, with the objective that the average realisation (from the dollar) must be higher than what competition is able to get, and this target is determined by the dollar chart itself.
In a 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. By dynamic hedging is what a business needs to protect its competitiveness vis-a-vis other businesses; it is difficult, no doubt, and needs specialised skills...just like heart surgery is difficult, but the only other option is a heart attack!
Basically, static hedging means selling all your dollars at a given price “which looks good”; dynamic hedging is much more humble, it a statistical method of selling your dollars and buying them back, to make sure that the average realisation on your net dollars sold is at or above the top of the 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 per cent of his annual turnover, he is running a hedge ratio of 50 per cent.
A business has 'flows', i.e. it gets Re/dollar as sales flows, and pays out Re/ dollar / commodity costs (like cotton, steel, aluminium) as flows. The 'Hedge Ratio' is the proportion of future flows (of dollar, gold, silver, etc) 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. If an exporter has sold one pot (of dollar) too early, he makes a 'loss' if the dollar goes up and ends above his selling price (this is reflected in his MTM). But he makes a profit on the many other pots lying further up the line. If the dollar reverses, he may have made a profit on his 'current pot', but he now has a 'notional loss' on the pots further down the line.
So you never really make a profit or loss on the MTM. The only real profit or loss is made on your closed trades. I call it a 'daily wage', i.e. dehadi. When the sum of this dehadi exceeds the MTM, you are fooled into thinking that we have a 'profit', when the sum of this 'dehadi' is less than the MTM, you are equally fooled into thinking that you have a loss. Over any long term, the dehadi will exceed any MTM; hence at that time, you will again be fooled into thinking that you have recovered your money.
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, realised in cash. The time 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 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 'parta', 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, 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 Re 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 Re 1 per day, then it will take us (maybe) 200 days to recover the VaR. This is 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 company. 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 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 recovered 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 for the day.