Hedging Against Falling Rubber Prices using Rubber Futures

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Hedging against a falling rupee

Without proper currency hedging, businesses may always be at the receiving end.

Without proper currency hedging, businesses may always be at the receiving end.

IT Industry witness sharp decline in hiring to cut costs

Can’t arrest rupee fall if driven by weak fundamentals: RBI

Indian businesses have not managed currency risk well enough.

The rupee crossed historic 56.40 levels recently against the dollar and depreciated against other major currencies. The volatility in rupee movements is only set to increase on account of a host of external and domestic forces.

The importance of currency risk management — adopting new hedging methods and moving beyond forward contracts — has increased in this scenario. Bungling on currency risk management can adversely affect profits, sales, cost, revenue and competitiveness of companies involved in international business.

HEDGING ERRORS

Indian companies mainly use forward contract derivatives from their banks to hedge currency exchange risk. Exchange-traded currency futures and options are yet to become popular, in spite of the fact that these were introduced by RBI and SEBI to provide a transparent hedging system, specially to small and medium scale units.

Indian companies went in for over-the-counter derivatives, duly encouraged by banks, only to have their fingers burnt when the rupee rates moved against them.

Such structures were developed for speculation rather than for hedging, and now have been banned by RBI.

Another area where currency risk has been mismanaged is foreign currency loans. Companies have taken huge cheap dollar loans, which have turned expensive with steep depreciation of the rupee.

PROSPECTS AHEAD

Unhedged liabilities in foreign currencies and past hedging strategies by export companies will force companies to report marked-to-market losses, which will affect their share values. Companies need to develop a new approach to protect market share and profit margins in international business. Indian companies now have to shift to a portfolio of forex derivatives, instead of depending heavily on forward contracts. The proportion of hedging with vanilla put and call options can be increased.

Option derivatives can correct wrong hedging decisions at low cost. Options ensure minimum rupee funds income for exporters and maximum rupee costs for importers, with an opportunity to derive benefits from favourable rate movements. Small and medium companies do use exchange-traded futures and options derivatives for hedging currency risk. Exchange traded currency futures and dollar/rupee options up to 12 months’ forwards are available in India.

Foreign currency exposures must be divided into monthly, quarterly, half-yearly and yearly basis. Short-term exposures up to, say, one month may be fully covered with forward contract derivatives, and after that the strategy of partial hedging may be used to deal with volatility in the dollar-rupee rate.

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The concept of stop loss, to follow market trends for hedging, should now be used seriously. Option and futures exchange traded derivatives, which have transparency and offsetting characteristics, may be used when rupee volatility against the dollar increases.

Such flexibilities are not available in the case of hedging by forward contracts. Futures can also be used to correct the forward contract hedge at low cost and effort. Importers may remain hedged using forward derivatives contract for short and medium-term committed exposures. Call options may be used for uncommitted import exposures to benefit from corrections in rates.

Hedging with forex derivatives may create situations for marked-to-market losses. Indian corporates should give serious attention to operational hedging techniques, specially for very long term exposures in foreign currencies. Companies must now develop their brands and plan to develop manufacturing capacities close to their main foreign markets. Volatility in the external value of rupee requires an innovative approach towards currency exposures.

GLOBAL SITUATION

Global and local macro economic factors, and risk avoidance by forex dealers, have created a huge demand for the dollar. The global factors that have led to a strong dollar worldwide are: the Euro debt crisis; financial uncertainty in France and Germany, the flagship Eurozone economies; downgrading of Japan due to its high levels of debt; high oil and commodity prices; and overall negative global sentiments.

Added to these are local factors, such as a negative trade deficit, high inflation, indifferent FII/FDI investments, growth slowdown, burgeoning fiscal deficit, ratings downgrade, and paralysis in policymaking — all of which have led to rupee depreciation against the dollar. But present trend of the declining rupee can be converted into big opportunity, particularly by expanding exports in new international markets. Currency risk management will play a crucial role in translating this potential into reality.

The rupee will not appreciate in any significant way, unless our current account achieves surplus position. The rupee-dollar exchange rate is a critical factor in exports, imports, international loans, foreign remittances, tourism and overseas education. The depreciating rupee poses major challenges for importers and those servicing unhedged foreign currency loans. Future business decisions will be influenced by the external value of the rupee against major currencies, including the dollar.

Contrary to what is generally believed, even dollar depreciation can hurt exporters because foreign buyers, especially in Europe and the US, exert pressure on Indian exporters to cut prices. What’s more, export-oriented large companies may have hedged their short, medium and long-term exposures at, say, 48-50 to a dollar, when the rupee was below 45.

So, without currency risk management, one may always be at the receiving end.

The author is Professor, Indian Institute of Foreign Trade.

A Beginner’s Guide to Hedging

Although it might sound like something done by your gardening-obsessed neighbor, hedging is a useful practice that every investor should know about. In the markets, hedging is a way to get portfolio protection – and protection is often just as important as portfolio appreciation. Hedging, however, is often talked about broadly more than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Even if you are a beginner, you can learn what hedging is, how it works, and what techniques investors and companies use to protect themselves.

Key Takeaways

  • Hedging is a risk management strategy employed to offset losses in investments.
  • The reduction in risk typically results in a reduction in potential profits.
  • Hedging strategies typically involve derivatives, such as options and futures.

What Is Hedging?

The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event to their finances. This doesn’t prevent all negative events from happening, but something does happen and you’re properly hedged, the impact of the event is reduced. In practice, hedging occurs almost everywhere and we see it every day. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage. Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

Technically, to hedge you would trade make off-setting trades in securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another. For instance if you are long shares of XYZ corporation, you can buy a put option to protect you from large downside moves – but the option will cost you since you have to pay its premium.

A reduction in risk, therefore, will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit you could have made, but if the investment loses money, your hedge, if successful, will reduce that loss.

A Beginner’s Guide To Hedging

Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. We’re not going to get into the nitty-gritty of describing how these instruments work. Just keep in mind that with these instruments, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Let’s see how this works with an example. Say you own shares of Cory’s Tequila Corporation (ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

The other classic hedging example involves a company that depends on a certain commodity. Let’s say Cory’s Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would severely eat into their profits. To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less-regulated cousin, the forward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating commodity.

If the agave skyrockets above the price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and would have been better off not hedging.

Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including a stock, commodity price, interest rate, or currency. Investors can even hedge against the weather.

Hedging is not the same as speculating, which involves assuming more investment risks to earn profits.

Disadvantages of Hedging

Every hedge has a cost; so, before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn’t to make money but to protect from losses. The cost of the hedge, whether it is the cost of an option or lost profits from being on the wrong side of a futures contract , cannot be avoided. This is the price you pay to avoid uncertainty.

We’ve been comparing hedging to insurance, but we should emphasize insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.

What Hedging Means to You

The majority of investors will never trade a derivative contract in their life. In fact, most buy-and-hold investors ignore short-term fluctuation altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market. So why learn about hedging?

Even if you never hedge for your own portfolio, you should understand how it works because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil, while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.

The Bottom Line

Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves. Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.

China launches natural rubber futures

China on Monday started the trading of yuan-denominated natural rubber futures, the technically specified rubber (TSR) 20 futures.

The TSR 20 futures is the country’s fourth commodities futures open to both home and overseas investors after crude oil futures, PTA futures and iron ore futures.

The listed futures on the Shanghai International Energy Exchange are contracts to be delivered from February to July of 2020. The benchmark prices of six contracts were set at 9,260 yuan (1,319 U.S. dollars) per tonne.

The trading margin for each contract was 7 percent of the contract value while sitting at 9 percent in the initial period. The daily trading band is 7 percent up or down from the settlement price of the previous trading day.

On Monday, the most active NR2002 contract was 560 yuan higher than its benchmark price to close at 9,820 yuan per tonne. The total trading volume for six listed contracts on the exchange was 96,702 lots, with a turnover of about 9.6 billion yuan.

Largely produced in Southeast Asian countries like Indonesia and Thailand, the natural rubber TSR 20 is a main raw material for tires.

China has become a major consumer of TSR 20 as the country sees a growing automotive industry, with total import volume of natural and synthetic rubber exceeding 3 million tonnes in the first half of 2020. The whole industry chain has been calling for risk management tools to hedge against price fluctuations.

Jiang Yan, chairman of the Shanghai Futures Exchange, said the launch of TSR 20 trading will promote risk management in related industries using the futures market and form a multi-layer system interconnecting domestic and overseas markets.

The previously-launched natural rubber futures in the Shanghai Futures Exchange mainly reflect the market supply and demand at home, while TSR 20 futures, a good complement, function in the global scope.

In recent years, China has opened more commodities futures to overseas investors and improved corresponding institutional systems and processes, said Fang Xinghai, vice chairman of the China Securities Regulatory Commission, at the launching ceremony.

China’s crude oil futures trading, launched in March 2020, has become the third-largest crude oil futures market globally, with the number of overseas investors surging 121.6 percent year on year.

Fang said TSR 20 is also an important product in bilateral trades between China and Belt and Road countries such as Thailand, Indonesia and Malaysia. China will further open up its commodities futures market to boost the influence of its commodities futures in global price setting.

Global TSR 20 production hit 8.74 million tonnes last year, accounting for 63 percent of the world’s natural rubber yield.

Li Jie with CCB Futures Co., Ltd. said that TSR 20 futures have been listed in commodity exchanges in Singapore and Japan. The launch will link the two with Shanghai through intermarket arbitrage.

“It will attract overseas investors and enhance the international influence of the Chinese commodity futures market,” Li said.

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