Managing risks is becoming riskier. With the markets in perpetual motion, the costs of transmitting funds from savings to investment have become uncertain. As the South-East Asian Meltdown demonstrated, the insulation of the past will not protect bottomlines in future. So, the CFO of tomorrow needs to deftly deploy sophisticated hedging strategies. BT charts the CFO's guide to managing risk in 2000.

By Gautam Chakravorthy

In any economy, finance is The conduit between savings and investment. Naturally, CFOs have always had to cope with the fact that the cost of such transmission may vary. Indeed, there is nothing new about price variability; what is new is price volatility. Since the mid-1970s, a potent mix of fast-interlocking markets and a revolution in information technology has increased the speed, frequency, and magnitude of price changes in both commodities and financial markets which, in turn, have multiplied both opportunity and risk for the CFO.

Not surprisingly, in the developed capital markets, much innovative energy has been devoted to devising instruments and mechanisms that enable the CFO to survive this turbulence. While creative financial engineering has opened the flood-gates for a deluge of products, two broad classes of risk management techniques have evolved.

The first deploys a natural hedge to manage exposures to risk. Typically, this means explicitly factoring in risk perceptions when choosing the components of the financing mix. Or, to neutralise exposures in a particular market, a natural hedge could involve taking a counter-position in another market. The second class of tools, however, creates a synthetic hedge by utilising specific financial instruments. Notably, derivatives.

While CFOs across the world were honing their risk-management skills, such instruments were not even part of the Indian CFO's lexicon. That neglect may be justified and, perhaps, even cost-effective, in a protected, control-driven economy. But it will lead to competitive suicide in an open market economy. Points out Madhu Pavaskar, 67, a consulting economist: "No corporate can afford to merely sit on its operations in the hope that they will regularly churn out profits. If risks arising out of day-to-day operations are not managed effectively, profitability will be hit."

Agrees Kiran Umrootkar, 50, senior vice-president (treasury), Tata Finance: "While deregulation has provided the corporate with several choices, it has also, in turn, given rise to new risks." True, attempts at risk management have been hampered by a slew of regulations and a lack of availability of financial tools. Markets regimented by restrictions made it difficult and, in some cases, impossible to take hedge positions. Further, such segmentation hobbled the ability of the financial intermediaries to write rupee-based derivative products.

If deregulation creates volatility, it also equips the CFO with a tool-kit to manage it. So, as India Inc. learns to cope with a rapidly-changing environment in which prices, interest rates, and exchange rates are fluctuating, what hedging strategies will provide buffers to the bottomline? And what instruments can be deployed in this effort?

The CFO's Need:
Minimising The Foreign Exchange Outgo Caused By The Movement Of Exchange Rates

Any transaction of the company in a currency other than the balance-sheet currency leads to foreign exchange exposure. Naturally, the move away from the virtual autarky that cocooned the economy for over four decades has multiplied these exposures. And since the value of the rupee is now a variable, the risks have multiplied. Observes A.V. Rajwade, 61, a foreign exchange consultant and a member of the Tarapore Committee on capital account convertibility: "Currencies are fast becoming commodities."

The growth of such exposures, and risks, will only accelerate. The dismantling of non-tariff barriers to meet the World Trade Organisation norms and the phased reduction in customs duties will boost international trade as a percentage of Gross Domestic Product: at 23.10 per cent already as compared to 16.20 per cent in 1990-91. With full convertibility by 2000, companies will have greater access to the financial markets abroad. Sure, for blue-chip companies seeking debt capital for either working capital or project financing, External Commercial Borrowings (ECBs) at the London Inter-Bank Offered Rate (LIBOR), plus 50-100 basis points are cheaper than domestic borrowings. But given the inflation differential of 5-plus per cent between India and the developed world, the rupee will depreciate over the medium to the long term, implying that the cost of servicing external debt will rise.

The Natural Hedges

EXPORT, AND OTHER, EARNINGS. Since the impact of exchange rate fluctuations on exports is the opposite of that on imports and foreign currency borrowings, export earnings are a simple, but powerful, hedging tool. Declares P.B. Desai, 52, the vice-president of the Rs 422-crore United Phosphorus: "The prospects of a falling rupee do not perturb us as we have a natural export hedge of Rs 150 crore."

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