Of course, the treasurer must ensure that the timings of foreign exchange inflows match those of outflows. If they do not, payments have to be rescheduled to create the natural hedge. Other foreign currency earnings could be generated by way of interest, dividends, and royalties on investments abroad by corporates. Although the regulations restrict the amount of such investment outflows at present, the move towards capital account convertibility will per force ease these constraints.

CURRENCY DIVERSIFICATION. The basic lesson of portfolio theory, which underlies most of today's finance, is simple: a diversified mix of commodities is less risky than a single commodity. So long as currency movements are not highly correlated, conducting transactions in multiple currencies will reduce the impact of a sudden, and substantial, depreciation in any one currency. Agrees Anil Jaggia, 36, head (trade finance distribution, Asia), Citibank: "To protect their bottomlines, corporates will have to diversify their exposures by borrowing in different currencies, or by importing from different countries."

Sure, the downside of such a strategy is limited, but the upside is truncated as well. The gains of a sudden rupee appreciation vis-a-vis other currencies will be diluted. More subtly, it creates exposures in currencies with which the company may not be familiar. The treasury team will then have to track a host of cross-currency movements to gauge the impact on the rupee. Says Suresh Kumar, 35, the general manager of the Rs 702-crore Ruchi Soya: "If a company has only dollar exposures, it should confine itself to the dollar rather than trading in a third currency. But it can opt for a third currency depending on its appetite for risk." Concurs Yeswant Rao, 46, the deputy general manager of the Rs 982-crore Arvind Mills: "In future, firms will have to choose their borrowing currency carefully."

The Synthetic Hedges

FORWARD CONTRACTS. The simplest of the derivative securities, the forward contract is an agreement to buy, or sell, an asset at a certain time for a certain price. Since forwards--unlike futures--are not traded on exchanges, the only exit option is through the cancellation of the forward cover. To cover its short-term foreign currency obligations, a company expecting the rupee to depreciate can lock in a rate at a specified premium over the current spot rate.

Clearly, the decision to hedge, and the extent of hedging, will depend on the comparison between the current forward premiums and the extent of the depreciation, or appreciation, expected. One of the more famous maxims of economics, the interest rate parity theorem, states that in perfect capital markets, forward premiums mirror interest rate differentials. In the advanced economies, the forward rates are a function of such differentials. In our imperfect, and shallow, foreign exchange market, such premiums have gyrated in response to supply-demand mismatches.

Blame, in part, the restrictions on the money market. For instance, the imposition of a Cash Reserve Ratio (CRR) on inter-bank borrowings caused call market rates to collapse every reporting Friday as bankers scrambled to minimise their liabilities. Fortunately, the Monetary & Credit Policy for the first half of 1997-98 (M&CP, 97) has done away with the inter-bank reserve requirement, paving the way for the evolution of a term money market with varying maturities.

Not only will the emergence of a rupee-yield curve lead to the more realistic pricing of forward contracts, it will also extend the duration of those contracts. At present, although authorised dealers are permitted to offer forward cover for durations upto a year, forward deals that stretch beyond six months are rare. To hedge their long-term exposures, treasurers often have to roll over six-month forwards--a hedging strategy that only partially reduces the exchange rate risk since the forward rate at the time of the roll-over is uncertain. Explains S.S. Kelkar, 57, the executive director of the Rs 1,105-crore Bombay Dyeing: "With increasing liquidity at the far end of the yield curve, corporates will find it easier to manage their long-term foreign exchange exposures."

CURRENCY OPTIONS. While the potential of the upside is limited since forward contracts are tied to a particular rate, options grant the holder the right--not the obligation--to buy or sell the asset at a specified price known as the exercise price. An exporter due to receive deutsche marks (DM) three months from now can hedge against the risk of its depreciation by buying a three-month DM put option. If, contrary to expectations, the DM appreciates, the exporter will not be denied the windfall gains since the option does not have to be exercised. Effectively, the put sets a floor on the DM to be received. Conversely, a company that has to make a DM payment can insure against its appreciation by purchasing DM call options. This caps the cost of the DM to be paid.

Naturally, this flexibility does not come free. Options, unlike forwards, require the payment of a premium upfront. In that lies the explanation for its surprisingly rare use by the Indian treasurer. Complains Hari Mundra, 47, the CFO of the Rs 5,641-crore RPG Group: "Despite their flexibility, options are not a viable alternative because of their large upfront cost." Premiums are fat because the banks that write such options are faced with a paucity of alternatives to hedge their exposure.

Ergo, there are very few players in these markets. The numbers, however, will jump since capital account convertibility will allow corporates and banks to access the foreign exchange and money markets abroad, increasing the hedging possibilities. Further, as a proper rupee yield curve begins to take shape, the banks can price such options more appropriately.

CURRENCY SWAPS. A swap is a simultaneous spot transaction combined with a series of forward contracts that exchanges one set of recurring obligations for another. While forwards and options are essentially short-term tools, the swap enables the CFO to hedge his longer-term exposures. Corporates with ECBs can slough off the foreign exchange risk for the entire life of the loan by simply swapping their foreign currency liabilities for rupee liabilities.

The counter-party to this transaction: corporates that are not able to tap the markets abroad, but are willing to assume the currency risk. Swaps are offered on a routine basis by banks abroad. Here, however, their growth has been stunted. Until the M&CP, 97, allowed dealers to run swap books and offer rupee-foreign exchange swaps without having to obtain the prior approval of the Reserve Bank of India (RBI), there was a virtual ban on swap arrangements. Already, volumes are climbing in response. For example, while the Rs 9,004-crore Reliance Industries and the Rs 3,508-crore ipcl have entered into a five-year swap arrangement, totalling $17 million, in a three-year deal brokered by Citibank, the Rs 1,865-crore bses is swapping a Rs 18-crore rupee liability for a $5-million dollar liability linked to the LIBOR.

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