Importer with a Cancellable Order: Forwards vs Calls Under a Budget Rate
Surya Polymers Ltd imports PVC resin and holds a confirmed purchase order for USD 2,000,000 payable in three months. The supplier has a 30-day renegotiation window, and procurement estimates a one-in-three chance that the ordered quantity will be cut by 40%. Treasury has no USD receivables to net against. The board policy permits forwards only on confirmed exposures, sets a hedge-ratio band of 60-100%, and allows options on quantities that may still change. Today's market: spot USD/INR 83.80; three-month forward 84.40; three-month USD call struck at 83.80 quoted at a premium of Rs 0.90 per USD; six-month forward 84.95. The CFO's budget rate for this order is Rs 84.50 all-in, and the board has asked that no hedge be capable of breaching that budget on its worst-case cost. Surya has no other USD cash flows and borrows INR at 8.5%.
1. Compare the all-in rupee cost of hedging the full USD 2,000,000 with (a) the three-month forward and (b) the 83.80-strike calls. Which one survives the Rs 84.50 budget test, and by how much?
Read the worked answer
Forward leg: 2,000,000 x 84.40 = Rs 16,88,00,000, i.e. Rs 84.40 per USD. Against the budget of Rs 84.50 the saving is 10 paise per USD, or Rs 2,00,000. The cost is fixed and certain.
Option leg: premium 0.90 x 2,000,000 = Rs 18,00,000 paid upfront, which is 0.9% of notional. Worst case all-in = 83.80 + 0.90 = Rs 84.70, i.e. 20 paise above budget (Rs 4,00,000 worse). Upside is retained: if spot at expiry is 82.50, all-in = 82.50 + 0.90 = Rs 83.40.
Judgement: on the strict budget test only the forward passes. But the forward's 'saving' is Rs 2,00,000 while the option premium is Rs 18,00,000 - the two are not comparable in risk terms. The forward also converts a cancellable commercial decision into a firm financial obligation. The budget test should not settle the question while 40% of the quantity is still negotiable.
2. Recommend a hedge split. Show the blended worst-case rate and check it against the budget.
Read the worked answer
Hedge the firm 60% with the forward and the uncertain 40% with calls, which is exactly the policy intent.
- Forward: USD 1,200,000 x 84.40 = Rs 10,12,80,000.
- Calls: USD 800,000 at 0.90 = Rs 7,20,000 premium; worst case 83.80 + 0.90 = 84.70 on that slice.
- Blended worst case = (1,200,000 x 84.40 + 800,000 x 84.70) / 2,000,000 = Rs 84.52.
The blended worst case is 2 paise over the Rs 84.50 budget, so the structure needs one adjustment: either shift to 70/30 (blended 84.49), or buy the option slice at a lower strike where the premium is smaller in rupee terms, or accept a Rs 40,000 overrun as the price of flexibility. Note the asymmetry: below 83.80 the option slice keeps improving while the forward slice does not, so the expected cost is below 84.52. The cancellable 40% must never be forward-covered; that is the discipline the policy is protecting.
3. Six weeks later the supplier cuts the order and treasury cancels USD 500,000 of the forward. The three-month forward is then 83.10. Quantify the cancellation and state the lesson.
Read the worked answer
Cancellation economics: treasury contracted to buy at 84.40 and the market is now 83.10, so the contract is out of the money for the customer by 1.30 per USD. The bank will close it out by charging the difference: 1.30 x 500,000 = Rs 6,50,000, payable by Surya. Had the market moved to 85.00, the bank would have paid Surya 0.60 per USD - cancellation is a two-way mark-to-market, not a free release.
Note the Rs 6.5 lakh loss is real cash and completely separate from the Rs 7.2 lakh premium already spent on options. The forward was supposed to reduce risk; because it was sized to a quantity that could disappear, it added a new exposure - the risk that the rupee strengthens before the cancellation.
Lesson: hedge ratio discipline exists to cap exactly this. A forward on a cancellable quantity is a speculative position dressed as a hedge, and its true cost is only visible at cancellation. Cancel and rebook requests should also be logged and reviewed by the board-level policy owner, not treated as routine treasury housekeeping.