CFO's 24-Month Hedge and a Net-Written Option Structure
Kaveri Engineering has documented USD payables of USD 12,000,000 spread evenly over the next 12 months, plus a further USD 10,000,000 of forecast payables in months 13 to 24 that are not yet contracted. The rupee has weakened from 82.10 to 83.60 in three months and the CFO wants to act now. Market data: spot 83.60; 12-month forward 84.90; 12-month USD call struck at 84.90 at a premium of Rs 1.60; 12-month USD call struck at 87.00 at Rs 1.60, so a 84.90/87.00 collar is zero-cost. The CFO proposes selling USD 15,000,000 of 12-month 87.00 calls to collect Rs 2.40 crore and buying USD 12,000,000 of 84.90 calls for Rs 1.92 crore, arguing 'the rupee cannot cross 87 in a year'. The board policy caps tenor at 12 months, permits bought options only, forbids net written options, and requires hedges to be supported by documented exposure.
1. Identify the policy and exposure problems in the proposal and quantify the downside if spot is 91.00 at expiry.
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Three distinct breaches:
- Net written options. Selling USD 15,000,000 of calls while buying only USD 12,000,000 leaves USD 3,000,000 of naked short calls, which the policy forbids outright.
- Tenor. The structure is a 12-month instrument, so the 13-24 month forecast payables are not hedged at all - the CFO believes he has covered 24 months, but he has not.
- Exposure support and motive. Hedging a 24-month forecast with a 12-month option and funding it by selling more notional than the documented exposure is a view on the rupee, not a hedge.
Downside at 91.00: the naked USD 3,000,000 loses (91.00 - 87.00) x 3,000,000 = Rs 1,20,00,000. Net of the Rs 48,00,000 credit (Rs 2.40 crore collected less Rs 1.92 crore paid) the loss is Rs 72,00,000. On the covered USD 12,000,000 the effective cap is 87.00 - 0.40 = 86.60 and the effective floor 84.90 - 0.40 = 84.50, both far worse than the 84.90 forward available today.
2. Explain the accounting consequence of the proposed structure and why it matters for reported earnings.
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Under Ind AS 109, a written option does not generally qualify as a hedging instrument because it does not reduce risk - it creates it - unless it is designated as an offset to a purchased option. A structure that funds a bought call by writing a larger call therefore cannot be designated as a clean cash-flow hedge of the payable. The bought call may be designated, with its intrinsic value hedging the exposure and its time value deferred in other comprehensive income as a cost of hedging; the written call, being ineligible or ineligible in part, is measured at fair value through profit or loss.
The result is the worst of both worlds: the board believes the payables are hedged, while a rising USD/INR drives a mark-to-market loss on the written call straight into the P&L each quarter, with no offsetting hedge reserve. Effectiveness testing on a structure whose notional exceeds the designated exposure will also fail prospectively. For a listed company the earnings volatility, not just the cash loss, is the issue - and it will surface precisely in the scenario the CFO thinks is impossible.
3. Recommend a compliant alternative with numbers.
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Stay inside the 12-month, bought-option-only limits and keep the notional equal to documented exposure:
- Option A - pay the premium: buy USD 12,000,000 of 84.90 calls for Rs 1,92,00,000 (1.9% of the rupee notional). Floor is 84.50 all-in and the upside below 84.90 is fully retained. This is a known, budgetable cost.
- Option B - zero-cost collar sized correctly: buy USD 12,000,000 of 84.90 calls and sell USD 12,000,000 of 87.00 calls, net premium nil. Effective floor 84.90, cap 87.00, no naked exposure and a clean 1:1 hedge ratio that can be designation-tested. The cost is the forgone upside above 87.00.
- For months 13-24, run a rolling programme that starts hedging when the exposure becomes contracted, or use the policy-permitted forecast facility with the treasurer reporting monthly.
Recommend B on cost grounds and A if the board will not accept a cap at 87.00. Either way, the decision should go to the risk committee with the worst-case numbers written down, not rest on a forecast that the rupee 'cannot' cross a level.