Why the Weaker Rupee Did Not Lift the Margin
A Tiruppur garment exporter contracts in US dollars. Over six weeks the rupee moved from Rs 82 to Rs 86 per dollar. The finance director expected a windfall: annual sales are $4 million and the firm's rupee costs are largely fixed.
The result disappointed him. Three things happened alongside the currency move:
- Hedging. $2 million of the $4 million was covered by a forward contract struck at Rs 82.50.
- Price review. The largest buyer invoked a price-review clause and obtained a 4% reduction on the whole $4 million order.
- Imported inputs. 60% of yarn is imported and invoiced in dollars, $1.2 million for the year.
Domestic wages, power and overheads total Rs 18 crore and do not change with the exchange rate.
The managing director wants three things: an explanation of why a weaker rupee did not improve margins, a view on whether the forward cover was a mistake, and a list of what the firm should change before the next contract cycle.
1. Quantify the effect of each of the three channels on annual profit, and reconcile the total with the actual change in profit.
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Before (at Rs 82). Revenue $4m x 82 = Rs 32.80 cr. Imports $1.2m x 82 = Rs 9.84 cr. Domestic Rs 18.00 cr. Profit = 32.80 - 9.84 - 18.00 = Rs 4.96 cr.
After. Revenue with the 4% cut ($3.84m), split by hedge: $2m x 82.50 = Rs 16.50 cr; $1.84m x 86 = Rs 15.82 cr; total Rs 32.32 cr. Imports $1.2m x 86 = Rs 10.32 cr. Domestic Rs 18.00 cr. Profit = 32.32 - 10.32 - 18.00 = Rs 4.00 cr.
Channel decomposition (change vs before):
| Channel | Calculation | Effect |
|---|---|---|
| FX gain on sales | $4m x Rs 4 | + Rs 1.60 cr |
| Costlier imported yarn | $1.2m x Rs 4 | - Rs 0.48 cr |
| 4% price concession | $0.16m x 86 | - Rs 1.38 cr |
| Hedge opportunity cost | $2m x (86 - 82.50) | - Rs 0.70 cr |
| Net | - Rs 0.96 cr |
The reconciliation is exact: 4.96 - 0.96 = Rs 4.00 cr. The headline point: the firm's net dollar exposure was only $2.8m, and a commercial concession priced off the spot rate consumed almost the entire translation gain.
2. Was the forward cover a mistake? Argue the case ex ante (at the time it was struck) rather than ex post (after the rupee moved).
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Not a mistake, but it was mis-sized.
Ex post it looks costly: $2m x Rs 3.50 = Rs 0.70 cr was forgone. But that number is only visible because we know the rupee went to 86. At the time the contract was struck, the true probability of the rupee moving either way was roughly balanced - a firm that hedges every exposure will always "lose" on the forwards in the half of the years when the currency moves in its favour. Judging the policy by one realisation confuses outcome with decision quality.
What is a genuine error is the amount, not the act. The firm's natural position is already short dollars, because $1.2m of yarn is bought in dollars. Net exposure was $4m - $1.2m = $2.8m. Hedging $2m covered about 71% of the net exposure while the treasury team believed it had covered 50% of sales - so the cover was larger than intended and the firm was, in effect, over-insured on a net basis.
The real profit damage came from the price-review clause (Rs 1.38 cr), a commercial term, not from the hedge (Rs 0.70 cr opportunity cost). Fixing the hedge while leaving that clause untouched would repeat the same result next year.
3. Recommend two specific changes for the next contract cycle, and explain the mechanism by which each one protects margin.
Read the worked answer
1. Reprice the review clause rather than delete it. The current clause lets a buyer take 4% when the rupee moves 4.9% (82 to 86) - a full pass-through of the currency move while yarn costs rose only Rs 0.48 cr. Insert an FX trigger (review only if the rupee moves more than, say, 6% against a stated base rate) and a cap on the concession (say 2%), and make the review symmetric so the exporter can re-open price if the rupee strengthens sharply. Mechanism: it breaks the automatic link between spot movement and margin.
2. Hedge net exposure, not gross sales, with matched tenor. Compute the dollar inflow from receivables minus the dollar outflow on yarn ($2.8m today) and cover that, in tranches timed to the actual receipt dates, using forwards for the committed portion and options for the uncertain portion. Mechanism: it removes the currency mismatch without paying to hedge dollars the firm is simultaneously spending.
A supporting third step, if feasible: qualify a domestic yarn supplier so the dollar cost base shrinks. Every rupee of imported input converted to a rupee contract is a permanent natural hedge, not an annual treasury decision.