A 6.5% Forward Premium Against a 10% Depreciation View
A textile exporter invoices in US dollars. Annual exports are USD 96 million, of which USD 58 million is matched by imported cotton and machinery spares, giving a natural hedge. The remaining USD 38 million is unhedged. The twelve-month forward premium is quoted at 6.5% annualised, reflecting the interest rate differential (policy rate 19%, USD rates around 5.3%). The CFO expects the rupee to depreciate by 10% over the year and wants to stay unhedged to capture the gain. The company also carries a PKR 3.0 billion floating-rate term loan at 3-month KIBOR plus 250bp; KIBOR is 20.9% and the loan amortises 20% a year over five years. A European customer has issued a letter of intent for a USD 12 million order that depends on a tender result due in four months. Treasury policy requires hedging of 50-80% of firm committed exposures, prohibits speculative positions, and requires Board approval for derivatives with tenors over 12 months.
1. Is an unhedged stance consistent with policy? Show the exposure arithmetic, the required hedge range, and explain what the forward premium does and does not tell you.
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Exposure. Gross USD 96m less natural hedge USD 58m = USD 38m net. The natural hedge covers 60%; the residual 40% is where the risk lives. Policy requires hedging 50-80% of firm committed exposure, so the required range is USD 19m to USD 30.4m. A zero hedge is a policy breach and a speculative position, whatever the outcome.
What 6.5% means. Forward points are the market's price of the interest rate differential (19% vs ~5.3%), not a forecast of depreciation. Selling dollars forward at a 6.5% premium is not 'giving up' 6.5% of value - it is the price of certainty, and it already embeds most of the carry the CFO hopes to earn.
The bet, stated honestly. If the rupee falls 10%, hedging costs about 3.5% of hedged notional relative to doing nothing - an opportunity cost. If the rupee is flat or appreciates 5%, the unhedged position loses 6.5% to 11.5% of notional. The CFO is being paid a small expected edge for carrying a large variance. That may even be a good trade - but it is a trade, and only the Board can authorise it, in writing, with a stated limit and a review date.
Framing that usually settles the argument. Take the product margin (say 8%) and ask what a 10% adverse move does to the unhedged slice: it wipes out more than a full year of profit on that slice. Hedge ratios should follow the certainty of the exposure and the margin at risk, not the direction view.
2. How should the USD 12 million letter of intent be treated in the hedging programme?
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A letter of intent conditional on a tender is not a firm commitment. Hedging it with forwards is the classic trap: if the tender is lost, the company is left holding an open forward that is itself a speculative position - and it will be marked against P&L at the worst possible moment.
Options, in order of preference:
- Record only. Put it in the FX exposure register as a contingent exposure with a note on the tender date, and hedge nothing. This is policy-compliant and requires no approval.
- Options, if the policy allows them. A purchased USD put (right to sell USD) with tenor matching decision date plus settlement gives protection without obligation. Premium is the cost of optionality and must be budgeted and disclosed, not netted against an expected gain. Do not fund it by selling a call unless the Board understands the resulting cap.
- Probability-weighted partial hedge with options only - for example 60% probability × 80% hedge ratio × USD 12m ≈ USD 5.8m. This requires a policy amendment; forwards must never be used on a contingent exposure.
Two checks before any of this. Is the tender price fixed in USD, or does it allow a PKR adjustment that shifts the currency risk to the buyer? And does the letter of intent survive a change in specification or volume? Both may reduce the true exposure well below USD 12m. Also note the tenor: an option running past 12 months needs Board approval under current policy.
3. Advise on whether to fix the term loan with a swap, buy a cap, or leave it floating. Quantify and show the reasoning.
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Current cost, year 1: PKR 3.0bn × 23.4% (20.9% KIBOR + 250bp) = PKR 702m. A 5-year fixed swap quoted at 21.5% gives 23.75%, or PKR 712.5m - about PKR 10.5m (35bp) a year for certainty.
Four tests before locking:
- Revenue correlation. USD-linked revenue means a weaker rupee raises PKR cash flow, which partially offsets higher KIBOR if both are driven by the same macro pressure. Check whether that correlation has actually held - if it is unreliable, the hedge is more valuable, not less.
- Tenor and amortisation. The loan falls 20% a year. A bullet 5-year swap on PKR 3.0bn would leave the company over-hedged and paying fixed on debt that no longer exists - a new speculative position created by the hedge itself. Use an amortising swap matched to the repayment schedule, or laddered caps.
- Absolute level. Locking 23.75% for five years at a historically high rate converts a rate view into a permanent cost. Defensible if interest cover would otherwise fall below the covenant; indefensible if management is simply forecasting a cut.
- Asymmetric exposure. A cap at, say, 22% KIBOR for three years costs premium but keeps the benefit if rates fall - better matched to a 5-year exposure whose revenue backdrop is uncertain.
Recommendation: hedge the first three years' amortising notional, using a swap or a cap, and retain floating on the tail; document the hedge objective in terms of interest cover or DSCR, not the rate view; obtain Board approval because the tenor exceeds 12 months. If the cap premium is unaffordable, a zero-premium collar is acceptable only if the Board explicitly accepts the floor it sells.