V K Sharma: Financial market volatility and the risk management
imperative
Address by Mr V K Sharma, Executive Director of the Reserve Bank of India, at the
Bangalore Chamber of Industry and Commerce, Bangalore, 5 January 2012.
* * *
The views expressed are those of the author and not of the Reserve Bank of India.
1. First of all, I would wish to thank Bangalore Chamber of Industry and Commerce for
giving me this honour and privilege to address this very distinguished and august audience. I
must congratulate and compliment Bangalore Chamber of Industry and Commerce (BCIC)
on conceiving, and organizing, this contextually, and topically, most appropriate and relevant
Interactive Session on Forex Risk Management. What with the cataclysmic and apocalyptic
events like the US downgrade and Eurozone sovereign debt crisis overwhelming the world
and India, the year 2011 was characterized by unprecedented and excessive volatility in
asset prices and currency values, catapulting the critical imperative of Risk Management to
the centre-stage like never before. Against a financial backdrop as somber, traumatic,
portentous and sobering as this, today's event has come not a day too soon!
2. To be honest, I am also impressed, no less, by just the right focus, emphasis and
clarity in the Preamble, Objectives and Key Takeaways of today's Interactive Session, as set
out by BCIC in their circular! However, if only to reinforce the context of today's Interactive
Session, I would like to share with this learned and discerning audience the commonalities
between the crisis of 2008-09 and the current one. Specifically, the rupee depreciated
against the dollar by about 24% between March 2008 and March 2009 (Rs.39.80 to
Rs.52.20) with the volatility doubling to about 12% (as measured by annualised standard
deviation of daily percentage changes). And during the current crisis, the rupee depreciated
by almost 18% in less than 6 months between August 5 and December 15, 2011, with the
volatility almost doubling from about 5% to 12%. Equally deserving of the attention of this
learned audience is the fact that since March 2010 to date, the Reserve Bank hiked key
policy rates 13 times, raising the effective policy rate from 3.25%, (the effective rate then
being the Reverse Repo Rate) to 8.5% (the effective rate currently being the Repo Rate),
resulting in a cumulative tightening of 5.25% in a matter of a little over 1-1/2 years! Equally
significantly, global commodity prices have been just as volatile since the crisis of 2008;
crude prices, after rising steeply to US $ 147 per barrel in July 2008 and then falling
precipitously to $ 32 per barrel in December 2008, have risen from US $ 32 to around
US $100 now! The reason why I have broadened the canvas to also include interest rates
and commodities is to approach the subject matter of Generic Financial Risk Management
holistically, as it is not just currency risk alone, but interest rate and commodity price risks
just as much, that represent significant sources of risk not just to businesses themselves but
equally to financing banks and thus potentially to systemic financial stability!
3. In an increasingly globalised trade and investment environment, business and
industry have inevitably to contend with, and manage, not just their normal core business
risks, but also financial risks like foreign exchange, interest rate, and commodity price risks.
While it will be presumptuous on my part to even contemplate, much less attempt, telling this
learned gathering how to manage their normal business risks, I do consider it my dharma to
attempt shining light on financial risk management, comprising foreign exchange, interest
rate and commodity price risks.
4. Before I proceed further, I would like to put the subject matter of Financial Risk
Management in appropriate perspective. Risk Management is not about eliminating , or
which is the same thing as completely hedging out, risk but about first determining , like
one's pain threshold, risk tolerance threshold and then aligning an entity's existing risk, be it
currency, interest rate or commodity price risk, with its risk tolerance threshold. Having said
that, it would also be in order to have a sense of how risk itself is defined and measured.
Risk is uncertainty of future outcomes such as cash flows. In finance theory and practice, it is
typically measured by annualized standard deviation of a time-series of percentage changes
in asset prices. While courting financial risks in pursuit of financial return is the staple and
dharma of banking and finance industry, it is not so for industrial and manufacturing
businesses! The staple and dharma of business and industry is courting their normal core
business risks in pursuit of delivering a market-competitive return on equity to shareholders.
5. I turn now to the subject-matter proper of financial risk management. I propose to
deal, in some detail, with the specifics of risk management strategies for hedging foreign
exchange, interest rate and commodity price risks. I would very strongly encourage business
and industry to invariably hedge their actual risk exposures without exception as a base-case
strategy. To say the least, this is by far the most conservative and prudent strategy. Indeed,
in the background of the measures announced by the Reserve Bank of India on December
15, withdrawal of the facility of cancelling and rebooking of forward contracts leaves no other
option but to follow the base-case strategy. But as this learned and discerning audience will
readily recognize, the excruciating and wrenching volatility, experienced recently,
unquestionably attests to the credentials of such a base-case strategy of being fully hedged.
Of course, it does mean that risk is being completely eliminated and, therefore, so is being
financial return. But then, this is just as well because, as I said before, this is not the dharma
of business and industry whose cardinal principle it must be to earn their market-competitive
return on equity from their normal core business risks only to the complete exclusion of
foreign exchange, interest rate and commodities price risks!
6. As regards forex risk exposure of business and industry, I would like to take this
distinguished audience back in time to the late 1990s when the Indian corporate sector went
in for large scale ECBs. These ECBs were almost completely for domestic rupee expenditure
and were mostly un-hedged and LIBOR-linked-floating-interest-rate based. Indeed, so also
was the case with the corporates in Thailand and Indonesia which became repositories of
unhedged currency and interest rate risk exposures creating credit risk for the domestic
banks. The saving grace was that, unlike in East Asian countries, ECBs by corporates in
India were subject to overall limits under Automatic and Approval routes. I am sure the
distinguished audience would recall that such un-hedged and floating-rate-based foreign
currency exposures culminated eventually into the now-all-too-familiar apocalyptic
denouement, entailing forex losses in India and the East Asian Currency crisis in India's
neighbourhood! I would, therefore, very strongly commend that business and industry be not
tempted and enticed by nominally low interest rates and invariably rigorously evaluate such
foreign currency borrowing options, benchmarking them against the comparable rupee
borrowings. Only if business and industry find the long-term foreign currency borrowing costs
are lower, on a fully-hedged basis, than the comparable rupee borrowing costs, must they
choose such borrowing options! I also regret to have to say that the current popular, but
uninformed and totally untenable, refrain has been that forward cover for foreign exchange
for longer term such as five years, or so, is not available; what is available is out to one
month, three months, six months and maximum one year and not beyond. But I would like to
enlighten the discerning audience here that a long-term forward foreign exchange hedging
solution can be easily customized by banks by recourse to what is known as rolling hedging
strategy which simply involves simultaneously cancelling, and rebooking, a short-term
forward exchange contract until the desired long-term maturity. Incidentally, such
simultaneous cancellation and rebooking of forward contracts for rollover is exempted from
the RBI restrictions introduced on 15th December, 2011. Of course, precisely the same
strategy can be replicated in the exchange-traded foreign currency futures markets as well.
Contrary to the popular perception, this strategy is fairly simple and perfectly do-able and
locks in the original starting spot exchange rate. What, in other words, this entirely
unexceptionable, and highly desirable, strategy does is substitute volatility of the spot
exchange rate with that of forward margins at each roll over date. It is empirically, and
anecdotally, established that volatility of forward margins is far less onerous than that of the
spot exchange rate. Therefore, I would very strongly encourage business and industry to
routinely avail of this hedging solution both to cover forex risk of long-term imports and
longterm foreign currency borrowings.
7. I turn next to the other very popular foreign currency funding option, namely, Foreign
Currency Convertible Bonds (FCCBs). I must confess that I have been very intrigued by what
I have read in business and finance newspapers. The sense that I got was that corporates
use FCCBs to raise long-term fixed rate foreign currency funds hoping that overseas
investors will exercise the option embedded in FCCBs and convert into equity! And precisely
for this reason, it has been noticed that corporates do not make provision of domestic rupee
and foreign currency resources!! In fact, such basic motivation underlying the FCCB-based
funding strategy is completely antithetical to both corporate finance theory and international
practice and turns the entire rationale of such funding strategy on its head! This is because
the very raison d'être of FCCB funding option is to lower borrowing costs below that of an
otherwise comparable plain- vanilla non-convertible foreign currency bond. The short point is
that the FCCB borrower is baiting the overseas investor with an equity option
kicker/appetizer, embedded in an otherwise comparable plain- vanilla non-convertible bond.
Effectively, in this structure, overseas investor in FCCB purchases an embedded option and
pays an option premium in the form of lower coupon on FCCB. I hardly need belabor the
point that equity is always more expensive than debt capital of whatever kind, including even
junk / high-yield bonds! So I would urge business and industry to fully provide domestic
rupee/foreign currency resources to meet potential liability under FCCBs, rather than hope
that FCCBs will be converted which, in fact, if anything, can be the case of overseas
investors, but certainly not, of issuers of FCCBs!
8. Although as serious as foreign exchange risk, interest rate risk has not compelled as
much attention in the Indian debt market space. If only to have a sense of how significant,
and serious, it can be, I invite your attention to what I said about the key policy rates rising
cumulatively by 5.25% since March 2010 to date! Just like unhedged foreign currency
exposure, long-term floating rate loans represent a source of significant risk not only to
businesses themselves, but equally to financing banks as they transfer interest rate risk from
lenders to borrowers, effectively substituting interest rate risk of lenders with potential credit
risk in terms of creating potential non-performing loans! At another level, as fixed rate loan
has more certainty, and hence less risk, both for borrower and lender, it should be preferred
both by borrowers and lenders alike. Thus, for interest rate risk management, the base-case,
risk-neutral strategy, is invariably fixed rate long-term funding by corporates. Contextually,
the current popular refrain in the policy debate is that absence of a competitive, liquid, deep
and efficient corporate bond market has been the undoing of infrastructure financing which
typically involves long-term fixed rate funding. And as to why banks cannot make long-term
fixed rate infrastructure loans, the stock refrain is that this will create asset liability mismatch
in banks' balance sheets as their liabilities are mostly short-term. Even then banks have a
combined infrastructure loan portfolio of about Rs.6 trillion (US $ 110 bn), representing about
9% of the total bank assets in India of Rs.71 trillion (US $ 1.35 trillion). As against this,
corporate bond market is around Rs.9 trillion (US $ 170 bn). But this common and popular,
but again uninformed and counter-intuitive, refrain that banks cannot fund long-term fixed
rate infrastructure assets is untenable in that banks have not thought of using a very "vibrant"
Interest Rate Swap (IRS) market, where outstanding notional principal amounts aggregate
Rs 60 trillion (US $ 1.14 trillion) (almost 82% of total banking assets in India as also of the
nation's GDP)! For banks can easily transform their short term liability into a long-term fixed
rate one and thus create a synthetic long-term financing solution for long gestation
infrastructure projects by doing the following:
(i) Receive fixed rate for one year and pay floating overnight rate in the IRS market.
(Assuming banks' average liability is about one year).
(ii) Receive floating overnight rate and pay 5/10-year in IRS market. This effectively
synthetically transforms a one-year floating rate liability of bank into a synthetic
5/10year fixed rate liability. By loading margin over this rate, banks can make a
5/10year fixed rate loan to an infrastructure company. And, significantly, considering that
IRS trades about 140 to 150 basis points below sovereign yield, it is win-win for both
banks and infrastructure companies who, even after bankers' spreads/ margins, will
be able to borrow at around 5/10 year Govt. bond yield (currently 8.40%). That is as
simple as it can get in terms of creating two-in-one fixed-rate long-term
marketbased financing solutions for infrastructure.
Incidentally, another uninformed and untenable, refrain against use of IRS market is that this
strategy entails "basis" risk and "liquidity" risk. It has been established that there is a
statistically significant and positive correlation between one year IRS rate and one year bank
deposit rate of 0.75 which will improve further to near perfect level of 0.90 to 1 once this
strategy is actively engaged in. As regards "liquidity" risk, banks have never so far
experienced this and will not as their deposits have grown by 18%-plus every year. Indeed,
large corporates, can themselves do it in-house by accessing the Rupee Interest Rate Swap
Markets. As I said before, corporates must treat fixed rate long-term funding as the
basecase, or risk-neutral, strategy. Considering that the five year OIS (Overnight Indexed Swap)
have traded about 1% to 1.5% below the corresponding maturity government bond yields,
corporates can, and should, swap their short-term floating-rate loans into fixed rate long-term
loans and yet pick up the above negative yield spread, effectively borrowing long-term funds
much more cheaply than perhaps would be the case if they were to borrow either from
banks, or for that matter, from the corporate bond market. This is totally risk free arbitrage
strategy corporates can, and must, engage in. Of course, when this starts getting done on a
large scale as it indeed should, but has not so far happened, such negative yield spreads will
automatically be arbitraged away. In fact, CFOs in corporates must routinely compare the
two fixed rate long-term funding options to continually assess if they can borrow fixed rate
long-term funds cheaply by borrowing in the short term market where they might have a
comparative advantage. But the reverse viz., corporates borrowing fixed rate long-term and
swapping loan proceeds into overnight floating rate funds must be scrupulously avoided.
Nothing supports this better than the recent period of tightening cycle which caused
overnight floating rates to go up from 3.5% in March 2010 to 8.5% in October 2011 i.e.,
effective cumulative rise in overnight interest rates of 5%! Having said that, it is both
counterintuitive, and disturbing, to note that some corporates have consistently been "receiving
fixed" and "paying floating"! What this means is that corporates have been speculating by
courting interest rate risk by paying "overnight floating rate" and receiving "fixed rate". Why I
say this is for the reason that if corporates first borrowed fixed rate long-term funds and then
swapped them into overnight floating rate, then they are exposed to interest rate risk
because of 5% increase in interest rates. On the other hand, if they speculate in IRS market
without any underlying exposure in the fixed rate long-term loans, then they will obviously be
paying overnight and receiving OIS fixed rates and, therefore, they lose both on the floating
rate side as also on the fixed rate side because during the same period, five year OIS rates
also increased, though only, by 0.6%. We thus see if they have speculated in interest rate
markets, rather than hedge, they have lost both ways any which way one looks at it! What I
have said about management of rupee interest rate risk applies just as much to floating rate
Libor-linked long-term foreign currency loans as well and I would, therefore, strongly
commend to business and industry to go in for interest rate swap-enabled fixed rate
longterm financing both in domestic and foreign currencies.
9. As regards commodity prices, business and industry can use international
commodity exchanges to hedge dollar price risk, and domestic commodity exchanges to
hedge rupee price risk. In fact, whenever some commodities, like crude oil, are in
backwardation (the futures price being lower than the current spot price), in addition to
buying price protection, business and industry also earn what is known as "rolling", or
"convenience", yield.
10. By now, I am sure this learned audience must have got a fairly good sense of the
repertoire of derivatives to choose from in management of financial risks business and
industry need to contend with day in and day out. However, as regards derivatives, I would
like to quote Financial Times Columnist Wolfgang Munchau and Warren Buffett who
famously described derivatives "as probably the most dangerous financial products ever
invented" and "financial weapons of mass destruction", respectively. I would beg to differ
because, to my mind, they are as strong statements as saying that cars and driving are most
dangerous because they might lead to accidents! The problem is not so much with
derivatives, or with cars, for that matter, but with how we use them!! In this context, as this
distinguished audience is well aware, there have reportedly been massive derivatives-related
losses incurred by business and industry in India. These losses arose primarily because
derivatives were used by business and industry not for hedging, but for speculative,
purposes. As reported in the media, huge losses were sustained by business and industry on
account of complex structured and synthetic, but so much less transparent, derivatives. In
other words, business and industry must go in for plain vanilla derivatives which upfront,
transparently, and explicitly, disclose cost of hedging strategy rather than arcane, complex,
synthetic and structured derivatives which camouflage risk. As regards prudent use of
derivatives, the touch-stone that business and industry can use with profit is that any
derivatives strategy which promises reduction, or elimination, of hedging cost, or promises
enhancing income, is intrinsically speculative and the one that involves incurring hedging
cost and promises no income enhancing is intrinsically a hedging strategy.
11. To sum up, such is the insidiousness of risk that its under-pricing is perceived as
low, or no risk, and, therefore, economic agents including banks, business and industry are
caught unawares and unpleasantly surprised when risk suddenly eventuates. Therefore, to
my mind, nothing conveys and expresses the Risk Management mantra more trenchantly
than the following: "Just as you make friends when you don't need them, not when you need
them and certainly not after you need them, so also you hedge when you don't need it, not
when you need it and certainly not after you need it". Complete internalization and ingraining
of this holistic risk hedging culture, attitude and temper by business and industry will, in
equilibrium, reduce cost of both debt and equity capital by reducing volatility of ROE as
markets will perceive them as much less risky and more safe! If I have succeeded in alerting
and sensitizing the learned and discerning audience to the Financial Risk Management
imperative enough, I will feel vindicated that I have delivered on my dharma today. And, I
have no doubt, if business and industry completely internalize and ingrain this mantra and
dharma, they will exemplify the following fairy tale ending viz. "And they lived happily ever
after"! Finally, with the fond hope that I have not unwittingly come across as pontificating on
the mantra and dharma of Financial Risk Management, I conclude my address and going
forward wish business and industry a truly blissful Risk Management nirvana!
12. Thank you all so very much indeed!!