A new dawn for hedging

Hedging is about doing things that reduce your exposure to bad events. India's transition into a market economy has been accompanied by a new regime of market volatility. Individuals and firms are exposed to volatility in interest rates, currencies, the stock index and commodity prices which is quite unlike that seen in previous decades.

Suppose a person exports garments and is hence exposed to the fluctuations of the dollar-rupee. There are exactly two strategies that he can adopt: speculation or hedging.

He can take interest in currencies, learn about exchange--rate fluctuations, and try to forecast future fluctuations in order to make his own decisions.
He could decide that currency forecasting is not part of his core competence, and he could hedge away this exposure by selling the dollars that will come to him in the future on the dollar--rupee forward market.

The choice -- to hedge, or to speculate? -- appears again and again in the modern economy. A third option, of doing nothing, does not dodge the question; doing nothing is the same as speculating. A person who has unhedged interest--rate exposure is an interest--rate speculator. There was $100 billion of unhedged external debt in Thailand in 1996 -- these firms were betting that the central bank would produce a stable currency. When hedging instruments are unavailable, individuals and firms are forced to become speculators.

Hedging is not a recipe to make money. Hedging is a recipe to reduce risk. Every hedging activity can look smart or look foolish, after the fact, depending on the direction that prices take. Suppose the exporter sells dollars forward on 31 Dec 2000 at Rs.45/$. On 31 Dec, there are exactly two cases: either the dollar will be above Rs.45 or below it. If the exchange rate is at Rs.50/$ on 30 June, the exporter will obtain reduced proceeds from his forward contract as compared with what he might have got on the spot market. In this sense, half of all hedged positions look like ``losses in derivatives trading'' on the day the derivative matures. This induces a feeling of ``post--hedge disappointment'' in the mind of the hedger. Yet, we should not forget that the advantage of the hedge was the elimination of risk -- the hedger was locked into the price of Rs.45, and did not have to pay attention to currency fluctuations thereafter.

Many people get sucked into speculative activities without even noticing the steps leading up to it. Faced with risk, their innate sense of responsibility makes them try to learn more about the source of risk. This knowledge equips them to try to make statements about the future of the market. This emboldens them into assuming speculative positions. There are innumerable CEOs in India today, engaged in exports or imports, who will confidently hold forth on their views about the future of the dollar--rupee. These efforts are doomed to failure.

The modern view of speculative markets emphasises the essentially adversarial nature of speculation. Speculation is a zero--sum game; every winner in speculation is matched by an equal and opposite loser. Most manufacturing companies simply do not know enough to profitably engage in financial market speculation; they are likely to suffer transactions costs and trading losses.

It is useful to think of this as a question of core competence. A garment exporter should cultivate a special expertise in garments. He cannot afford to ``not be a speculator'' on questions concerning garments -- he makes speculative choices about what to produce, how to produce it, distribution strategies, etc. But a garment exporter would be diffusing his efforts if he tried to also be an expert on currency movements. In this sense, the garment exporter is better off hedging away his currency exposure. Adopting currency risk, i.e. speculating on currency movements, is not a core competence for a garment exporter.

Speculation and Hedging on the Equity Market. The stock market offers a most elegant example of the distinction between speculation and hedging, and the appropriate role for each.

Today, in India, we see numerous ``speculators'' on the equity (cash) market. Enormous speculative trading volumes are observed on NSE and BSE. We see individuals who are ``buy ITC'' or ``sell Infosys''. It is useful to go closer to these positions and link them up with the underlying rationale. There are exactly two cases.

  1. Many times, positions on stocks like ITC or Reliance are undertaken while treating the stock as an index proxy. A person is bullish about the ``broad market movement'' and adopts a position in a few highly liquid stocks so as to profit from it.
    In this case, the person is actually an index speculator. His positions of a few stocks are inefficient proxies for the index. Now that index futures are available, his speculation would be more efficiently implemented using the index futures market. The ``buy Nifty'' position is a more efficient bet on the index than a ``buy ITC'' position.
  2. Alternatively, there are people who are truly stock speculators. A person may truly be pessimistic about Infosys, because he has thought about the valuation of Infosys and thinks that the market price is presently too high. In this case, this ``sell Infosys'' position is an inefficient implementation of his view. This is because Infosys could additionally fluctuate because of broad market movements.
    The analysis of Infosys could be right, but the position could yield losses because Nifty rises! The position ``sell Infosys'' combines speculation on Infosys with gambling on Nifty. Until today, stockpickers in India could not escape the Nifty exposure when they worked on valuing stocks. In the absence of an index futures market, every stockpicker in India was forced to be an index gambler.
    There is a superior alternative that's now available -- the position ``sell Infosys'' coupled with ``buy Nifty''. The buy position on the futures market strips out the index exposure that is latent in the stock position. The position ``sell Infosys + buy Nifty'' is a case of hedging in speculation -- the speculator has a core competence in Infosys and has hedged away the extraneous Nifty exposure. The resulting position is less risky, which benefits the speculator and makes the overall marketplace safer.

In this sense, every speculative position on the equity cash market can now be done more efficiently using the index futures market. Index speculators can now directly implement views on the index, without using inefficient proxies. Stock speculators can hedge away their latent index exposure, and hence avoid gambling on the index when they speculate on a stock. In doing so, they obtain less risky positions which are focussed on their core competences.

Online trading, the clearing corporation, and the depository have had a tremendous impact upon the Indian equity market. Yet, their impact has only been upon convenience in trading. Today, trading technology is enormously advanced, but the ideas that underlie trading are as primitive as they were in 1992. Index futures transform the very paradigm of trading. Once a stockpicker gets used to a ``buy BSES + sell Nifty'' lifestyle, he will look back with amazement at the Jurassic markets that existed prior to June 2000, which forced him to buy Nifty every time he wanted to buy BSES.

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