Case 035Rates and hedgingWarm up

Sitanshu Pharma has a USD 100 million five-year loan and earns mostly in rupees. The rupee weakens 8%. What does that cost unhedged, and how does it compare with a hedge costing 2.5% a year?

The situation

Sitanshu Pharma makes generic formulations for the domestic market and earns almost all its revenue in rupees. EBITDA is Rs 240 crore. Two years ago it took a USD 100 million five-year bullet loan at 6.0% because it looked cheaper than a rupee loan at 8.75%. Assume an illustrative exchange rate of Rs 85 to the dollar, so the loan is Rs 850 crore.

The rupee has just weakened 8%. A bank offers to hedge the principal and interest for the remaining term at a cost of about 2.5% a year.

Your task

Put a rupee figure on the 8% move, compare it with the hedge, and say whether a rupee earner should carry this loan unhedged.

Quick check

The 8% fall adds roughly how much to the rupee value of the principal?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The 8% fall costs about Rs 68 crore on the principal plus about Rs 4 crore a year of extra interest, less than five years of hedging at about Rs 106 crore. But that is the wrong comparison. Hedged, the dollar loan costs about 8.5%, close to the 8.75% rupee rate. Unhedged, Sitanshu saves about 2.5% a year only by betting the rupee will not fall faster than that, and a 20% fall would cost Rs 170 crore.

Step 1What does the 8% move actually cost?

A student who borrows in dollars to study abroad and later earns in rupees feels every fall in the rupee: the same dollar instalment takes more rupees each year. An unhedged foreign loan for a rupee earner is a currency bet stacked on top of a borrowing. Here the principal was Rs 850 crore and now needs Rs 918 crore to repay, a Rs 68 crore loss. Interest of USD 6 million a year also costs about Rs 4.1 crore more each year.

Step 2Is 2.5% a year for the hedge expensive?

On its face it looks dear: 2.5% on Rs 850 crore is about Rs 21.25 crore a year, Rs 106 crore over five years, more than the 8% move cost. The hedge cost is mostly the gap between rupee and dollar interest rates, so a hedged dollar loan costs about 8.5%, almost exactly what a rupee loan costs. That is not a coincidence. The forward market prices in the difference in interest rates, so the apparent saving on the dollar loan was always payment for carrying currency risk.

Hedged, the cheap dollar loan costs about what a rupee loan costsDollar loan, unhedged?6.0% + the rupee's fallDollar loan, hedged8.5%Rupee loan8.75%The 2.5% hedge cost is mostly the gap between rupee and dollar interest rates
Unhedged, the dollar loan costs 6.0% plus whatever the rupee loses; hedged it costs about 8.5%, against 8.75% for a rupee loan, so the dollar loan's cheapness was the price of taking currency risk.
Step 3So should a rupee earner carry it unhedged?

Compare the known cost with the range of unknown ones. Unhedged, Sitanshu comes out ahead only if the rupee weakens by less than about 2.5% a year, about 13% over five years compounded; one bad year can wipe out the whole saving. A 20% fall would add Rs 170 crore, about 71% of a year's EBITDA, and it would arrive when the company can least choose the timing. Pharma exporters have natural dollar income to offset such a loan; a domestic formulator has none.

An 8% move costs less than five years of hedging; a 20% move costs moreRupee falls 8%, unhedged68 on principalFive years of hedge cost106, known in advanceRupee falls 20%, unhedged170, 71% of EBITDAUnhedged, the cost is unknown and lands when the rupee moves
An 8% fall in the rupee adds Rs 68 crore to the loan, less than the Rs 106 crore five-year hedge cost, but a 20% fall adds Rs 170 crore, about 71% of Sitanshu's annual EBITDA.

The view for a credit or syndicate desk: hedge the remaining principal and interest, or refinance into rupees at the next opportunity. The 8% already lost is gone and should not drive the decision; what matters is the next three years of exposure. Check also whether hedging in India on this loan is subject to any reporting or eligibility rules for foreign currency borrowing, and confirm the current framework before executing.

Where candidates lose it

The common slip is comparing the 8% move with the hedge cost and concluding the hedge is not worth it. That compares one outcome with an insurance premium; the question is what the hedge protects against, which includes moves far larger than 8%.

The second is calling the dollar loan cheap. At 6.0% against 8.75% it looked cheaper, but the difference is roughly the forward premium, and the cheapness disappears the moment the currency risk is priced.

What the interviewer asks next

  • Why is the hedge cost roughly equal to the interest rate difference between the two currencies?
  • Would a partial hedge, say 50%, make sense here?
  • How would your answer change if 60% of Sitanshu's sales were exports in dollars?
  • What does a cross-currency swap do that a series of forwards does not?

Company names and figures are illustrative.