Faced with rising competition and thin margins in a quota free era, Sri Lankan exporters are turning to sophisticated hedging instruments to gain a competitive edge

Faced with rising competition and thin margins in a quota free era, Sri Lankan exporters are turning to sophisticated hedging instruments to gain a competitive edge. Faced with rising competition and thin margins in a quota free era, Sri Lankan exporters are turning to sophisticated hedging instruments to gain a competitive edge. Sri Lankan apparel exporters usually invoice sales in dollars, since raw materials, most of which is imported, are also costed in dollars.

Exporters also take loans in dollars, so most of their liabilities are also in dollars.

Until recently, Brandix, a top Sri Lankan apparel exporter, invoiced all their sales in dollars. Their books are also dollar based.

To fix a price in another currency is to exposes the firm to an unacceptable exchange risk, especially in a long-term contract where wide cross currency movements can occur.

“We give a pricing to our buyer based on a particular parity between two currencies,” explains Kishan Jayasekera Group Treasurer of the Brandix.

“Now if it moves against us, all the hard work we have done, could be lost on the exchange, because pricing has to be so competitive specially in the post quota era,” Jayasekera told our sister programme The Money Report.

But this year, Brandix started invoicing in Sterling Pounds, because a buyer did not want to take on the exchange rate risk.

Brandix’s treasury had to run the risk in Colombo, and manage the exchange risk on behalf of the buyer, or risk losing the buyer to someone who could.

In effect, Brandix is now selling both clothes and exchange cover.

Brandix decided to hedge the foreign exchange risk using a series of forex derivatives, based on its own view of the expected currency movements during the period of the contract.

“In order to protect the exchange rate volatility that arises from the sterling-dollar cross rate, Brandix entered into this transaction and protected their gross profit margin,” says Kenneth de Zilwa Head of Treasury Sales, at HSBC in Colombo, which structured the deal.

“They bought protection at one level and sold an option at a higher level.”

First, Brandix sold a call option at one rate, which gave the right to the counterparty who bought the option, to buy Sterling at one rate (say 1.95 dollars to a pound), and used the money to buy a put option (say 1.85 dollars to a pound), which gave the right to sell in case Sterling fell below or neared, Brandix’s break-even point.

The seller of an option receives a premium, because he has an obligation to make good the losses of the buyer and is running a risk.

But since Brandix is getting the Sterling anyway, it has the underlying asset to cover the call option in case the buyer exercises the option.

At that level it is already getting more dollars for its Sterling than Brandix needs, so it is quite happy to sell.

The money from the call option also covers the costs of HSBC Bank, which arranged the deal, so Brandix did not have to pay anything.

For this to happen, a knockout built into the transaction, which voided the entire deal in case the Sterling fell very much further than expected and limited the risk of the counterparty of the put option.

“That is basically to fit Brandix’s view of the particular currency movement,” says de Zilwa. “So Brandix could get the deal at zero cost.”

Until now, most Sri Lankan firms would have gone for simple hedging instruments like forward bookings. But forwards can be expensive and leaves the buyers locked into one price.

“You can avoid this situation and actually gain if the markets move in your favour by even after hedging yourselves by using derivatives like options,” says Dudeepa Ratwatte, from the financial house First Capital which is trying push derivative usage in the country.

But not every Sri Lankan corporate has very definite views on exchange movements, or has staff that understands the complexity of derivatives transactions.

Many chief financial officers of firms, have an accounting background, and don’t bother with derivatives.

But things may be changing at last.

“But going forward we see a there is lot of ex bank treasurers moving out to the corporate treasury field,” says HSBC’s de Zilwa.

“I think it is a good sign for the industry; because that has taken the knowledge base wider. They need to see deep into their cost structures and see how they can protect themselves from adverse market conditions they are exposed to.”

Bradix’s Jayasekera was also an ex-bank treasurer who worked for Indo-Suez and later Societe General, so options are nothing new.

He can find other risks in the group, which has an apparel making businesses spread over several countries.

Something that would be really clever, says Jayasekera, would be to work out how to use commodity derivatives like cotton futures to hedge against volatility in raw material prices.

-Asantha Sirimanne: asantha@vanguardlk.com