Hedging currency risk across various market scenarios

The human mind can be influenced by emotional and cognitive biases, leading to irrational behavior and impulsive choices. Sometimes, we fail to thoroughly analyze all the facts before making decisions due to constraints such as limited time, resources, or cognitive dissonance.

However, in the modern era of Quant and AI, we have access to tools that can provide us with a comprehensive understanding and a more objective perspective. Having a model that encompasses all the significant variables and offers a relative assessment can be extremely beneficial.

In order to counteract biases and make more well-informed decisions, we conceived the idea of developing a barometer that captures the underlying momentum in USD-INR. This barometer aims to provide a means to gauge the direction and strength of the exchange rate (USD-INR), enabling more informed hedging strategies across various market cycles and multiple scenarios.


There are numerous factors we have considered in our barometer, some of the most important being:

- Dollar Index
- FPI & FDI Flows
- Trade Balance
- Crude Prices
- Real Effective Exchange Rates
- U.S. Real Interest Rates
- RBI Reaction Function

All the variables incorporated in the model cover different factors which drive USD/INR. Care has been taken to avoid the problem of multicollinearity which is associated with multiple Regression models i.e. where two or more independent variables are highly correlated.

For instance, real rate differential drives FPI flows. Therefore, having both factors would result in multi-collinearity. Crude prices predominantly drive inflation. Therefore, to have both crude and inflation in the model could potentially result in multicollinearity.

Significant emphasis is placed on the dynamics of the Balance of Payments (BoP), with particular attention given to the influence of the Current Account, Capital Account, and Reserve Account (RBI reaction function) on the domestic currency.

The barometer incorporates technical indicators like ADX and RSI, which assist in measuring the currency's momentum, strength, and trend. This comprehensive approach transforms our barometer into a techno-funda measurement of USD-INR, allowing us to assess its medium-term strength effectively.

When we consider currency hedging for specific companies across sectors, we pay keen attention to their working cycle, collection cycle, and numerous other factors to estimate the most appropriate band of hedge ratio. This hedge ratio can be aligned with our currency barometer reading, which varies between 36 and 180.

A reading of 36 indicates a highly bearish sentiment in USD/INR, while a reading of 180 suggests a strong bullish sentiment. When the barometer reading is at 36, it is advisable to position oneself at the upper limit of the allowed hedge ratio range, and when it reaches 180, it is recommended to be at the lower limit of that range.

(Disclaimer: Recommendations, suggestions, views and opinions given by experts are their own. These do not represent the views of Economic Times)