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Don't fall for the trap: The dark side of TARF exposed - Indian businesses beware!

The dark side of TARF exposed

Banks are actively seizing the opportune moment to present hedging strategies to Indian companies, taking advantage of the current low volatility in the rupee.

While these strategies may seem attractive amid the rupee's stable phase, there is a potential downside that could expose companies to substantial losses when market conditions become unpredictable.

One particularly intriguing product that has caught the attention of the market is the Target Redemption Forward (TARF), predominantly promoted by foreign banks. TARF is being marketed as a solution to assist exporters in securing favorable rates for their future dollar receivables.

This proposition is especially appealing given the rupee's limited fluctuation of just 2% since the previous June, coupled with historically low implied volatility.

The zero-cost structure of TARF is designed to allow exporters to sell dollars on predetermined dates at rates significantly better than the prevailing forward rate, as outlined in term sheets from foreign banks.

While intuitively enticing, these structures may lead to unintended consequences for less sophisticated treasuries, as explained by a senior treasury official at a private sector bank.

Despite its apparent simplicity as a potential money-making opportunity, TARF exposes exporters to significant losses in the event of rapid rupee depreciation. In contrast, a conventional plain vanilla forwards hedge might have provided better protection during periods of swift currency appreciation.

An illustrative example from a term sheet highlights potential risks, where an exporter could sell dollars at a predetermined rate on multiple expiry dates over a year. While the profit is capped, the losses are uncapped and could exceed 20 rupees if the rupee depreciates significantly.

Moreover, the capped profit feature means the contract expires at the predetermined limit, leaving the exporter unhedged for the remaining tenure. This aspect, coupled with the potential for substantial losses, raises concerns about the suitability of TARF as a hedging tool.

Currently, TARFs are not widely adopted, with only a handful of companies executing such strategies. Despite being actively promoted by a few foreign banks, the demand for TARFs seems to be more driven by the supply side rather than genuine demand from companies seeking risk management solutions, according to an fx salesperson at a domestic bank.

In one term sheet seen by Reuters , the tenure of a TARF was as long as five years, introducing additional risk factors. Experts caution that while such exotic structures may seem appealing during favorable market conditions, they lack risk management justification when market dynamics shift.

Samir Lodha, managing director at fx risk management advisory firm QuantArt Market Solutions, emphasizes that exotic structures can be beneficial if well-designed and prioritize safety in volatile market environments.



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