If you are familiar with banking and international trade, you would surely be familiar with the concept of a forward cover. A forward cover is the most basic form of a forward contract. A forward cover is an over-the-counter (OTC) contract that is offered by a bank to its customers. Let us say that you are an exporter of handicrafts and you are scheduled to receive $500,000/- as an advance for the first leg of your order from the Middle East. This amount will be received in 3 months time. Currently, the exchange rate is at 65/$ and you are comfortable with that rate. Your calculation is that at the current exchange rate, this will translate into Rs.3.25 crore, which will be sufficient to pay off all your outstanding dues to suppliers. The catch is that you have just read in the papers that due to strong FDI flows into India, the INR could strengthen to Rs.61/$. That means, unless you take protection measures, you are likely to incur a notional loss of Rs.20 lakhs. You can get protection by asking your bank to sell forward dollars.
How a Rupee forward contract can help
A forward dollar market is an OTC market. That means, it is not a recognized exchange but deals are conducted over the telephone. The participants are the large banks, mutual funds and financial institutions and hence the risk of default is almost non-existent. You can approach your banker and tell them to sell dollar forwards at the rate of Rs.66/$. Remember, forwards always quote at a premium and very rarely at a discount. By selling forwards, you have locked in your price at Rs.66/$ and therefore you are not worried even if the rupee appreciates to Rs.61/$. Of course, if the rupee weakens to Rs.68/$ then there is a notional loss. But the purpose of a hedge is to protect your downside risk not to making trading profits.
Rupee forwards are extremely popular among exporters and importers. Since exporters have dollar receivables, they need to protect themselves against an appreciation of the rupee. They would prefer a weak rupee as they get more rupees for each dollar earned. The importer, on the other hand, wants to protect against the depreciation of the rupee. Importers prefer a strong rupee as that will mean they have to pay fewer rupees to buy each dollar they need to pay out. Like importers, even foreign currency borrowers need to protect themselves against a weakening rupee. Historically, since importers and exporters need to anyways go through Authorized Dealer (AD) banks, forward cover was the logical choice for them. There are two types of forward contracts that banks offer. There are Fixed Date Delivery contracts which are settled on a specific future date. Secondly, there are Optional Delivery Contracts that banks offer with contracts that are deliverable any time within period of 12 months, almost equivalent to American options in equities.
The risk of un-hedged positions
Hedging through forwards or through futures involves a cost and that cost is a price you pay for the protection that it offers. Many importers and foreign currency borrowers tend to keep their exposures un-hedged. This is more so when the rupee has been showing strength; especially like the phase we have seen since January 2017. During such times, exposures are deliberately left open to save on the hedging costs. While this may appear to be a good strategy in times when the rupee has been strong, this is not advisable from a long-term business perspective. We have seen in the past that the INR tends to show bouts of extreme volatility as we saw in 2008 and again in 2013. In such situations, the currency losses in an un-hedged position can go literally out of control, endangering the very solvency of the business. Un-hedged positions are best avoided as the cost of hedging is worthwhile from the longevity of your business.
How is the currency futures market different from the forward market?
There are some basic parameters on which the futures market is different from the forwards market. Here are a few key areas of differences...
While the forward market is an OTC market, the futures market is an exchange traded market. That means contracts on the currency futures market tend to be structured by the exchange and guaranteed by the clearing corporation of the exchange.
The futures market being a guaranteed market is free of counterparty risk. As mentioned earlier, all trades on the currency futures exchange are guaranteed by the clearing corporation. The rupee forward market being an OTC market does carry technical counterparty risk. However, since all the participants are large banks and institutions, this risk is more theoretical than real.
Transaction lot sizes are much smaller in the currency futures exchange. Most banks will not be willing to write a forward cover unless it has a certain minimum size. Also the cost of forward cover requires that it is of a minimum economical size to be viable to the banker and to the customer who may be an importer or an exporter.
A forward cover can only be taken against an underlying open currency position. Either you should have a foreign currency receivable or a foreign currency payable. There are no such conditions in the currency futures market. You can also take a view on the dollar or the Pound or the Euro and take a position in futures accordingly.
While both the rupee forward market and the currency futures market can be used to hedge your currency risk, the forward market is a delivery market and all transactions must result in actual delivery or purchase of dollars. The currency futures market, on the other is a market where all transactions are settled in cash. Hence it is much easier to speculate in the currency futures market.