How to Effectively Hedge Currency Risk through the Exchange | Motilal Oswal
How to Effectively Hedge Currency Risk through the Exchange | Motilal Oswal

How to Effectively Hedge Currency Risk through the Exchange

Any individual or business that deals with foreign currency is exposed to forex risk. Irrespective of whether you are an exporter, importer, ECB borrower, FCNR borrower or a global tourist, currencies do tend to impact your economics. An importer or a foreign borrower has payables in foreign currency. Hence, they will be keen to ensure that the INR remains strong so that they can get more dollars for the same number of rupees when their foreign currency payable is due. An importer or a foreign currency borrower will have to hedge his business against a weakening of the rupee.
The exporter, on the other hand, has receivables in foreign currency at a future date. The exporter will have to ensure that the rupee stays weak as that will mean that he gets more INR for each dollar received. The exporter will be happy if the INR weakens but will need to protect himself against a strengthening of the rupee. For both the importer and the exporter, the same can be achieved through the USD-INR pair. The risk can be hedged either using futures or using options and we will see how both these methods can be applied. While the USD-INR pair is being taken as an example due to its liquidity and popularity, the same logic can be used for receivables in Pound, Euro and Yen also.

How can an exporter use currency derivatives to hedge his currency risk?

Let us understand this with the help of an illustration. Assume that Raghav Exports Ltd. has an export inward remittance that is receivable on 30th September for $50,000/-. While Raghav knows the dollar amount that he will get on 30th September, he is not too sure about how about how much INR that will translate into as it will depend on the USD-INR exchange rate on that particular date. Currently, the exchange rate is Rs.64/$. That means at this will translate into a rupee inflow of INR 32 lakhs on September 30th. Raghav has certain commitments on October 10th and is comfortable with the exchange rate of 64/$ on the settlement day.
However, Raghav Exports has been advised by their banker that due to heavy FDI inflow into India, the INR may actually appreciate to 62/$ by September 30th. That will mean that Raghav exports will receive only Rs.31 lakhs in rupee terms. Raghav Exports is apprehensive that this will leave them with a shortfall in meeting their outflow commitment on October 10th. The company, therefore, needs to hedge its inward dollar risk. How can Raghav Exports do this?
Simply put, Raghav Exports can hedge this risk by selling 50 lots (each lot is worth $1000) of the USD-INR pair at a price of Rs.64. This will give them a perfect protection. This is how it will work. On the inward date of 30th September, let us assume that the INR has actually appreciated to 62/$. When Raghav Exports receives its remittance of $50,000/- on September 30th, the converted value will be Rs.31 lakhs. However, Raghav has also sold 50 lots of the USD-INR futures at Rs.64. Since the price is now down to 62, Raghav exports will make a profit of Rs.1 lakh on that position. Thus, the total receivable will now be Rs.32 lakh (Rs.31 lakh from conversion and Rs.1 lakh from the short USD-INR futures). Effectively, Raghav exports has managed to hedge its conversion price at Rs.64/$.
The counter question is what happens if the INR depreciates to Rs.68. In the normal course, Raghav Exports would have made a profit but due to the hedge it will be locked in at Rs.64/$. This will result in a notional loss of Rs.4, but the intent here is to protect your downside risk, not to make profits. There are two ways this can be overcome. Either, one can hold the USD-INR pair with a strict stop loss or the hedging can be done through put options instead of futures so that the maximum risk can be restrained to the extent of the option premium.

What to do in case of an importer of a foreign currency borrower

The situation, in this case will be the converse of that of the exporter. An importer or a foreign currency borrower will have a dollar payable at a future date. Therefore, they need to ensure that the INR does not depreciate too much as it will mean that they will require more rupees to get the equivalent amount of dollars. The importer or the foreign currency borrower can hedge their risk by buying the USD-INR futures. When the rupee depreciates, the dollar will appreciate and therefore the value of the USD-INR futures will go up. Any loss on his dollar payable due to weaker INR will be compensated by the long futures on the USD-INR. Even in case of an importer or foreign currency borrower, the hedging can also be done through options by buying a call option on the USD-INR pair.
The currency derivatives (both futures and options) also offer a good method of hedging future dollar risk. While the OTC forward market still holds sway, the currency derivatives market is fast catching on as the preferred choice for managing currency risk.

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