Currency Hedging

May 20, 2022
Posted by: OptimizeIAS Team
Category: DPN Topics

Currency Hedging

Subject: Economy

Section: External sector

Context: Experts say hedging is the only way for importers to protect themselves from depreciating currency

Concept:

Currency Hedging is the act of entering into a financial contract in order to protect against unexpected, expected or anticipated changes in currency exchange rates. Hedging can be likened to an insurance policy that limits the impact of foreign exchange risk.

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.

How does currency hedging work?

There are two main ways portfolio managers manage foreign currency risk:

Forward contracts – The portfolio manager can enter into an agreement to exchange a fixed amount of currency at a future date and specified rate. The value of this contract will fluctuate and essentially offset the currency exposure in the underlying assets. Keep in mind that the investment will not benefit if currency fluctuations work in its favour.
Options – For a fee, options give the holder the right, but not the obligation, to exchange one currency for another at a set rate for a certain period of time. This reduces the potential that a change in exchange rates will affect the return on the investment.

The risk can be hedged either using futures or using options. Let’s take the example of the US-Rupee pair:

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

Assume that Raghav Exports Ltd. has an export inward remittance that is receivable on 30th September for $50,000/-.Currently, the exchange rate is Rs.64/$. That means this will translate into a rupee inflow of INR 32 lakhs on September 30th.

Suppose 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.

The company, therefore, needs to hedge its inward dollar risk.

Selling 50 lots (each lot is worth $1000) of the USD-INR pair at a price of Rs.64. On the inward date of 30th September, let us assume that the INR has actually appreciated to 62/$. When Raghav Exports receives its remittance of $50,000/- on September 30th, the converted value will be 31 lakhs. However, Raghav has also sold 50 lots of the USD-INR futures at Rs.64. Since the price is now down to 62, Raghav exports will make a profit of Rs.1 lakh on that position.
The counter question is what happens if the INR depreciates to Rs.68. In the normal course, Raghav Exports would have made a profit but due to the hedge it will be locked in at Rs.64/$. 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.

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

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.