Currency Hedging is a very effective way to protect against currency volatility and restrict or minimise loss of any adverse movement in currency. Given recent foreign exchange volatility, this article looks into currency hedging mechanisms and how they can help importers and exporters when trading.
One of the biggest risk factors involved in operating an Import or Export business is that while your Purchase or Sales is in progress, the value of currency may change relative to the value of the U.S. dollar (assuming Import or Export is with USA). This means that your business is open to risk in terms of adverse movement in INR against US$.
Currency Hedging Explained
In very simple terms, Currency Hedging is an act of entering into a financial contract in order to protect against anticipated or unexpected changes in currency exchange rates. Currency hedging is used by businesses to eliminate risks they encounter when conducting business internationally.
The concept of Currency hedging is the use of various financial instruments, like Forward Contract and other Derivative contracts, to manage financial risk. It involves the designation of one or more financial instruments (usually a Bank or an Exchange) as a buffer for potential loss.
Let us understand How Currency Hedging helps business;
Suppose a firm receives an export order today with the delivery date being in 3 months time. The contract is worth, say, US$100,000. At the time the contract is placed, the INR is say Rs. 65 per US$. Hence the value of the order, when placed, is Rs. 65,00,000. But suppose that the exchange rate changes significantly between the date when the order is received and the date the order is paid for (which we will assume is one month after the delivery date). The exchange rate of the INR & US$ is at Rs. 62 on payment date. Which means that the firm receives only Rs. 62,00,000 rather than Rs. 65,00,000. This will result in loss of Rs. 3,00,000 for the exporter. To insure against this happening, the firm can, at the time it receives the order, hedge the currency risk.
So any business that has dealing in overseas market is open to such Currency or more popularly known as Forex exposure. There may be other kinds of exposure including commodity risk, Interest rate risk, wage inflation etc. Un-hedged exposure of FX can affect the balance sheet or profitability, which can create cash flow and operational issues. Hedging reduces a firm’s exposure to unwanted risk. This helps in sustaining profits, reducing volatility and ensuring smoother operations.
Different type of Exposure
|Revenue Exposure (in Foreign Currency)||Expense Exposure (in Foreign Currency)|
|Value of Exports (FOB value)||Value of Imports, Purchase of products and services|
|Revenue from Services and other consultancy||Salaries and other administrative overheads|
|Other Income (Interest/ Dividend)||Business establishment expenses|
|Purchase of Fixed Assets|
There are several ways to hedge currency.
Foreign Bank Account
If you’re an importer and need to purchase merchandise abroad, one currency-protection method is to simply open an account in the country you are importing from. When the exchange rate is favorable, send U.S. dollars to your foreign account for deposit. The bank will change them into the local currency. Now the money is locked into the other country’s currency and ready to spend.
Major Banks offer currency forward contracts, which are essentially an agreement to exchange certain amounts of dollars for foreign currency on a future date. This allows business to lock in an import purchase or export sale at the current exchange rate, guaranteeing your transaction at the agreed upon price. Of course, if you are Importer and if the INR appreciates against US$ afterwards, you can’t profit from it; you’re locked into an exchange rate. But you have protected your business from the risk of a weakening of INR against US$.
Similar to forward contracts, futures are a commitment to purchase currency in the future at an agreed upon rate based on current exchange rates. You should purchase currency futures contracts from an exchange such as NSE or MCX. Futures contracts have one important advantage over forward contracts: There is a secondary market for them, so you could opt to sell your contract before the term is up if you change your mind or your business needs the cash. On the other hand, futures contracts usually allow a range of final exchange prices rather than a fixed point, so you may not get the exact exchange rate you want when the contract hits its maturity date. Also, the contracts are only offered in fixed amounts, which may make it hard to hedge the exact amount you want through futures.
Banks offer currency options, which give you an opportunity, but not an obligation, to buy or sell a set amount of currency at a set price, on or before a chosen date. Options come with a “strike price,” the price at which the currency can be bought or sold, and an expiration date, after which your opportunity to purchase at the agreed upon price ends. In essence, futures and options allow you to bet on where currency prices will go. You lock in at a rate you’re hoping will be at least as good as the actual rate when the contract or option comes up.
However as a business house, one needs to understand the Cost of Hedging. An important drawback to note about contracts and options is that each of these currency-hedging strategies comes with fees and commissions charged by the bank, exchange, or other party administering the hedging vehicle. Weigh those costs to your business in evaluating whether Currency hedging makes economic sense or not.