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Hedging Through Exchange Traded Derivatives

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Any individual or business that deals without foreign currency is exposed to forex risk. Irrespective pf whether you are an exporter, importer, ECB borrower, FCNR borrower or a global tourist, currencies do impact your economics. An importer or a foreign borrower has payables in foreign currency. Hence they will be keen to ensure that INR remains strong so that they can get more dollars for the same amount of rupees when the foreign currency payable is due. An importer or a foreign 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 USDINR pair. The risk can be hedged either using futures or options. While USDINR pair is more liquid and popular, the same logic goes for receivables in pound, euro and yen also. How can an exporter use currency derivatives to hedge his currency risk?

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Assume that Raghav has an export one inward remittance of $100000 that is receivable two months from now. Currently the exchange rate is $67. That means this will translate into a rupee inflow of 67 lakhs.

However, Raghav is advised by the banker that due to heavy FDI inflow into India, the INR may actually appreciate to $64. That means Raghav will receive only 64 lakhs and incur a loss of 3 lakhs. The company therefore needs to hedge its inward dollar risk.

Raghav exports can hedge this risk by selling 100 lots (each lot being of $1000) of USDINR pair at a price of $67. This will give him a perfect protection. This is how it will work. On the inward date, let us assume that the INR has actually appreciated to $65. Since the price is now down to $65, Raghav exports will make a profit of Rs.2 lakh on that position which will offset the loss of Rs.2 lakhs he will be incurring on the spot leg of the transaction where he will receive 65 lakhs. Effectively, Raghav exports has managed to hedge its risk of currency conversion.

However, if the INR depreciates to Rs.68, on the spot leg Raghav exporters would’ve made a profit of 1 lakh but would’ve lost 1 lakh on the futures position so effectively locking the conversion price at Rs 67 only. But the intent here is to protect your downside risk, not to make profits. However, there are two ways this can be overcome and one can benefit from the favourable marketplace movement, which is by either holding the USD INR pair with a strict stop loss or the hedging can be done through options by buying a call on tge USD INR pair.

The currency derivatives (both futures and options) also offer a good method of hedging future dollar risk the OTC marketplaces still holds sway, the currency derivatives marketplace is fast catching on as the preferred choice for managing currency risk.

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

The situation, in this case will be converse of that of the exporter. An importer of a foreign currency borrower will have 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 equivalent amount of dollars. The importer or the foreign currency borrower can hedge this risk by buying the USD INR futures. When the rupee depreciates, the dollar will appreciate and therefore 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.

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