By Naveen Mathur
An important tool in the global financial markets, hedging is used in every asset class to mitigate losses. This can be utilised by anyone, whether it is an individual or corporates, to overcome the negative impact of price volatility.
For the corporates in which the business activity is dependent on import and export of commodities, there is an automatic exposure to foreign exchange and, hence, the need for hedging is higher. In the current context, since the world markets are interlinked, they eventually affect and impact the movement of currencies.
Hedging, in any asset class, is ultimately a strategy to decrease or transfer risk in order to protect one's portfolio or business from uncertainty in prices. In case of hedging in the foreign exchange market, a participant who is entering a trade with the intention of protecting the existing position from an unexpected currency move, is said to have created a forex hedge.
With the help of a forex hedge, a participant who is long in a foreign currency pair, can protect himself from the downside risk. On the other hand, a hedger who is short on a foreign currency pair will protect his existing position from the upside risk.
The strategy to create a hedge would depend on the following parameters: (a) risk component (b) risk tolerance and (c) to plan and execute the strategy.
From the point of view of Indian importers and exporters, we have tried to explain this strategy with some illustrations. It will help us gauge better as to why and how one should hedge, and the manner in which an importer and/or exporter can hedge his currency risk.
The impact of the movement in the USD-INR currencies affects both importers and exporters. In other words, an importer will benefit when the rupee appreciates, while the exporter will gain when the rupee depreciates against the US dollar. The cost of import reduces when the rupee gains strength, thus benefiting an importer, and at the same time creating a loss for the exporter, since a stronger rupee will reduce the export remittances when converted to Indian rupees.
In order to reduce the risks associated with these uncertain movements in the financial markets, both importers and exporters can utilise the derivatives platform of currency futures. By creating an equal and opposite position in the derivatives market, a hedge can be created.
How hedging works for an importer
Suppose an oil importer wants to purchase oil worth $1,00,000 and places his order on 15 March 2013, with the delivery date being three months away. At the time of placing the contract in the spot market, one US dollar is worth, say, Rs 54.50. However, suppose theIndian rupee depreciates to Rs 57 per dollar when the payment is due in June 2013, the value of the payment for the importer goes up to Rs 57,00,000 rather than Rs 54,50,000.
In this case, if the importer hedges the currency risk, the losses can be reduced. Here's how the hedging strategy for the importer would work:
Had the importer not hedged his position, he would have suffered a loss of Rs 2,50,000 (Rs 57,00,000 - Rs 54,50,000). However, by creating a hedge position on the futures platform, his losses were reduced to Rs 50,000.
How an exporter can use hedging
A jeweller, who is exporting gold jewellery worth US$50,000 in March 2013, wants protection against a possible appreciation in the Indian rupee in June 2013 (spot Rs 54.50), when he receives his payment. When he is required to make the payment in June 2013, suppose the rupee appreciates to 53. If, in this situation, he wants to lock in the exchange rate for the above transaction, his strategy would be as follows:
Sell US$50,000 in spot market @54.50 in June 2013. Assume that initially the Indian rupee depreciated, but later appreciated to 53 per USD as foreseen by the exporter at end of June 2013.
Had the exporter not hedged his position, he would have suffered a loss of Rs 25,000, but by creating a hedge he has made a profit of Rs 25,000 in the futures, offsetting his business loss. Hence, exposure management is essential, given the premise of a volatile foreign exchange market. Hedging in the currency markets, therefore, holds prime importance.
Note: The objective of hedging is not to make profits, but to mitigate losses incurred due to currency price fluctuation.