CURRENCY HEDING
Currency Hedging is one of the major possibilities to reduce foreign
exchange risks. And there are kinds of risks like interest rate risk,
commodity risk, wage inflation etc.
Currency hedging is a financial contract entered to reduce unexpected or
anticipated risks in currency exchanges. It is used international trade.
The traders can reduce financial risks through currency hedging if they deal
with financial instruments like forward contract and other derivative
contracts. It involves the designation of one or more financial instruments as
a buffer for potential loss.
Let’s see how hedging helps
Suppose a firm receives an export order today with the delivery date being
in 3 months’ time. The contract is worth, say, US$100,000. At the time the
contract is placed, the INR is say Rs.75 per US$. Hence the value of the
order, when placed, is Rs. 75,00,000. But suppose that the exchange rate
changes significantly between the date when the order is received and the
date the order is paid for. The exchange rate of the INR & US$ is at Rs. 70
on payment date. Which means that the firm receives only Rs. 70,00,000
rather than Rs. 75,00,000. This will result in loss of Rs. 5,00,000 for the
exporter. To insure against this happening, the firm can, at the time it
receives the order, hedge the currency risk.
How to hedge currency
Forward Contract: Future contract is an agreement to exchange two
currencies on a future date. It secures export and imports as well.
Forward contracts lock imports and exports at a current exchange
rate, and it will guarantee the exchange upon an agreed price. It may
not be possible for a trader to make profit from the contract but he is
secured from the loss. Like if you are an Indian importer and your
currency appreciates against USD the importer may not make profit
from that, but the importer is protected against the risk of weakening
INR against USD.
Future Contract: Future contracts trade on a future date agreed up
on by both parties based on current exchange rates. To trade in
futures the trader has to purchase future contracts from a recognized
exchange (BSE, NSE, MCX). Futures having one advantage than
forward contract. There is a secondary market for traders who trade in
futures. If the trader needs cash urgently, they can sell their future
contract in that market. In future contracts the trader may not get the
actual exchange price in the maturity because it provides of a range of
final exchange rates. But the problem is that futures are traded on a
fixed rate, so the trader may not get the actual amount which he
expected from futures.
Foreign Bank Account: If the importer wants to get protected from
an international trade the importer can start a new account in the
country from where he purchases. Just deposit in the foreign account if
the USD is favorable. The bank will change into local currency. And
your money is locked and safe in foreign currency and locked too. So
can spend easily. It will benefit you if the importer is a continuous
buyer from that country.
Currency Options: 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.
Currency Hedging is a very effective way to protect against currency
volatility and restrict or minimize loss of any adverse movement in currency.
But definitely currency hedging helps the trader from currency volatility. But
in real business currency hedging involves some cost also. The trader has to
definitely apply their mind in hedging to help this positively towards the
business, otherwise it will not make any sense. And the trader loses the
money.
