Indian Forex market was deregulated in 1993 and exchanges rates were allowed to be driven by the markets. As the Indian economy opened up, increasingly businesses have to transact in the overseas market for either sourcing raw materials or machinery. Indian Businesses are also are now exporting worldwide across Goods and services. This increasingly global integration of Indian economy exposes businesses to the fluctuation of currencies and risks associated with it.
What is Hedging Forex?
Hedging Forex is primarily meant to protect foreign exchange receivables/payable against adverse currency fluctuations. A forex hedge is done to preserve a current or future position from an unwanted change in the currency prices. Forex Hedging is not a money-making strategy, but it is about protecting you from losses due to fluctuations. The process of identifying risks faced by the businesses and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management. For corporates and small businesses, having forex loans and exposures, they need to look at hedging forex exposures.
Importance of Hedging Forex:
Small Businesses and MSME’s today are facing enormous competition, both domestically and internationally. Due to this, there is high pressure on margins for every organization. Given this competitive environment, currency hedging could protect profit margins on import/ export transactions. Currency exposures also affect a firm’s balance sheet by affecting the value of firm’s assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign banks etc.
Types of Hedging Instruments:
Spot Contracts:
Forex Spot trades are primarily meant for purchase or sale of foreign currency for immediate delivery. Typically trades are settled in T+2 days. This is the most basic hedging tool, usually for a concise period of time.
Currency Option:
Foreign currency option give the purchaser the right to buy or sell but not the obligation. This makes it the preferred way of forex hedging. Like insurance, there are premiums to be paid for buying foreign currency options, and this requires an upfront payment. eg. One can buy CALL options till Mar 2020 on NSE. This call option gives a business right to buy a currency at a particular rate. However, business is not under any obligation to exercise his choice. So should currency rate not be favorable to the business, a call option can be allowed to expire with no liabilities to the business. Similarly a PUT option could be used by an exporters. Eg an exporter has an order worth USD 1Mn (Rs 7 Crores) for a specific textile garment on 16th June 2019 when the Spot price was 70. Let us say the payment is expected in 9 months. The exporter can buy a PUT option (which is right to sell) at the strike price of USD/INR price of 70 at a premium of 0.6125 expiring on 27th March 2019. So for USD 1Mn, the premium would work out to Rs 6,12,500. By buying this PUT option, the exporter has protected the downside i.e. rupee appreciation, but has unlimited profit potential should rupee depreciate.
Currency Forwards:
As per Investopedia, a currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. They allow either individuals or businesses with exposure to currency risk to protect themselves from adverse moves in the foreign exchange market.
Currency Futures:
A currency future is a futures contract to exchange one foreign currency for another at a specified date in the future at a specified rate(exchange rate). Eg. If a company knows that it will be purchasing/importing some machinery in the future, the cost of the machinery(in forex) should ideally be hedged today. So the company will go long on currency futures. Let us say the company is estimating the purchase to be 2 Mn USD with the current USD/INR rate at 72. The company would buy futures and lock rate at 71.5 and avoid all fluctuations. A similar kind of trade can be executed by an exporter who is expecting to receive payments in the future.
The above instruments can be used for forex hedging by a small business. Difference between currency futures and forwards is that currency futures are traded on an exchange; they are standardized, more transparent, can be executed for small volume whereas currency forwards are over the counter contracts between two counter parties and are generally more opaque but could be customized as per need.
Swaps:
A swap is a forex contract wherein the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. On maturity, the principal amount is re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Swaps can be effectively used to reduce interest rate on long term loan and even create a natural hedge with import/ export exposure.
One can use numerous forex hedging strategies as shared above to hedge risk.
Given that the forex market is open twenty-four hours a day, it can become physically exhaustive exercise to keep an eye out for changes as they happen. It is always better to use the help of Specialized consultants or forex experts as they have specialized teams and systems in place to take care of market moves and forex trades while you are asleep. A good forex consulting company can help you with forex hedging protection against losses.