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Hedging the Foreign Exchange Exposure - Know the Basics & Strategies to Hedge

Updated: Jan 4


Any individual or business dealing with foreign currency as an importer, exporter or investor has to deal with foreign exchange risk. Indian Importers pay their dues in foreign currency; therefore, they would like to ensure that Indian Currency gets stronger so that they have to pay less rupees against the purchase of foreign currency. An importer will hedge against a weakening of rupee (or strengthening of foreign currency). Similarly, Indian Exporters receive their dues in foreign currency, therefore, they would like to ensure that Indian Currency gets weaker so that they can get more Rupees for the same amount of foreign currency. This foreign exchange can be reduced using different strategies.


Example of Exporter Hedging Foreign Currency Risk

Exporters can hedge against the appreciation of Indian Currency by selling the futures at a predetermined date. Afterwards even if the Indian Currency appreciates, the exporter will have equal number of receivables in Indian currency.


To give an example;

  • An exporter sold goods for which it will receive Euros 1000 after a month and recently the exchange rate has been fluctuating between Rs. 90 to Rs. 92 for each Euro.

  • The exporter will wish to that at the rate of Rs. 92, he/she gets Rs. 92000, however there is also a risk that after one month the exchange rate may be Rs. 90.

  • Now, the exporter can hedge this risk by selling his 1000 Euros today at rate of Rs.92. After one month, if the exchange rate reaches to Rs.90, the converted value will be Rs. 90,000, however, by selling futures, he has also earned profit of 2000 Rs (1000 euros * Rs. 2) which makes total receivables Rs. 92000 (Rs. 90,000+Rs. 2000 Profit in Futures).

  • Even if the Exchange Rate increases to Rs 93, the net receivable for Exporter remains Rs. 92,000 (Rs.93,000 less Rs.1000 Loss in Futures).

However, hedging is not free, it comes with a certain cost attached to it. In fact, there are different transaction charges in hedging current risk such as transaction cost (including transaction taxes), brokerage fee, option premiums, future contract costs, interest rate costs, swap costs and hedging advisory fee.


Different strategies for hedging currency risk are:


Currency Options: These options will give the investor right but not the obligation to buy or sell currency at a predetermined rate on a specific date. For example, if an investor wishes to buy $10000 after 1 month and expecting price to rise, investor can enter into an option contract. Suppose the investor entered in the contract at the rate of Rs. 82. Now after 1 month if the rate is above Rs. 82, the investor can execute the contract and buy dollars at Rs. 82 costing Rs. 8,20,000. However, if the rate is below 82, investor can let the option expire worthless and buy dollars at the spot price costing less than Rs. 820000. This strategy limits the upside risk for the investor. Option contracts have cost in the form of an upfront fee known as premium. Here, it needs to be ensured that the benefit from option is more than its premium for the investor.


Option Collars: It involves purchasing a put option and selling a call option with the same expiry. This strategy provides a range within which the exchange rate can fluctuate. For example, an investor wishes to exchange dollar to Rupee and current exchange rate is Rs. 82. Investor buys one put option at Rs. 80 and sells call option at Rs. 84. Now if dollar falls below Rs. 80, the put option provides downside protection. Here, cost will include premium paid on both put and call option.


Forward or Future Contracts: These options will give the investor an obligation to buy or sell currency at a predetermined rate on a specific date. For example, if an investor wishes to buy $10000 after 1 month and expecting price to significantly rise, investor can enter into a forward contract. Suppose the investor entered in the contract at the rate of Rs. 82. Now, the investor will buy $10000 at the rate of Rs. 82 after one month regardless of the spot exchange rate after one month. This strategy eliminates the risk of uncertainty for investor. These contracts require a deposit amount with the currency broker.


Natural Hedging: It includes matching foreign currency revenues with foreign currency expenses which will naturally offset the currency risk. For instance, if the dollar expenses are Rs. 10000, then dollar revenue should be Rs. 10000 as well for eliminating exchange risk. Here, it may seem that there is no cost involved, but still there is opportunity cost involved. Also this option mostly works for organization which have imports equivalent to exports.


Exchange Traded Funds: There are different ETFs which holds multiple securities including currencies that generate profit or loss on the basis of underlying currency exchange rate. These funds aim on providing long and short i.e., buy and sell exposure of currencies. Currency based ETFs can be expensive and generally charge fee at the rate of 1%.


Indicative Transaction Charges on Foreign Currency Future or Options Trade

Brokerage – Around 0.03% or Rs 20 / Order whichever is lower

NSE Charges – 0.0009%

SEBI Charges – Rs 10 / Crore

Stamp Charges – 0.0001% or Rs. 10/crore on buy side


While hedging currency risk, it is important for an investor to know risk appetite & cost involved perform due diligence and take professional help, if required. Along with that is should be kept in mind that the aim is to reduce the risk level, not to earn profit.

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