Hedging is simply a way to reduce the amount of loss one would incur if something unexpected happened. Foreign Exchange (Forex) refers to the foreign exchange market. We live in a world of open economies where a major economic happening in any part of the world affects our revenues and thus it has become of utmost importance to hedge against forex losses.
Let’s get the basics clear for the understanding of Forex hedging
Exports and imports get impacted, depending on whether the rupee is appreciating or depreciating against the US dollar. When the rupee appreciates, it is good news for importers as a strong currency brings down the import cost.
However, it is negative for exporters as their forex revenue will decrease. Similarly, when the rupee depreciates, revenue for exporters shoots up. But, the expenses go up for importers resulting in losses or decreased profit.
The rupee appreciated over 7 percent from 68.85 in November 2016 to 64. This sharp appreciation would have caught most exporters off the hook as they would have expected a rupee depreciation, given the global and domestic conditions and this caused their profits to take a hit.
Likewise, the sharp depreciation in the rupee, from around 55 to 68 between May and August 2013 would have hit the importers hard.
Current Indian Scenario
Only 36 percent of the imports and exports combined are hedged. The rest of the 64 percent is left open to forex loss in case there is any volatile increase or decrease in the rupee.
Investors have been neglecting the fact that the rupee has been weakening year after year and the current dire situation only seems to worsen it further.
How Can We Apply Forex Hedging?
We use various instruments like Forward Contracts. Futures, Options, etc. In this article, I’ll be explaining a bit about how to use Futures contract to your advantage to safeguard oneself from forex losses.
A future is a derivative contract in which two parties agree to buy or sell to each other at a particular price at a FUTURE date.
It clearly means that the delivery is not immediate and is set at a much later date. More importantly, payment is also not immediate, it is at a later date. This kind of contract is also called a forward contract.
It has the feature of short selling. One can sell shares without owning it and then buy it later. Yes, this is certainly possible. So if one believes that the price of a share is going down, one can sell it. Since the concerned person doesn’t have to deliver it right now, the buyer does not care if you already have it or not. On the later date, just buy those shares from the market and give it to the buyer, pocketing (or losing) the difference.
If the rupee appreciates to 64 or 63 in the next six months, then taking forward contract today will give the exporter a better rate of 67.93 after six months when the spot rate would be 64 or 63.
But conversely, if the rupee depreciates to 70 in the next six months, then it is a loss as the exporter had locked the rate at 67.93.
Similarly, we can use other instruments to hedge the forex losses and instead gain from it.
Image Credits: Google Images