Hedging with Foreign Currency Futures

Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders’ often use the currency futures. For example, a long hedge (i.e., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currency’s value.

It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firm’s profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement.

The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is:

  • Loss from appreciating in Indian rupee= Short hedge
  • Loss from depreciating in Indian rupee= Long hedge

Short Hedge

A short hedge involves taking a short position in the futures market. In a currency market, short hedge is taken by someone who already owns the base currency or is expecting a future receipt of the base currency.

Short Hedge Strategy Through an Example.

An exporter is expecting a payment of USD 1,000,000 after 3 months. Suppose, the spot exchange rate is INR 57.0000: 1 USD. If the spot exchange rate after 3-months remains unchanged, then exporter will get INR 57,000,000 by converting the USD received from the export contract. If the exchange rate rises to INR 58.0000: 1 USD, then exporter will get INR 58,000,000 after 3 months. However, if the exchange rate falls to INR 56.0000: 1 USD, then exporter will get INR 56,000,000 thereby losing INR 1,000,000. Thus, exporter is exposed to an exchange rate risk, which it can hedge by taking an exposure in the futures market .By taking a short position in the futures market, exporter can lock-in the exchange rate after 3- months at INR 57.0000 per USD (suppose the 3 month futures price is Rs. 57). Since a USD-INR futures contract size is of 1000 USD, exporter has to take a short position in 1000 contracts. Whatever may be the exchange rate after 3-months, exporter will be sure of getting INR 57,000,000. A loss in the spot market will be compensated by the profit in the futures contract and vice versa.

An exporting firm can thus hedge itself from currency risk, by taking a short position in the futures market. Irrespective, of the movement in the exchange rate, the exporter is certain of the cash flow.

Long Hedge

A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the base currency at the expiry date by paying the agreed exchange rate. This strategy is used by those who will need to acquire base currency in the future to pay any liability in the future.

Long Hedge Strategy Through an Example.

An importer, has ordered certain computer hardware from abroad and has to make a payment of USD 1,000,000 after 3 months. The spot exchange rate as well as the 3-  month’s future rate is INR 57.0000: 1 USD. If the spot exchange rate after 3-months remains unchanged then importer will have to pay INR 57,000,000 to buy USD to pay for the import contract. If the exchange rate rises to INR 58.0000 : 1 USD, then importer will have to pay more – INR 58,000,000 after 3 months to acquire USD. However, if the exchange rate falls to INR 56.0000: 1 USD, then importer will have to pay INR 56,000,000 (INR 1,000,000 less). Importer wants to remain immune to the volatile currency markets and wants to lock-in the future payment in terms of INR. Importer is exposed to currency risk, which it can hedge by taking a long position in the futures market. By taking long position in 1000 future contracts, importer can lock-in the exchange rate after 3-months at INR 57.0000 per USD. Whatever may be the exchange rate after 3-months, importer will be sure of getting the 1 million USD by paying a net amount of INR 57,000,000. A loss in the spot market will be compensated by the profit in the futures contract and vice versa.

An importer can thus hedge itself from currency risk, by taking a long position in the futures market. The importer becomes immune from exchange rate movement.

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