Currency Hedging Illustrations

Illustrations

Illustration 1
A vegetable oil importer wants to import oil worth USD100,000 and places his import order on 15 July 2009, with the delivery date being four months later. At the time of placing the contract one US Dollar is worth 44.50 Indian Rupees in the Spot market. Let’s assume the Indian Rupee depreciates to INR44.75 per USD by the time the payment is due in October 2009, then the value of the payment for the importer goes up to INR4,475,000, rather than the original INR4,450,000. The hedging strategy for the importer, thus, would be:
Current Spot rate (15 July 2009)44.5000
Buy 100 USD - INR October 2009 contracts on 15 July 2009(1,000 * 44.5500) * 100 (assuming the October 2009 contract is trading at 44.5500 on 15 July 2009)
Sell 100 USD - INR October 2009 contracts in October 2009, profit/loss (Futures market)44.7500
1000 * (44.75 – 44.55) * 100 = 20,000
Purchases in Spot market at 44.75 total cost of hedged transaction44.75 * 100,000
100,000 * 44.75 – 20,000 = INR4,455,000

Illustration 2
A jeweller who is exporting gold jewellery worth USD50,000 wants protection against possible Indian Rupee appreciation in December 2009, ie when he receives his payment. He wants to lock in the exchange rate for the above transaction. His strategy would be:
One USD - INR contract sizeUSD1,000
Sell 50 USD - INR December 2009 contracts
(on 15 July 2009)
44.6500
Buy 50 USD - INR December 2009 contracts in December 200944.3500
Sell USD50,000 in Spot market at 44.35 in December 2009 (assuming that the Indian Rupee depreciated initially , but later appreciated to 44.35 per USD by the end of December 2009, as foreseen by the exporter)
Profit/loss from Futures (December 2009 contract)50 * 1000 *(44.65 – 44.35)
= 0.30 *50 * 1000
= Rs 15,000

The net receipt in INR for the hedged transaction would be: 50,000 *44.35 + 15,000 = 2,217,500 + 15,000 = INR2,232,500. Had he not participated in the Futures market, he would have got only INR2,217,500 However, he kept his sales unexposed to Forex rate risk.

Options Strategy for Exporters

Options Strategy for Exporters

Illustration :

An exporter, exporting garments to USA is supposed to receive his payments in USD (US Dollar) for the goods exported and thus is affected by depreciation or weakness in Rupee. Thus the exporter buys Put Option to cover his transaction on 1st October 2010 at a Strike Rate or 45.50. The expiry is 2 months hence, i.e. 30th December 2010. The premium for the call option is 0.30 paise. So at the time of making the actual payment if the spot price has moved above the Strike Price, the dollar becomes costlier and the loss on Call Option is maximum upto 0.30 paise. If at the time of making the actual payment, the spot price has moved below Strike Price, the Dollar becomes cheaper but the loss is compensated by an appreciation in the Premium Price.

Payoff Table depicting gains and losses at various levels of exchange rate –

SPOT RATEEXERCISE RATEPREMIUM PAID GAIN/LOSS
CALL@45.50
44.001.500.301.20
44.501.000.300.70
45.000.500.300.20
45.50 0.30-0.30
46.00 0.30-0.30
46.50 0.30-0.30
47.00 0.30-0.30

Options Strategy for Importers

Options Strategy for Importers

Illustration :

An Importer, importing raw materials from a foreign country is supposed to make payments in dollar. In this situation the importers is exposed to appreciation in USD/INR. The importer can thus buy USD CALL option to cover his transactions 1st October 2010 at a strike rate of 45.50. The expiry is 2 months, i.e. 30th of December 2010. The premium for the above mentioned Call Option is 0.30 paise, so at the time of making actual payment if the spot price has moved below the Strike Price, Dollar becomes cheaper and the loss on Call Option is maximum upto 0.30 paise. If at the time of making actual payment the spot price has moved above strike price, the Dollar becomes costlier but the loss is compensated by an appreciation in the premium price. Following is the Pay Off Table depicting gain and loss at various levels of exchange rate :

SPOT RATEEXERCISE RATEPREMIUM PAID GAIN/LOSS
CALL@45.50
44.00 0.30-0.30
44.50 0.30-0.30
45.00 0.30-0.30
45.50 0.30-0.30
46.000.500.300.20
46.501.000.300.70
47.001.500.301.20

Currency Hedging Scenario's

Currency Hedging Scenario's

Exchange Traded Currency Futures are used to hedge against the risk of rate volatilities in the Forex markets.
Below we give two illustrations to explain the concept and mechanism of hedging.

Hedging against Indian Rupee appreciation

Let’s assume an Indian IT exporter receives an export order worth EUR100,000 from a European telecom major with the delivery date being in three months. At the time of placing the contract, the Euro is worth 64.05 Indian Rupees in the Spot market, while a Futures contract for an expiry date that matches the order payment date is trading at INR64. This puts the value of the order, when placed, at INR6,405,000. However, if the domestic exchange rate appreciates significantly (to INR63.20) by the time the order is paid for (which is one month after the delivery date), the firm will receive only INR6,320,000 rather than INR6,405,000.
To insure against such losses, the firm can, at the time it receives the order, enter into 100 Euro Futures contracts of EUR1,000 each to sell at INR64 per Euro, which involves contracting to sell a foreign Currency on expiry date at the agreed exchange rate. If on the payment date the exchange rate is INR63.20, the exporter will receive only INR6,320,000 on selling the Euro in the Spot market, but gains INR80,000 (ie 64 - 63.20 * 100 * 1,000) in the Futures market. Overall, the firm receives INR6,400,000 and protects itself against the sharp appreciation of the domestic Currency against the Euro.
In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is to protect against excessive losses. Firms also tend to benefit from knowing exactly how much they will receive from the export deals and can avoid the uncertainty associated with future exchange rate movements.

Hedging against Indian Rupee depreciation

An organic chemicals dealer in India places an import order worth EUR100,000 with a German manufacturer. Let’s assume the current Spot rate of the Euro is INR64.05 and at this rate the value of the order is INR 6,405,000. The importer is worried about the sharp depreciation of the Indian Rupee against the Euro during the months until the payment is due. So, the importer buys 100 Euro Futures contracts (EUR1, 000 each) at INR64 per Euro. At expiry, the Rupee has depreciated to INR65 and the importer has to pay INR6,500,000, gaining INR100,000 (ie INR65-64 * 100 * 1,000) from the Futures market and the resulting outflow would be only INR6,400,000.
In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is to protect against excessive losses. Firms also tend to benefit from knowing exactly how much they will pay for the import order and avoid the uncertainty associated with future exchange rate movements.

Current Strategy for Exporters

Strategy for Exporters

24th September, 2012

TIME FRAMESTRATEGYOPTIONS
30 DaysSell on rise to 54Buy 52.00 PE Oct series
60 DaysSell on rise to 54.50Buy 51.50 PE Oct series
90 DaysSell on rise to 54.00Buy 52.00 PE Nov series

EXPECTED RANGEPRICE
1 month52 - 54
2 month51 - 54.50
3 month50 - 55

Currency Strategy for Importers

Strategy for Importers

24th September, 2012

TIME FRAMESTRATEGYOPTIONS
30 DaysBuy in dip to 52.50Buy 53.50 CE Oct series
60 DaysBuy in dip to 52.00Buy 53.50 CE Oct series
90 DaysBuy in dip to 51.00Buy 53.50 CE Nov series

EXPECTED RANGEPRICE
1 month52 - 54
2 month51 - 54.50
3 month50 - 55

Forex Risk Management Ideas

Forex Risk Management Tips

As Currency fluctuations can adversely impact SMEs, it is very important for SMEs to protect their exposure in an efficient and effective manner. We feel that every SME should follow the following steps to manage their exposure:
Determine risk exposure : The following will help SME’s to determine their risk exposure:
  • Percentage of sales or purchases (especially receivables and payables) that is done in foreign Currencies?
  • Is the environment such that your SME is not in a position to pass on the Currency losses by increasing the prices?
  • Can you enter into price variance clauses with your customer based on exchange rate fluctuations?
  • Do you have a tight cash flow? Can adverse Currency fluctuation cause problems for you?
  • At what point will a change in exchange rates affect your profitability significantly?
  • Which Currencies are you exposed to and in which Currencies do you have payment obligations?
Determine risk mitigation strategy : The following strategies may be followed, depending on the level of risk exposure:
A. Selective hedging : This is a good method if you have significant but short-term foreign Currency exposure. In such a scenario, you can decide to hedge 50% to 60% of your total exposure and accept the benefit or loss from the unhedged portion.

B. Systematic hedging : Here, you hedge your position as soon as you enter into any foreign Currency commitment. As a general rule, the more your business relies on Forex cash flows, the more you should hedge against foreign Currency risk.

C. No hedging : In this situation you simply accept the Forex risk. Hedging is not necessary if only an insignificant part of your total business is exposed to Forex risk or if you can pass on the entire benefit or loss arising from foreign Currency transactions to the customers.
Determine risk mitigation tools : You may want to choose from any of the following tools:
A. Currency diversification: You can reduce your Currency risk by diversifying the Currency base. For example, you can reduce your dependence on USD/INR exchange rates by accepting orders in other Currencies such as Euro, Yen, etc. 

B. Forward contracts: The Forex Forward contract is an agreement to convert a given amount of a Currency into another at a predetermined exchange rate and on a predetermined date. It is the preferred instrument for hedging against Forex risks. 

C. Swaps: A swap involves simultaneous Spot and period transactions of one Currency for another. It is used when you have receivables and payables in the same Currency with due dates that do not match. D. Call and Put Options: Call and Put Options act like an insurance policy. They allow you to profit when exchange rates shift in your favour and also protect you when the opposite happens.

How Market Forces Affect Exchange Rate Movements

How Market Forces Affect Exchange Rate Movements

Interest rate parity 

If capital is allowed to flow freely, exchange rates will become stable and an equality of real interest rates is established. The real interest rate is the nominal interest rate, taking into account the prevailing inflation rate in the country.

Law of one price

In theory, the same goods should sell at the same price anywhere in the world (net of costs arising from barriers to free trade). This implies that either the price of goods or the exchange rate should adjust to make prices the same everywhere.

Macro-economic environment

A positive macro-economic environment, including government policies, competitive advantages, etc, increases the demand for a Currency. Economic data such as Consumer Price Indices (CPIs), Producer Price Indices (PPIs), Gross Domestic Products (GDPs), international trade, productivity and industrial production figures also affect fluctuations in Currency exchange rates.

Stock market

The major stock indices also have a correlation with the Currency rates. The demand for the Equity of a country gives rise to the demand for the Currency of that country.

Political factors

All exchange rates are susceptible to political instability and speculation about new governments.

SME & Corporate Services

SME & Corporate Services

India is witnessing an unprecedented economic boom and is seeing increasing activity in the manufacturing as well as services sectors. Its export sector is thriving and various industry sectors such as IT, ITES, pharma, ship building, auto ancillary and textile produce goods for markets across the world. While the growth rate is showing a positive trend, export-oriented SMEs, MSMEs and corporates are also more exposed to Currency fluctuations – for many of them an unfamiliar territory.
Export comes with many associated risks relating to the realisation of payments and Currency exchange rates. Exporters are faced with a situation where costs are budgeted in Rupees and revenues are in foreign Currencies. It is very important to manage Forex fluctuations like any other business risks.
The Rupee appreciated to 39.4 per US Dollar in January 2008, compared to 44.00 a US Dollar in March 2007. After appreciating for almost 16 months, the Rupee then started depreciating and fell to an all time low of 51.2 a US Dollar in March 2009, due to Foreign Institutional Investors (FII) outflows. Today it is trading in the INR44–45/US Dollar range. This kind of volatility has exposed the SME, MSME, corporate and other export-oriented sectors to huge Currency risks which are eating up their profits. It has become imperative for these sectors to manage Currency exposures to mitigate risks.
However, there is not much awareness in this area and most exporters, out of ignorance, live with such risks. Given the cut-throat competition in the international markets, SMEs and other corporates need to operate at very low margins to retain market share or enter new markets. If profits are reduced by Forex losses, it is not a good thing for the businesses. Hedging in the Currency Futures market is an effective tool to mitigate risks. Currency Futures are Exchange Traded Derivatives which can benefit the small and medium exporters through hedging their Currency risk and minimising loss due to Currency volatility.
Exchange rate fluctuations impact different segments in various ways. When the domestic Currency appreciates, it is the importers who benefit from it and when the Indian Rupee depreciates, it is the exporters who benefits from it. However, the level of impact varies from sector to sector and the ability to withstand this impact is also different from sector to sector. For example, a company dealing in IT and IT-related services always has a higher margin than an individual dealing in the handicraft or textile sector. Hence, the IT company has greater capacity to withstand the impact of Rupee appreciation or depreciation.
We can classify this impact as follows:
  • Impact on exporters : Strengthening of the Rupee is a nightmare for exporters, while the weakening of the Rupee boosts their profit margins.
  • Impact on importers : Strengthening of the Rupee favourably affects an importer as their payments for goods go down when the Rupee appreciates.
  • Impact on borrowers : In this global economy, Indian firms choose loans in foreign Currencies over Rupee loans because they are cheaper. However, when accepting a foreign Currency loan, there is a risk involved relating to exchange rate fluctuations.

How Does Currency Derivatives Trading Work?

How Does Currency Derivatives Trading Work?

  • Presently, all Futures contracts on Exchanges are settled in cash. There are no physical contracts.
  • All trades on Currency Exchanges take place on their respective nationwide electronic trading platforms. These can be accessed from dedicated member terminals at various locations across India.
  • All participants on the Currency Exchange trading platform can participate only through trading members of the Exchange.
    • Participants have to open a trading account and deposit stipulated cash and/or collaterals with the trading member.
  • Exchanges stand in as the counter-party for each transaction. Therefore, participants do not need to worry about defaults.
    • In the event of a default, Exchanges will step in and fulfil the obligations of the defaulting party, and then proceed to recover dues and penalties from them.
  • Those who enter the market either by buying (long) or selling (short) a Futures contract can close their contract obligations by squaring-off their positions at any time during the life of that contract by taking an opposite position in the same contract.
    • Participants have to open a trading account and deposit stipulated cash and/or collaterals with the trading member.
    • A long (buy) position holder has to short (sell) the contract to square-off their position and vice versa.
    • Participants will be relieved of their contract obligations to the extent they square-off their positions.
  • All contracts that remain open at expiry are settled in INR in cash at the reference rate specified by the Reserve Bank of India.

Introduction of Currency Derivatives Trading

Introduction of Currency Derivatives Trading

A Currency market is a market in which one Currency is traded for another. The Spot exchange rate refers to the prevailing exchange rate at which a Currency can be bought or sold for another. The Forward exchange rate refers to the exchange rate for the future delivery of the underlying Currencies.
A Currency Futures contract, traded on Exchanges, is a standardised version of a Forward contract. The only difference between a Forward contract and the Futures contract is that the Forward contract is an over-the-counter (OTC) product. The main advantages of Currency Futures over Forwards are price transparency, elimination of counter-party credit risk and greater accessibility for all.
The Futures contract is an agreement to buy or sell the underlying Currency, on a specified date in the future, and at a specified price. The underlying asset for a Currency Futures contract is a Currency. The Exchange’s clearing house acts as a central counter-party for all trades and thus provides a performance guarantee.
Currency Futures can be bought and sold on the Currency Exchanges through members of the Exchange. MCX-SX, NSE, BSE and USE all offer Currency Futures in India. Before trading, the investor/trader/speculator needs to open a trading account and deposit the stipulated cash and/or collaterals with the trading member. The average daily turnover in global Forex and related markets is trillions of US Dollars.

Indian Forex Market - Introduction

Indian Forex Market

The Reserve Bank of India permitted Exchange Traded Currency Futures in 2008, in order to facilitate the cross-border transfer of funds for business purposes. The rapid integration of the global financial markets was another reason for the move. The National Stock Exchange of India (NSE) was the first to launch Currency Futures on 29 August 2008. The Bombay Stock Exchange (BSE) and MCX Stock Exchange (MCX-SX) started offering Currency Futures trading in September and October 2008 respectively.
Since then, the Forex market in India has seen significant growth, gaining depth and volume. As the Indian Forex market evolves, new Derivatives instruments are being added for trading and hedging against price risk.
Policy-makers in India are keeping a close eye on Currency Futures. The obvious reasons are to keep a tab on the speculative activities by traders and arbitragers who do not have any underlying physical exposure in this market and trade purely for speculation.
With speculation increasing, there are concerns that excessive speculation may adversely affect both Futures and the underlying Spot markets. Considering these developments, attempts need to be made to study the pattern of trade and the impact of Futures on Forwards and Spot.