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.
SMEs/Corporate Advisory Desk at Ludhiana - Indo Pak International Expo 2013 from 15th – 18th February 2013 in Ludhiana, PunjabMore details