How is currency hedging effective for exporters?

International financial transactions have a high possibility of incurring foreign exchange profit and loss because of currency fluctuation. It becomes imperative for the trader engaged in the cross-country deals to mitigate and manage such currency risk.

Since the currencies fluctuate when compared to each other, the cash flow resulting from the foreign trades gets highly affected. There comes the role of currency hedging, which is an effective way to minimize the loss and protect against high volatility.

Currency hedging is done by entering into a financial contract to protect international trade gains against the unexpected change in the currency rate. Taking a cue from the term “hedging” which means mitigating the risks and securing the profits from anticipated risks.

The currency hedging similarly mitigates the risk by fixing an exchange price at a pre-defined level to cap the upward and downward currency movements.

What is an example of Currency Hedging?

To understand the currency hedging, here is a straight example. Let's say there are two companies in India; ABC and XYZ. ABC company in India is dealing with the XYZ company in Belgium to import perfumes. ABC Company orders the perfume worth Rs. 50 lakhs. Currently, the rate of USD is $73 and ABC company wishes to fix this rate to avoid any losses in the future.

They enter into a future contract of tenure 6 months from the date of imports. On the completion of the tenure, the rate of USD is $74. Here the importer is able to protect themselves from the rise in exchange rates by hedging the position. Otherwise, the currency movement would have taken a good bite out of their profits.

Why is Currency Hedging important?

1. Currency Hedging helps in locking the current value of a particular deal as the international deal depends on the foreign currency movement (mostly USD). By knowing the value to be received in the future for a particular transaction becomes pivotal for the business in many ways.
2. Drawing an analogy with taking insurance, currency hedging helps in mitigating and making the business open to risk in terms of adverse movements in the currency.
3. An importer is feared by the foreign currency strengthening while an exporter is feared by foreign currency weakening. Currency Hedging protects against both fluctuations and helps businesses strive.
4. When the money to be earned is fixed, the bottom lines of the businesses are also saved in an improved manner.
5. Minimize faulty losses due to the uncontrollable financial markets by hedging the inter-country transactions.

How to hedge the currency risk?

While there are a few ways to hedge the currency risk, the main four methods that can help businesses to manage the unanticipated exchange rate volatility are the following:

Futures Contract

These are the financial contracts that enable the two parties to pre-define the exchange rate at which payment will be made. In India, the provision to buy a future contract is via exchanges like NSE or MCX. Apart from utilizing this for the purpose of hedging, traders also speculate with the currency futures contracts. There is a secondary market that aids in such transactions.

Forward Contract

These are similar to the futures contract except for the fact that they are traded via over-the-counter and not through exchanges. There is also a lack of a secondary market and so no speculations are done whatsoever.

Currency Options

An option is a financial contract that provides the buyer the right but not an obligation to buy at a fixed price. With currency, the options include the fixed currency rate. This also includes the strike price at which the currency can be bought and sold along with an expiration date.

Foreign Bank Account

This is the simple but least effective option to hedge the currency risk. In the above-mentioned example, company ABC can protect its business by opening an account in Belgium and when the exchange rates are favourable, transfer the funds back home. The domestic bank will thus convert them into local currency and preserve the funds.