| December 05
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.
An illustration to understand better
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 hedging so important?
1. 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
2. Drawing an analogy with taking
insurance, 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. Hedging protects against both fluctuations and helps businesses
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.
Several ways 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
1. 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.
2. 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
3. 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.
4. 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.