Hedging the currency risk- An Introduction

Organizations across the globe, big or small, are exposed to multiple business risks on a daily basis. Some of these risks, if materialized, can significantly paralyze the organization’s Financial and Operational capabilities to conduct its business. One of the key risks that can have a significant bearing on the firm’s finances is currency risk.

So, what is a currency risk, you ask?

Currency risk refers to a financial risk arising out of the fluctuations in exchange rates of foreign currencies. Exchange rates can fluctuate for various reasons such as inflation, interest rates, geopolitical events such as wars or natural disasters, foreign investments, trade balances, economic indicators such as GDP, unemployment nos., industrial production indices etc.

Ok, but why does this risk arise?

You see, today most of the medium and large organizations have operations outside their home country. ‘Globalization’ we say! It may either be some small sales office or an overseas branch or a full fledged global conglomerate with heavy exposure to global supply chains and markets. With this, organizations are required to deal in multiple currencies to operate their businesses in various geographies.

But where is the risk?

Well, the financial performance of all these global operations have to be consolidated, processed and reported in a single currency- let’s call it the home currency. For e.g. home currency for Indian companies is our good old Rupiah (INR). Any change in foreign currency with respect to home currency can have both positive or negative impact on the overall financial performance.

For e.g. a 1 dollar payment to vendor can cost us 80 Rupees today. But what if we have a 30 day credit period and we have to pay 1 month later? What if the exchange rate moves to Rs. 85 per dollar by then? We would end up paying Rs. 5 more!

Ok, but it can also be less than 80, right? Isn’t that good?

Well, yes it is. But that is not how currency risk management works! Risk management is not about addressing only the negatives. It is about addressing the uncertainty in your core business. You ask yourself this- How do you want to make money?- by selling best products and providing awesome services (your core business) or by profiteering through speculation on exchange rate movements?!

Ok, so how do I ensure I lock in my future rates today so I don’t have to worry about this volatility?

And voila! there you are…We hedge ‘em!

Hedging refers to a risk management strategy in which the risk arisen due to taking a position in one market / investment is countered and nullified by taking a position in opposing market / investment. In simpler terms, Hedging is an action taken to reduce substantial gains or losses suffered by an individual or an organization due to unforeseen changes in the underlying asset or a liability.

A hedge can be constructed from many types of financial instruments such as Stocks, Exchange Traded Funds (ETFs), Insurance products, Interest Rates etc. as well as derivative instruments such as Forward Contracts, Swaps, Futures and Option contracts etc. One or more of these instruments can be used to create virtually unlimited no. of combinations / deal structures to create various hedging strategies. This is probably one of the reasons why the topic has gained notoriety for being complex and unnerving...!

For this article we will consider one of the simplest form of derivative instruments widely used by Corporates for hedging the currency risk. These are called Forward Contracts. A Forward Contract is

• a contract between two parties
• to buy or sell an asset
• at a future date
• at a pre-determined / agreed upon price

Forward contracts are highly customizable in terms of their features. They are privately negotiated directly between the two parties and tailor made to suit the specific needs of the parties (over-the-counter / OTC). They are settled either physically (where the actual asset is delivered) or in cash (where the difference between contract price and actual price at the time of settlement is exchanged).

Now since we have understood what is hedging, what is a hedge and what are forward contracts, lets understand some of the terms- these will act like the arrows in your quiver to help tame these little demons!

(a) Spot Rate: Spot rate is the current market rate – meaning if I buy 1000 $ @ 80.00 (Spot rate), 1000 $ will be credited to my account and my rupee account will be debited by Rs 80,000.

(b) Forward Rate: A forward rate is the rate at which settlement occurs at a future date. On that future date, the buyer and the seller agree to exchange the currencies at the forward rate. Forwards for all currency pairs trade in the market and move based on various factors like interest rates, liquidity, demand & supply of individual currencies etc.

(c) Premia: The difference between the Spot rate & Forward rate is called Premia. Premia is a factor of time. That is to say, longer the duration of forward contract, higher the Premia & vice versa.

(d) Currency Appreciation / Depreciation: Currency appreciation refers to an increase in the value of currency relative to another currency. Appreciation occurs when, because of change in exchange rates; a unit of one currency buys more units of other currency. On the other hand, depreciation is said to have occurred when a unit of one currency buys less units of other currency. E.g. USD is said to have depreciated against the INR if it moves from 1 USD = 80 INR to 1 USD = 75 INR.

Well then, let’s jump into an illustration.

ABC Ltd. receives an order to manufacture and sell some equipment to a US Customer. The order value of the project is USD 10 Million and the payout on procurement of raw materials to manufacture the equipment amounts to USD 7 Million.

The order date is 1st June, when spot rate is: 1 USD = 80 INR. The expected date of receipt from the customer (inflow) is 31st Aug (3 months from order date) and the due date for making vendor payment (outflow) is say, 31st July (2 months from order date).

(For the sake of simplicity, single receipt and payment milestone is assumed).

Now how would you structure a hedge around this deal to safeguard your cashflows from FX volatility?

Post the necessary compliances and documentations with our banker, we enter into 2 forward contracts with the bank-

1. Sell $ 10 Million for a maturity date of 31-Aug at a USD/INR Forward Rate of 85.0
2. Buy $ 7 Million for a maturity date of 31-July at a USD/INR Forward Rate of 84.0

(The forward rates mentioned above are only illustrative).

Now let’s see what would happen on those 2 dates. There are 2 possibilities-

1. The actual market rate for USD/INR as on the due date is lower than the forward rate at which we signed the forward contract with the bank
2. The actual market rate for USD/INR as on the due date is higher than the forward rate at which we signed the forward contract with the bank

On the due dates, we would be required to take 2 actions-

1. Receive the customer inward or pay to the vendor at the prevailing market rate as on those respective due dates.
2. Cancel the forward contracts on maturity and settle the hedge gain / loss with the banker as on those respective due dates.

The cumulative effect of these 2 actions would ensure that our cashflows are FX neutral i.e. they would happen at the same effective rates which we always wanted to freeze our cashflows at, on Day 0 regardless of the market volatility in exchange rates.

Let’s see in the below table how this works out-

1. As can be seen above, hedging freezes the INR amount of cashflows for sale / purchase transaction irrespective of the fluctuations in the foreign currency.
2. The above is applicable to each customer receipt and each vendor payment during the project life cycle.
3. Cancellation of forward contract refers to entering into an opposite position than the original one at the prevailing market rate at the time of settlement. The gain / loss on cancellation works on the basic commercial prudence of buying cheap and selling dear. Selling dollar at a forward rate of 85.0 and buying back (by cancelling the forward contract) at 83.0 will result in gain.

Few points to remember-

1. Hedging entails cost. For foreign exchange forward contracts, the interest rate differential between the 2 currencies can influence the forward rate. In addition, there would be transaction fees, credit risk, opportunity cost etc. Organizations should understand these costs to evaluate net benefit of the hedging strategy.
2. It is extremely important for the organizations to put in place a comprehensive FX risk management framework to identify, measure, manage and monitor FX risk. It is important to have a governance structure, set risk limits, internal audit, board oversight and hedging policy to ensure proper authorization, documentation and compliance.
3. Accounting challenges. It is important to understand the complexities involved in hedge accounting. Timely audit and reporting requirements such as Ind AS should be carefully examined to ensure consistent and compliant reporting. Hedge documentation and effectiveness testing should be carried out on a timely basis.
4. Regulatory compliances- It is necessary to have strong control to ensure proper regulatory and banking compliances such as RBI circulars, FEMA guidelines, AML/KYC compliances, taxation laws etc.

To conclude, hedging can be a beautiful world in finance universe. It is important to not lose track of the intent of adopting hedging strategies and sign up for only those products that one understands.

In the words of Warren Buffett, derivatives may be “financial weapons of mass destruction” but as American investor James Chanos puts it- “Derivatives in and of themselves are not evil. There's nothing evil about how they're traded, how they're accounted for, and how they're financed, like any other financial instrument, if done properly.”