Hedging against Foreign Exchange Exposure:
Hedging: It is a process to make the net position for a given currency at a given date equal to
zero. The process involves buying or selling of an offsetting position in order to provide
protection against an adverse change in price. It is normally adopted in forward market and the
market for derivatives. Traders/parties wishing to manage their risks are called Hedgers.
The rationale for hedging lies in the exchange rate fluctuation which can move significantly and
erratically even within a short time. Since it is common for a customer to take some time in
accepting the quoted price, placing an order and making payment, financial loss due to
exchange rate movements can easily occur.
Without a hedge, the high degree of volatility in the foreign exchange market may erode or
even wipe out the amount of anticipated profit.
Forward Market Hedging
The forward market is used not only by the arbitrageurs but by the Hedgers too.
Changes in the exchange rate are usual phenomenon. Such changes result in some
foreign exchange risk in terms of loss or gain to the traders and other participants in the
foreign exchange market. The risk is reduced or hedged through forward market
transactions.
Under the process of hedging in forward market, currencies are bought and sold
forward. Forward buying and selling depends upon whether the hedger finds himself in
a long, or short position.( Long position: having greater inflow than the outflow than the
outflow of a given currency or holding greater assets than the liabilities of a given
currency. Short position: a position when the anticipated inflow of a foreign currency is
less than the anticipated outflow)
An export billed in foreign currency creates a long position for the exporter. On the
contrary, an import billed in foreign currency leads to a short position for the importer.
However the forward deal has disadvantages too. The advantage is that if the value of the
dollar falls (as in the above example), the exporter will not have to suffer any loss of income,
while the disadvantage is that if the value of the dollar appreciates (say to Rs 41 after 3 months
in the above example), the exporter will not benefit from the appreciation (as he would have to
sell dollars at the pre- agreed rate of Rs 40/$). Moreover in case a part of the merchandise is
not accepted and paid for by the importer, the exporter will have to arrange for the dollars(at
the spot rate of Rs 41/$ on the 90th day)to honour the forward contract.
The advantage or disadvantage of the forward deal is reaped not only by the exporter
but also by the importer. In case of short position, a forward discount is favourable by
the hedger because it enables him to obtain foreign exchange at a rate lower than the
current spot rate. On the contrary, a forward premium is unfavourable because it makes
the forward foreign currency costlier.
However, the exact magnitude of loss or gain to the importer depends upon the
difference between the forward rate and the future spot rate. If the forward rate is Rs
39.50/US$ and if the future spot rate is Rs 39.80/US$, the Indian importer will be able to
save Rs 300 because he will get US$ 1000 only for Rs 39500 under the forward contract;
whereas he would have to pay Rs 39800 for 1000 dollars, had there been no forward
contract. But if the future spot rate comes down to Rs 30/US$ the importer will have to
face a loss of Rs 500 under the forward contract.
Thus hedging in forward market, whether it concerns a long position or a short position,
is a double edged sword and if the trend in the exchange rate movement is not
according to expectations, it can result in a loss.
