Primary objective of forex hedging is to minimize risks associated with forex exposure and its volatility. So, it’s important to have a right hedging strategy that would protect your company from the extreme volatility or movements in a currency pair. There are many companies, which have been drastically affected due to the erosion of their margins purely due to forex movements. There are companies which have lost millions and reported losses solely due to them entering into complex hedging strategies that went horribly wrong for their company.
Considering above-mentioned scenarios, it is imperative to have an absolute understanding of various hedging products available in the market and assess both pros and cons before entering into the hedging contract with your bank.
Types of hedging products available:
Typically MSMEs in India avail two types of hedging products i.e. Forward Contracts and Options.
Let's understand how does a forward contract function in layman’s language.
Company ABC P Ltd is into software exports and receives 1 lakh USD a month for the services they provide. Assume USDINR pair as on 1st Oct 2017 is trading at 65, so if they were to enter into a Forward Contract with his bank for next 6 months for 50000 USD/ month i.e. 50% of his exposure, bank would quote rates which might read like below
Nov 17 – 65.30
Dec 17 - 65.60
Jan 18 – 65.80
Feb 18 – 66.10
Mar 18 -66.40
April 18 – 66.60
* Above-mentioned rates aren’t actual quotes. Actual quotes vary based on multiple factors and need to be taken from respective banks/advisors at the time of entering into a contract.
If ABC P Ltd believes INR would strengthen against USD in the coming months i.e. if they believe that USDINR pair would trade below 65 levels in the coming months, it would make sense to enter into a Forward Contract thereby protecting themselves from the downside of USDINR pair. So, if the company has entered into a contract, they would get rate only as covered in the contract i.e. if USDINR is at say 64 in Jan 18, the company would still get 65.80 as covered in the contract thereby company recording a notional gain of 1.80 Rupee/USD. The flip side to this is, assume the USDINR pair moves against the expectation and INR weakens against USD and USDINR is 66.50 in Jan 18, the company would get 65.80 as per the contract and tends to notionally loose 70 paisa/USD.
The company would be asked to deposit a certain amount as a fixed deposit which would be lien marked by the bank to mitigate against adverse volatility.
Any company /firm can enter into a Forward Contract with their bank based on the volumes or exposure that they have on a particular currency pair and completing necessary documentation as required by their bank.
Options, basically irons out the flip side that we have seen with forwards, that is when the currency tends to move against the expectation company could lose out. So in Options, the company can still go for the IBR(Inter Bank Rate) if the rate is in their favor. In the above example if ABC P Ltd was in an Options contract they could have ignored contract rate i.e. 65.80 and gone with IBR, which is 66.50. However, in Options company has to pay an upfront premium to the bank as the fee, which varies, on multiple factors. It is imperative that company analyzes various costs associated before entering into any hedging instruments.