A smart importer or the exporter opts for hedging to make a sharp-witted move against the currency fluctuations. Basically, it is a cautious initiative to cover yourself from encountering the fear of ‘probability of loss’. Whether an importer or exporter business is always initiated with a motive- “PROFIT”. There are a few strategies that can aid you to limit your risks to a certain extent and realize profits, ‘hedging’ is one of them.
What is Hedging in Finance?
Hedging is one of the proposed actions to mitigate risks and secure businesses from future uncertainties. The price movements of the currencies are unpredictable as the market forces have varied volatility in the global financial stability. When you want to avoid such exposures, “hedging” comes into the picture.
It is a strategy with an objective to save the potential profits by freezing the exchange prices for a fixed future date. It is similar to an insurance. Here, basically, the hedger is fixing the price at a certain level to cover the risk of upward and downward movement of prices.
There are various types of hedging namely financial instruments like options, currency future contracts, exchange- traded funds, derivatives, etc.
Example of Hedging:
An Indian importer imports 10,000 apple products from China for 10,00,000 lakhs, the exchange is performed in international currencies absolutely based on the currency movements.The importer hedges at 64.00 USD in the future contracts to protect his payments from appreciation and depreciations of the dollar values. The tenure of the contract is agreed at 6 months from the date of imports. On the completion of the tenure, the exchange rate of dollar lies at 66.00 USD. Here the importer has hedged himself and paid 6,40,00,000 against 6,60,00,000 and retained the loss of extra pay of 20,00,000 lakhs.
How hedging improves your business:
Overall protection: Hedging itself acts as a shield against currency fluctuations. Using this strategy you can hedge regardless of the upward or the downward movements. The “hedger” is on a safer side and is risk-free until the payments are settled.
Better informed decisions: Drafting strategies such as taking long positions in the forward markets and eliminating risks and uncertainties for the transactions settled in foreign currencies is very much important. It helps you understand the expenses, and in turn aids in increasing your business value.
Exact value price for import/export: In the case of importers and exporters, the international transaction predominantly depend on the dollar values. Hence, hedging is pivotal for them to cover from the risk of changing currency values. Otherwise, there are chances of losing profits with the adverse currency movements. Through hedging, the importer/exporter is locking the current value for a particular transaction through currency options or future contracts from London International Financial Future Exchange or Chicago Mercantile Exchange etc.(they also allow final exchange rates than a fixed point).
Protect you against currency fluctuations: Currency hedging, in essence, is protecting against volatility of the currency either be with the weakening or strengthening of the dollar rates.
Hedging example: Say the contract made on a particular date is US $2,00,000, and the dollar rate on the same day is INR 62.00. The payments are agreed to be made after two months. Assume that on the due date, the dollar rate is INR 60.00. The exporter is receiving INR 12000000 instead of INR 12400000, resulting in a loss of 4,00,000. Currency hedging against the contract is preferable here.
Bottomline is saved: This practice is better than the traditional ways, here we can usefully freeze the prices which are mutually decided beforehand. The fear of losing money is minimized. If this strategy is understood and executed properly, it will be of great importance in saving business bottomlines.
Better business opportunities: Hedging techniques aid in expanding business opportunities as the actions are planned formerly. With a minimal risk of loss, there are diversified choices for suited scenarios.You are ensured to be protected from the market upswings once you enter the contract.
The financial markets are uncontrollable, however, it is always better to hedge your business to narrow down faulty losses. Make a smart choice by opting hedging and anticipate profits against unfavourable financial climates.