Taking a short position in the futures market is referred to as a short hedge. In a currency market, a short hedge is taken by someone who already possesses or expects to receive the base currency in the future.
After three months, an exporter expects a payment of USD 1,000,000. Assume the current spot currency rate is INR 57.0000 to 1 USD. If the spot currency rate remains unchanged after three months, the exporter will get INR 57,000,000 from the USD obtained from the export contract. If the exchange rate climbs to INR 58.0000: 1 USD after three months, the exporter will receive INR 58,000,000. If the currency rate falls to INR 56.0000: 1 USD, the exporter will receive INR 56,000,000, resulting in a loss of INR 1,000,000. As a result, the exporter faces an exchange rate risk, which it might mitigate by holding a position in the futures market. Exporters can lock in the currency rate at INR 57.0000 per USD after three months by establishing a short position in the futures market (suppose the 3 month futures price is Rs. 57). Because a contract for USD-INR futures is worth 1000 USD, the exporter must have a short position in 1000 contracts. Whatever the currency rate is after three months, the exporter will receive INR 57,000,000. A profit in the futures contract will compensate for a loss in the spot market, and vice versa.
How do you use futures to mitigate currency risk?
Forex risk is a danger that any individual or business that deals with foreign currency is exposed to. Whether you’re an exporter, importer, ECB borrower, FCNR borrower, or a worldwide tourist, currencies have a significant impact on your finances. Payables in foreign currency are owed to an importer or a foreign borrower. As a result, they’ll be looking to keep the INR high so that they may collect more dollars for the same amount of rupees when their foreign currency obligation is due. Importers and foreign currency borrowers will need to protect their businesses from the rupee’s depreciation.
The exporter, on the other hand, has foreign currency receivables that will be paid at a later period. The exporter must ensure that the rupee remains weak, as this will result in his receiving more INR for each dollar received. The exporter will be glad if the rupee weakens, but he will need to protect himself if the currency strengthens. The USD-INR pair can be used by both importers and exporters to achieve the same result. Futures or options can be used to hedge the risk, and we’ll look at how each of these strategies can be used. While the USD-INR pair is presented as an example because of its liquidity and popularity, the same rationale may be applied to receivables in the Pound, Euro, and Yen.
Let’s look at an illustration to assist us comprehend this. Assume Raghav Exports Ltd. has a $50,000/- export inward remittance that is due on September 30th. While Raghav is aware of the dollar amount he will receive on September 30th, he is unsure of how much INR that will translate into, as it will be determined by the USD-INR exchange rate on that date. The current exchange rate is Rs.64 to $1. On September 30th, this will translate into a rupee inflow of INR 32 lakhs. Raghav has obligations on October 10th and is satisfied with the exchange rate of 64/$ on settlement day.
Raghav Exports, on the other hand, has been advised by their banker that the INR may actually appreciate to 62/$ by September 30th as a result of heavy FDI inflow into India. In rupee terms, this means Raghav exports will only receive Rs.31 lakhs. Raghav Exports is concerned that this will result in a shortfall in meeting their October 10th outflow pledge. As a result, the company must manage its inward dollar risk. How would Raghav Exports be able to accomplish this?
Simply put, Raghav Exports can mitigate this risk by selling 50 lots of the USD-INR pair at Rs.64 per lot (each lot is worth $1000). This will provide them with complete protection. This is how it is going to function. Assume that the INR has appreciated to 62/$ on the 30th of September, the inward date. On September 30th, Raghav Exports will receive a transfer of $50,000/-, which will be translated to Rs.31 lakhs. Raghav, on the other hand, has sold 50 units of USD-INR futures for Rs.64 each. Raghav exports will make a Rs.1 lakh profit on that position now that the price has dropped to 62. As a result, the total receivable is now Rs.32 lakh (Rs.31 lakh from conversion and Rs.1 lakh from the short USD-INR futures). Raghav Exports has effectively hedged its conversion price at Rs.64/$.
What happens if the INR depreciates to Rs.68, on the other hand? Raghav Exports would have made a profit in normal circumstances, but due to the hedging, it will be locked in at Rs.64/$. This will result in a Rs.4 notional loss, but the goal is to protect your downside risk rather than to profit. There are two ways to get around this. The USD-INR pair can be held with a stringent stop loss, or hedging can be done with put options rather than futures, limiting the maximum risk to the amount of the option premium.
In this case, the situation will be the polar opposite of the exporter’s. A dollar will be due at a later date to an importer or a foreign currency borrower. As a result, they must guarantee that the INR does not decline too much, as this will necessitate the use of more rupees to obtain the same amount of dollars. By purchasing USD-INR futures, the importer or foreign currency borrower might reduce their risk. When the rupee falls in value, the dollar rises in value, increasing the value of USD-INR futures. Any dollar loss he incurs as a result of the weaker INR will be offset by long USD-INR futures. Hedging can also be done using options in the event of an importer or foreign currency borrower by purchasing a call option on the USD-INR pair.
Currency derivatives (futures and options) are also a useful way to hedge future dollar risk. While the OTC forward market continues to dominate, currency derivatives are quickly becoming the preferred method of managing currency risk.
What is the best way to hedge a futures contract?
You can buy options with your futures brokerage account. You buy put options to protect yourself against declining prices. You are protected against increasing pricing by using call options. Each call enables you to purchase a futures contract at the strike price, whereas puts enable you to sell futures contracts at the strike price. Buying options with the same expiration date as futures contracts is standard practice. You are fully hedged if the strike prices of your futures and options are the same. You can partially hedge by acquiring fewer options or options with strike prices that are closer to the futures price.
Is it possible to use futures to hedge?
Both consumers and producers of commodities can utilize futures contracts to hedge their positions. Futures hedging essentially locks in a commodity’s price today, even if it will be bought or sold in physical form in the future.
How do you use forward contracts to mitigate currency risk?
The purchase of hedging instruments to counter the risk provided by certain foreign exchange positions is known as foreign currency hedging. Hedging is done by obtaining a currency exposure that is the inverse of the one being hedged. For example, if a corporation is obligated to deliver 1 million euros in six months, it might mitigate this risk by signing into a contract to buy 1 million euros on the same date, allowing it to buy and sell in the same currency. We’ve included a few options for foreign currency hedging below.
How do you protect yourself against currency depreciation?
With the value of the dollar growing, many experts advise typical investors to mitigate as much currency risk as possible, according to Boyle.
You won’t lose money if the currency in which your investment is held falls in value if you hedge foreign assets in your portfolio. Of course, if that currency appreciates, you will lose money.
Over the last year and a half, Boyle believes that hedging against swings in the Japanese yen would have been a sensible decision. The Nikkei Index has risen 45 percent since January 1, 2013, yet the yen has fallen 13 percent.
“If you hedged, you may have outperformed the S&P 500,” Boyle said. “However, the vast majority of people are unlikely to have done so.”
You can hedge by purchasing a currency-hedged mutual fund or investing in an exchange-traded fund. You don’t have to worry about risk with these funds; all you have to worry about is stock market returns.
What are some tactics for hedging?
Depending on the asset or portfolio of assets being hedged, there are a variety of effective hedging options for reducing market risk. Portfolio creation, options, and volatility indicators are three of the most popular.
Is it possible to use options to hedge futures contracts?
Hedging with futures options has the extra benefit of allowing investments in futures contracts to be hedged in the same ratio. If you possess one E-mini S&P 500 futures (ES) contract, you might use one ES option contract to mitigate risk.
How do you protect yourself from rising commodity prices?
Commodity Price Risk Hedging Producers and purchasers can hedge against commodity price changes by acquiring a contract that guarantees a set price for a commodity. They can also lock in a worst-case scenario price to protect themselves from possible losses.
How do alternatives help to mitigate risk?
An investor transfers the downside risk to the seller by purchasing a put option. The more downside risk that the buyer of the hedge wants to transfer to the seller, the more expensive the hedge will be. The downside risk is determined by the passage of time and the volatility of the market.