Currency derivatives are an effective method of dealing with the risks associated with foreign exchange fluctuations. Small and medium enterprises and other companies engaged in export and import businesses play a significant role in the development of any country. But these units have to worry about the impact of currency fluctuations in their businesses. SMEs currently contribute nearly 35% of India’s gross output of the manufacturing segment. This segment also accounts for 40% of the country’s total exports. The growth of this segment, has, however, been constrained by the risks associated with the fluctuations in the currency rates. All SMEs or other corporate units exporting their products have to worry about the impact of currency fluctuations and take actions to prevent the negative impact of such fluctuations. The units highly exposed to currency fluctuations are the ones engaged in export and import of a variety of products and services related to the food processing segment, agricultural inputs, pharmaceuticals, engineering, electrical and electronics, textiles and garments, leather goods, meat products, bio engineering, IT services etc.
The Indian rupee has been very volatile against the US dollar and has witnessed a significant decline in its value in recent months to currently stand at over Rs 60 per dollar. The weakening of the Indian rupee offers Indian exporters a cost advantage while raising the import costs for businesses importing equipment or other materials. Exposure to foreign exchange is a key measure of judging a firm’s future profitability, net cash flow and market value. Business units exporting or importing their goods and services face three kinds of risks related to foreign currency fluctuations:
A change in the currency rate leads to change in the valuation of outstanding financial obligations of any business. In many cases exporters work out their cost estimates in rupee terms but get their revenues in foreign currencies.
Translation of financial statements of foreign subsidiaries for the purpose of consolidation into worldwide financial statements of a corporate.
Change in the value of the operating cash flows of a business due to change in exchange rates.
Risks related to change in the cost of foreign currency loans due to fluctuations in the value of the currency.
One of the best options to deal with currency fluctuations and related risks is hedging. This means taking an opposite position in the futures market. This helps to minimize the risks associated with the unpredictable changes in the USD/INR rate. Derivative instruments can easily be bought and sold in India and thus are an attractive option for hedging against the currency fluctuation risks.
Exchange rates or the rate at which one currency can be exchanged for another fluctuates on a continued basis. Let’s look at the various factors that affect the movement of these rates: Interest Rates: An increase in the interest rate of a country means improved yields of assets denominated in the currency of that county. This in turn leads to greater demand and higher inflow of investment funds and thus a strengthening of the currency. In contrast lower interest rates dissuade investors which are followed by the weakening of the currency. However, interest rates are not the sole factor driving currency rates. Macro-economic environment: A positive macro-economic environment where the government policies boost the inflow of funds into the country is bound to strengthen the value of its currency. Release of economic data related to prices, GDP, trade, productivity, industrial product etc also impacts the exchanges rates. Political Environment- The currency of a country ruled by a stable government is bound to remain strong. However, any kind of political instability or turmoil may have a negative impact on that country’s currency value. Inflation Level- A country having a low inflation rate is bound to have a strong currency. In contrast countries with higher inflation rates are likely to have \weaker currencies in comparison to the currencies of countries having low inflation rates. Stock Markets- Active stock markets and increased demand for the equity of a country are bound to raise the demand for that country’s currency.
As we have already mentioned, SMEs having an exposure to foreign currencies need to take adequate steps to minimize the risk associated with the fluctuation in the exchange rate. Here are certain tips for SMEs to manage their foreign exchange risk. First and foremost every SME should determine and quantify their risk exposure. This can be done by 1.Identifying the percentage of sales or purchases that are made in foreign currencies. 2.The next step is to check whether the unit or the company is in a position to pass off the losses occurring due to currency fluctuations to the consumers. 3.Is it possible for you to add price variance clauses in your sale or purchase contracts to deal with exchange rate fluctuations? 4.What impact can the change in exchange rates have on your cash flows and profitability? Some estimates should be made assuming a certain percentage of change in exchange rates. 5.Which currencies does your business deal in and the extent of exposure to each of them? Once you have identified the exchange rate fluctuations risks facing your business, you can take steps to mitigate them. Possible strategies are: -Selective hedging wherein you decide to hedge about 50% of your total exposure while being ready to face the impact on the remaining 50%. -Systematic and regular hedging calls for hedging your position as soon as you enter into a commitment involving foreign exchange. -Change in the value of the operating cash flows of a business due to change in exchange rates. -Ignore the option of hedging and decide to accept the profits or losses arising from fluctuations in currency rate. This strategy is used only if you have a limited exposure to foreign currencies. -Minimise your currency risks by diversifying into several currencies. An SME tries to cater to not one but several markets at the same time to avoid risks associated with the fluctuation in the value of one currency pair. -Enter into forward contracts that allow you to have the right to convert a given amount of one currency into another at a predetermined exchange rate on a future date. -Businesses having receivables and payables in the same currency can choose swaps. A swap transaction involves spot and future transactions at the same time.
An importer of a good or service gets impacted by the volatility in the foreign currency rate in which the payment is to be made. Say for example if the value of the Indian Rupee or INR appreciates, the importer makes a profit by buying the goods or services at a lower price. However, if the INR depreciates, the cost of importing goods and services rises which in turn puts the importer in a serious financial problem. Since an importer can never be sure of future movements in the exchange rate, he has an open position in the cash position. In such a scenario any change in the exchange rate will affect his firm’s operating cash flows, income and hence its stock price. This is where hedging can prove to be useful. Say if the Indian importer believes that there is a high probability of the INR weakening against the USD, he should go long on currency futures and purchase a USD/INR Futures contract as part of his hedging strategy. This strategy will allow the importer to offset the losses occurring from INRs weakness with the profit earned on the currency futures
Exporters produce and ship their products to a foreign country while the payment for the same is received at a later date and is in foreign currency. The exporter will be affected by any change in the value of the foreign currency in which he is supposed to receive the payment. An appreciation in the value of INR leads to losses since his products have fetched him a lower price. In contrast if the INR depreciates, the exporter makes profits by selling the goods and services at a higher price. So we know that when the INR strengthens, the exporters incur losses but when the INR weakens the exporters make a profit. To avoid sudden changes in the value of a firm’s operating cash flows, income, competitive position and its share price, an exporter should hedge his exposure by using currency futures. Say if an exporter believes that the INR is likely to strengthen against the USD in the near future and he will have to sell USD. This situation can be handled by selling a USD/INR futures contract.
Hedging against currency fluctuations is highly important if you have business interest overseas, are exporting or importing on a regular basis or have an office abroad. Here are certain examples of how you can do that. Example 1- Hedging for depreciation in INR Say if an Indian company wishes to import machinery worth USD 360,000 and places his import order on 15th August 2013. The delivery date for this machinery is after four months on 15th December, 2013. The USD/INR rate at the time of the time of the placement of the order is Rs 60 in the spot market. Now if the value of the INR depreciates to Rs 65 per USD by the time the delivery of the machinery becomes due. This means that the Indian importer will have to pay a higher amount. Such a situation can be avoided if the importer hedges his risk by buying $360,000 in the spot currency market. In case the INR depreciates, the importer will make a profit by selling his USD holdings. This profit in his trading account will be adequate to offset any increase in the cost of imported machinery over the period. Example 2- Hedging for appreciation in INR Let’s take the case of an Indian IT Exporter bags an order for exporting goods and services worth $100,000 to a US company with the delivery scheduled after three months. Say at the time of the receipt of the contract the USD is worth Rs 65 in the spot market. This makes the value of the order in INR terms as 65,00,000. Now if the value of rupee appreciates over the three month period and stands at Rs 60, the value of the order stands reduced to 60,00,000. To avoid such losses, the Indian exporter can at the time of receiving the order enter into a USD futures contract to sell at Rs 65 per USD. The execution of this contract will allow the exporter to earn a profit which will be adequate to balance the decline in the value of the export order.
The concept of hedging can be better understood by going through the following examples of hedging when the INR appreciates and secondly when the INR depreciates. Example 1: Say if an importer from India enters into a contract to import 1000 barrels of oil, the payment for which is to be made in USD on December 1, 2013. Also the price of each barrel of oil has been fixed up at USD 100 per barrel at the prevailing exchange rate of 1USD=INR 65. In such a case the cost of one barrel is Rs 6500. Now if the importer faces the risk of the weaking of the USD in the next few months and thus increased cost of oil in terms of INR. Now if on December 1, 2013, the INR deprecates and the exchange rate is 1USD = INR 70. The cost of per barrel of oil now stands at Rs 7000. This means the importer will now have to pay Rs 7000 per barrel instead of the agreed price of Rs 6500. On the total transaction, the importer will now have to pay Rs 50, 000 extra for having bought 1000 barrels of oil. If the importer decides to hedge his position, he will purchase a USD/IND futures contract. This means the strengthening of the USD would lead to profit in the long futures position and thus mitigate the loss in the physical market. Example 2: Say an exporter of copper enters into a contract to export 1000MT of copper to the US. The agreed price for the sale has been fixed at USD 5200/MT at the current exchange rate of 1USD = INR 65. This means the total sale price of one MT of copper is 5200x65=Rs 3,38,000. Now if the INR appreciates and the exchange rate becomes 1USD= Rs 60 it means that he will get a payment of 5200x60 (Rs 3,12,000) for one MT of copper. To avoid such a situation, the exporter should go short on currency futures or sell a USD/INR futures contract as a hedging strategy. This will protect him against the weakening of the USD by offsetting the profit in the short futures position.
A company may be importing raw materials form a foreign country say US and thus needs to make the payment for the same in USD. A possible appreciation in the USD/INR rate will have a negative impact on him. Such a scenario requires that the importer hedge against the currency fluctuations by buying USD Call option. Say if he buys a option on 1st September 2013 at a strike rate of 65.50 whose expiry is in 2 months that is 1st November 2013. The premium for this call option is 0.50 paise which means that if at the time of making the actual payment if the spot price falls below the strike price, dollar becomes cheaper, the loss on call option will be a maximum of 0.50 paise. However, if at the time of making actual payment, the spot price rises above the strike price and the dollar becomes costlier, the loss will be compensated by an appreciation in the premium price.
|SPOT RATE||EXERCISE RATECALL@65.50||PREMIUM PAID||GAIN/LOSS|
Say if an exporter exports leather bags to USA, he will receive the payment for the same in USD and thus will be negatively impacted if the INR weakens. This situation requires that the exporter should buy a Put option to cover his transaction. Say if the exporter buys a Put option on 1st September 2013 at a strike rate of 65.50 and the expiry of the option is after two months on 1st November 2013. The premium on this Put option is 0.50 paisa. Now if the spot price moves above the strike price (the dollar becomes costlier) at the time of the actual payment the loss on call option will be a maximum of 0.50 paisa. However, if the spot price falls below the strike price ( dollar becomes cheaper) at the time of making the actual payment, the loss will be compensated by the increase in the premium.
|SPOT RATE||EXERCISE RATECALL@65.50||PREMIUM PAID||GAIN/LOSS|