Series on Forex Hedging
peaking to a number of exporters, importers, CFOs over the last several
years, we have felt that most people find forex to be a tough beast to
tame and view it with fear. Granted, managing forex risk is not easy,
but it is not impossible either. To start with, there is a need to throw
light on some fundamental concepts of forex risk management.
In this series of articles, we will deal with questions such as:
However, this is incorrect. The hedge is not the company's actual market
position. It is a transaction undertaken to offset, or square off, or
negate, the actual underlying position that the company has in the
market, as a result of its fundamental business transactions.
See diagrams alongside
For instance, an Exporter who is to receive Dollars after 3 months has
an intrinsic Long position in the market. The value of his receivable
Long position increases if the Dollar rises against the Rupee, it
decreases if the Dollar falls against the Rupee. In other words, the
export receivable is exposed to market fluctuations, and is, in
actuality, his position in the market.
If the Exporter now sells Dollars Forward for 3 months against this
export receivable, he is hedging or closing out or squaring off his
export receivable position. If the Dollar moves up against the Rupee,
the gain on the exports is offset by the loss on the forward contract.
On a net basis, therefore, the value of the Export Receivable is no
longer exposed to market fluctuations. The position has been closed
through the hedge, through the Forward Sale contract.
Similar, but opposite is the position of the Importer, who is Short
Dollars in the market by virtue of his imports. He has to buy Dollars in
the market to make good his payment obligation. When he actually buys
Forward Dollars, he is not taking a fresh position in the market. He is
simply covering his exposure, providing for his payment obligation,
squaring off the risk of Rupee depreciation.
Thus, when a hedge, whose quantum is, say, 30% of the actual underlying
exposure, makes money, there is no reason to be overjoyed. Quite
obviously, when the 30% hedge is making money, the balance 70% unhedged
exposure is losing money. Similarly, if the 30% hedge loses money, that
is no reason to crucify the risk manager - the balance 70% unhedged
exposure is actually making money. In fact, therefore, if the hedge
ratio is less than 50%, a loss making hedge is to be preferred to a
So, which is your position? Your exposure? Or your hedge? The business
division takes a market position. The risk manager "takes a hedge".
Think about it.
Unfortunately, since the Risk Manager does not himself undertake the
export or import transaction, or because the actually underlying
position is created by default, there is a tendency to not recognize it
for what it is, viz. the company's actual position in the currency
market. It is unfortunate because this misunderstanding causes the
company to ignore and overlook the profit or loss on its actual position
and instead focus on the profit or loss of its hedge. This is akin to
losing sight of the woods for the trees, because, usually, the quantum
of the actual underlying exposure is greater than the quantum of the
The above views are based on the latest available information. Though
the information sources are believed to be reliable, the information is
not guaranteed for accuracy. While the views are proffered with the best
of intentions, neither the author, nor the firm are liable for any
losses that may occur as a result of any action based on the above.
World financial markets, and especially the Foreign Exchange markets,
are inherently risky and it is assumed that those who trade these
markets are fully aware of the risk of real loss involved. Past
performance is not necessarily an indicator of future performance.