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23rd March, 2012

Series on Forex Hedging


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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:

  • What is your actual risk?
  • How much should you hedge?
  • What is Early Delivery?
  • Is the Forward Rate a forecast?
  • How to choose a Benchmark?
  • What is Cash-Spot?

Payoff on Unhedged Exports Payoff on USD FWD Sales Exports hedged with Forwards
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.
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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 hedge.


Hedge Exposure 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 profitable hedge.



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.

Prev: Your Exposure is your position Next: Never 0, never 100, and not in one go!
Disclaimer: 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.


 

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