Understanding Currency Risk
Currency risk, also known as exchange rate risk or forex risk, arises from the change in price of one currency in relation to another. For businesses engaged in international trade, currency fluctuations can significantly impact profitability, cash flows, and financial planning.
Forex hedging is the strategy of protecting your business against adverse movements in exchange rates. It acts as an insurance policy, ensuring that your international transactions maintain their expected value regardless of market volatility.
Why Forex Hedging Matters
For Exporters
If you have USD receivables and INR strengthens against USD, you receive less INR for the same USD amount.
Example: $100,000 receivable @ ₹83 = ₹83 lakhs. If INR strengthens to ₹80, you receive only ₹80 lakhs—a loss of ₹3 lakhs.
For Importers
If you have USD payables and INR weakens against USD, you pay more INR for the same USD amount.
Example: $100,000 payable @ ₹83 = ₹83 lakhs. If INR weakens to ₹86, you pay ₹86 lakhs—an extra cost of ₹3 lakhs.
Hedging Instruments
Several financial instruments are available for hedging currency risk in India. Each has its own characteristics, costs, and suitability depending on your risk appetite and business requirements.
Forward Contracts
Agreement to buy/sell currency at predetermined rate on future date. Binding obligation for both parties.
- • No upfront premium
- • Customizable amount and date
- • Available through banks
- • Lock-in rate provides certainty
Currency Options
Gives right but not obligation to buy/sell currency at strike price. Pay premium for flexibility.
- • Premium payable upfront (1-3%)
- • Limited downside (premium only)
- • Unlimited upside potential
- • European style (exercise at maturity)
Currency Futures
Standardized exchange-traded contracts. Cash settled in INR through recognized exchanges.
- • Available on NSE, BSE, MCX-SX
- • Standardized contract sizes
- • Daily mark-to-market
- • Lower counterparty risk
Currency Swaps
Exchange of principal and interest in one currency for another. Used for longer-term exposures.
- • Suitable for long-term exposures
- • Can structure as per requirements
- • Used for ECB hedging
- • Flexible tenor options
Forward Contracts
Forward contracts are the most commonly used hedging instrument by Indian businesses. They provide certainty by locking in an exchange rate today for a transaction that will occur at a future date.
How Forward Contracts Work
Example Scenario:
- • Exporter has $100,000 receivable due in 90 days
- • Current spot rate: ₹83/USD
- • 90-day forward rate quoted: ₹84/USD
- • Exporter enters into forward contract to sell USD at ₹84
- • On maturity (90 days later):
- • If spot rate is ₹82, exporter still gets ₹84 (benefit)
- • If spot rate is ₹86, exporter gets only ₹84 (opportunity cost)
- • Either way, exporter has certainty of ₹84 lakhs
Forward Contract Terms
| Parameter | Details |
|---|---|
| Tenor Range | 1 week to 1 year (trade), up to 5-10 years (ECB) |
| Margin | 5-10% initial margin; MTM margin if adverse movement |
| Cost | Bid-ask spread; no explicit premium |
| Settlement | Physical delivery or cash settlement |
| RBI Limit | Up to 100% of underlying exposure |
Currency Options
Currency options provide the right, but not the obligation, to buy or sell a currency at a predetermined price (strike price) on or before a specified date. This flexibility comes at a cost—the option premium.
Call Option (For Importers)
Right to buy foreign currency at strike price. Used to hedge payables.
Example: Buy USD Call at ₹84 strike, pay ₹0.50 premium. If USD rises to ₹86, exercise and buy at ₹84. If USD falls to ₹82, let option lapse and buy at spot.
Put Option (For Exporters)
Right to sell foreign currency at strike price. Used to hedge receivables.
Example: Buy USD Put at ₹84 strike, pay ₹0.50 premium. If USD falls to ₹82, exercise and sell at ₹84. If USD rises to ₹86, let option lapse and sell at spot.
Factors Affecting Option Premium
- Strike Price: Closer to spot = Higher premium
- Time to Expiry: Longer tenor = Higher premium
- Volatility: Higher currency volatility = Higher premium
- Interest Rate Differential: Affects forward points
Currency Swaps
Currency swaps involve the exchange of principal and interest payments in one currency for principal and interest payments in another currency. They are typically used for hedging long-term exposures such as foreign currency loans (ECB).
Types of Currency Swaps
Plain Vanilla Swap
Fixed-for-fixed or floating-for-floating exchange of interest payments in two currencies, with principal exchange at start and end.
Cross-Currency Swap
Exchange of floating rate in one currency for floating rate in another. Most common for ECB hedging.
Currency Futures
Currency futures are standardized contracts traded on recognized stock exchanges (NSE, BSE, MCX-SX). They are cash-settled in INR and provide a transparent, regulated hedging mechanism.
Key Features
| Feature | Specification |
|---|---|
| Contract Size | USD 1,000 (or equivalent) |
| Tenor | Monthly expiries (max 12 months) |
| Settlement | Cash settled in INR |
| Margin | SPAN margin + Exposure margin |
| Trading Hours | 9:00 AM to 5:00 PM |
Futures vs Forwards
Futures
- • Exchange traded
- • Standardized contracts
- • Daily MTM
- • Lower counterparty risk
- • Available to retail
Forwards
- • OTC (bank)
- • Customizable
- • Margin at start
- • Bank counterparty risk
- • Through AD banks
RBI Regulations
The Reserve Bank of India regulates forex hedging activities under the Foreign Exchange Management Act (FEMA), 1999. These regulations ensure that hedging is used for genuine business purposes and not for speculation.
Key Regulatory Requirements
- Underlying Exposure: Hedging allowed only against genuine forex exposures (trade, ECB, FDI)
- Hedging Limit: Up to 100% of exposure can be hedged
- Authorized Dealers: Hedging only through AD Category I banks
- Documentation: FEMA declaration and proof of underlying exposure required
- No Speculation: Hedging without underlying exposure is prohibited
Eligible Exposures for Hedging
Trade Exposures
Export receivables, import payables, with maximum tenor matching trade cycle (typically 1 year)
External Commercial Borrowings
ECB loans can be hedged up to 100% of outstanding amount, for tenor matching the loan
Foreign Currency Loans
Buyers credit, suppliers credit, PCFC can be hedged for the exposure period
Past Performance
Based on average of last 3 years' actuals, subject to declaration and verification
Hedging Strategies
Choosing the right hedging strategy depends on your risk appetite, market view, cost considerations, and business margins. Here are common strategies used by Indian businesses.
Strategy Selection Framework
| Strategy | When to Use | Cost |
|---|---|---|
| Forward Contract | Want certainty, no view on market direction | Low (spread only) |
| Option | Want protection + upside participation | Medium (1-3% premium) |
| Collar/Range Forward | Want defined range, low/zero cost | Low to Zero |
| Participating Forward | Want protection with partial participation | Low |
| Natural Hedge | Have matching receivables and payables | Zero |
For Exporters
Exporters with foreign currency receivables face the risk of domestic currency appreciation (or foreign currency depreciation). Here are tailored strategies for exporters.
Recommended Exporter Strategies
- Conservative: Hedge 100% of confirmed receivables using forwards
- Moderate: Hedge 70-80% with forwards, leave balance open
- Opportunistic: Use put options to protect while retaining upside
- Layered: Hedge portions at different rates to average out
Best Practices for Exporters
- ✓ Include hedging cost in export pricing (typically 1-2%)
- ✓ Hedge as soon as order is confirmed
- ✓ Don't try to time the market
- ✓ Use PCFC in foreign currency if expecting INR depreciation
- ✓ Monitor hedge effectiveness regularly
For Importers
Importers with foreign currency payables face the risk of domestic currency depreciation (or foreign currency appreciation). The urgency to hedge is typically higher for importers as a payable represents a certain liability.
Recommended Importer Strategies
- Conservative: Hedge 100% of confirmed payables immediately
- Moderate: Use call options for protection with upside potential
- Zero-Cost Collar: Define acceptable range with no premium cost
- Natural Hedge: Match with export receivables where possible
Best Practices for Importers
- ✓ Hedge confirmed payables immediately upon LC opening
- ✓ Consider buyers credit in foreign currency if expecting INR appreciation
- ✓ Factor hedging cost into landed cost calculations
- ✓ Maintain hedging discipline—don't delay hoping for better rates
- ✓ Review supplier credit terms for natural hedge opportunities