Hedging
Also written Hedge · To hedge · Currency hedging · FX hedging
Taking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
In plain language
You do not hedge a view. You hedge an exposure you are already stuck with.
An Indian exporter who has invoiced a US buyer in dollars will be paid in dollars in three months. He does not want dollars — he wants rupees, and he has already priced his shirts assuming a particular rupee rate. Between today and the day the money lands, that rate can move against him by two rupees, and his margin is gone.
Hedging removes that. He sells a currency futures contract today at a known rate. If the rupee strengthens and he gets fewer rupees in the spot market, the futures position makes exactly that much back. If the rupee weakens and he gets more, the futures position loses exactly that much.
That symmetry is the whole idea, and it is also the whole cost. A hedge that protects you from a bad rate also takes away the good one. Hedging is not a way to make money on currency. It is a way to stop caring about currency.
Under Indian foreign exchange rules the word is a defined one: hedging means the activity of undertaking a foreign exchange derivative transaction to manage currency risk — the potential for loss from movement in the rupee against a foreign currency, or between two foreign currencies, or in the interest rate applicable to a foreign currency.
How it works
Building a hedge is three decisions, and the workbook sets them out in exactly this order.
1. Which contract? It follows the currency pair of the exposure. Euro receivable, EURINR contract. Dollar payable, USDINR contract.
2. Long or short? It follows the direction of the cash flow, not your opinion. Someone who will receive foreign currency is hurt if that currency falls, so he sells futures or buys a put. Someone who will pay foreign currency is hurt if it rises, so he buys futures or buys a call. An exporter shorts; an importer goes long.
3. Which contract month? The one whose expiry falls just after the money is due. An exporter expecting dollars on 17 March picks the March contract expiring 26 March, not April — the cash flow must land inside the life of the hedge.
The cost is real, and it is in three parts: the upside you give away, the margin blocked at the clearing corporation and marked to market every day, and transaction costs (brokerage, exchange charges, GST, stamp duty — though securities transaction tax is not currently levied on exchange traded currency derivatives).
The formula
Effective price = Price actually realised in the spot market
+ Payoff on the hedge
For a receiver (exporter) the hedge payoff is added; for a payer (importer) a positive hedge payoff is subtracted from the remittance rate, because a lower rupee rate is what helps him.
When only part of the exposure is covered:
Effective price = (Unhedged fraction × Spot rate)
+ (Hedged fraction × Hedged effective rate)
A worked example
A garment exporter ships 10,000 shirts at USD 100 each — USD 1,000,000, payable three months after shipment. At USD 1,000 a contract, that is 1,000 USDINR futures contracts.
He budgeted the order at the spot rate of Rs 81. To protect it he sells four-month futures at 81.75.
Case A — the rupee weakens. He converts at spot 83.00 and squares the futures at 83.05.
Spot : 83.00 − 81.00 (budget) = +2.00
Futures: 81.75 − 83.05 = −1.30
Net = +0.70
Effective rate = 81.00 + 0.70 = 81.70
Case B — the rupee strengthens. He converts at 80.00 and squares at 80.05.
Spot : 80.00 − 81.00 = −1.00
Futures: 81.75 − 80.05 = +1.70
Net = +0.70
Effective rate = 81.00 + 0.70 = 81.70
The same 81.70 both times. Now put it in rupees on the full USD 1,000,000:
| Hedged | Unhedged | |
|---|---|---|
| Rupee weakens to 83 | Rs 8,17,00,000 | Rs 8,30,00,000 |
| Rupee strengthens to 80 | Rs 8,17,00,000 | Rs 8,00,00,000 |
The hedge saved Rs 17 lakh in the bad case and cost Rs 13 lakh in the good one. That Rs 13 lakh is not a mistake — it is the price of certainty, paid in a year when the market happened to move his way. An exporter who calls it a loss and stops hedging has misunderstood what he bought.
Partial cover. A pulses importer buying 1,000 tonnes of chickpea at USD 1,600 a tonne (USD 1.6 million) hedges half at 81.50 with spot then at 81. At payment the spot is 82.00 and futures 82.05, a gain of 0.55 on the hedged half:
Hedged half : 82.00 − 0.55 = 81.45
Unhedged half : 82.00
Effective : (82.00 × 0.5) + (81.45 × 0.5) = 81.725
Full cover would have given 81.45; no cover at all, 82.00.
Why NISM asks about it
Chapter 2 (Foreign Exchange Derivatives) defines hedgers as one of the three participant classes and gives the FEMA definition of "hedging" and "currency risk". Chapter 5 (Strategies using Exchange Traded Currency Derivatives), section 5.2, is where it is worked: the three hedging decisions, the combined position of futures with an export remittance and with an import remittance, and partial hedges.
The recurring question hands you a budgeted rate, a contracted futures rate, a final spot rate and a squaring-off rate, and asks for the effective price. Get the sign convention right — added for a receiver, subtracted for a payer — and the arithmetic is trivial. Get it wrong and every such question in the paper is wrong.
Common exam traps
- The hedge is not supposed to make money. A question showing a loss on the futures leg is usually showing a successful hedge, because the spot leg gained more or the same.
- Direction follows the cash flow, not the forecast. Exporter (receives) sells futures or buys puts; importer (pays) buys futures or buys calls. Candidates reverse this under time pressure more than any other single thing in the paper.
- Hedging is the activity; a hedger is the participant. FEMA defines the activity; the workbook classifies the person.
- Exchange traded contracts are standardised and cash settled, so the amount and date rarely match the exposure exactly. What is left over is basis risk, and the workbook lists cash settlement itself as a source of imperfect hedging.
- Pick the expiry after the cash flow. A contract expiring before the money arrives leaves the exposure naked for the gap.
- Do not confuse hedging with insurance: a futures hedge removes the downside and the upside; buying an option removes only the downside, for an explicit premium.
Where this is taught
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series XVI · Chapter 5: Uses of Commodity Derivativesintroduced here
- Series I · Chapter 2: Foreign Exchange Derivativesintroduced here
- Series XV · Chapter 11: Fundamental Analysis of Commoditiesintroduced here
- Series V-D · Chapter 19: Interest Rate Derivativesintroduced here
- Series SEBI-ICE · Chapter 5: Investment in Securities Marketintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
- Series X-A · Chapter 10: Understanding Derivativesintroduced here
Related terms
- Basis riskThe risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Effective priceThe rate a hedger actually ends up with: the price realised or paid in the spot market, adjusted by the payoff on the hedge — added for a receiver, subtracted for a payer.
- Forward contractA bilateral, over-the-counter agreement between two parties to buy or sell an asset on a fixed future date at a price agreed today — customised to suit them, and binding on both.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- InsuranceThe risk-management approach that pays an explicit upfront premium to remove the downside while keeping the upside — which in derivatives means buying an option rather than selling a future.
- Partial hedgeCovering only a fraction of an exposure with derivatives, leaving the rest open — so the effective rate is a weighted average of the hedged rate and the spot rate.
- Protective putBuying a put option to protect a foreign currency receivable: it sets a floor rate (strike minus premium) while keeping the benefit if the currency rises. Suited to contingent cash flows.
- HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
- Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
- Long-only Equity StrategyA Category III AIF strategy that takes only buy positions in selected stocks when investing, aiming at absolute returns over the medium to long term with a strong emphasis on capital preservation.
- Risk transferThe economic function by which commodity price risk moves off the hedger, who does not want it, onto the speculator, who is willing to carry it for a return.
- Sectoral indexA commodity index built from the futures of a single segment — bullion, base metals, energy or the guar family — with fixed annual weights and no 30 per cent cap per constituent.
- Hedging instrumentIn hedge accounting, the derivative — a forward, future or option — used to reduce the risk of the hedged item, whose gains and losses are matched against that item under the ICAI Guidance Note.
- Cash Flow Hedging ReserveThe equity account in which the fair-value gains and losses of a derivative designated as a cash flow hedge are parked until the hedged forecast transaction hits profit and loss.
- Retrospective effectiveness testingThe mandatory check, at each reporting date, that a designated hedge actually was highly effective — its results falling within 80 to 125 per cent — as a condition of continuing hedge accounting.
- Forward Rate AgreementAn OTC contract that locks in an interest rate today for a borrowing or lending period starting later; only the rate difference on a notional principal is settled, in cash.
- Interest-rate derivativesContracts that let borrowers and investors hedge adverse interest-rate movements — interest-rate futures, interest-rate swaps, interest-rate options (caps and floors) and forward rate agreements.
- Offshore derivative instrumentsInstruments issued by an FPI that reference Indian securities; SEBI bars ODIs referencing derivatives and allows onshore derivative hedging only via a separate Category I registration, within limits.
- Hedging disclosure normsSEBI's requirement, dated 15 November 2018, that a listed company disclose its commodity risk policies and, for each commodity, its exposure and the extent hedged in domestic and international markets.
- Monsoon proxyUsing an agricultural commodity index future as a stand-in for a bet on the monsoon — buy it for a deficit monsoon, short it for a good one — which the workbook offers as an approximation only.
- Naturally longThe position every business holds in its finished goods — it gains when their prices rise and loses when they fall, which is why finished goods are hedged by selling futures.
- Naturally shortThe position every business holds in its raw materials — it must buy them in future, so a price rise hurts it exactly as a short position would, and a long hedge cancels the exposure.
- Offsetting hedgeA hedge undertaken to offset price risk that has arisen from a physical market activity already carried out — one of the workbook’s two basic hedging strategies, the other being locking in a price.
- Currency swapAn OTC derivative in which two parties exchange streams of interest payments and/or principal in different currencies on set dates over the swap's life, at an exchange rate agreed at the start.
- Hedge accountingAn optional accounting treatment that matches the timing of gains and losses on a designated hedging derivative with the item it hedges, instead of taking the derivative's fair value changes straight to profit and loss.
- Fair value hedgeA hedge of the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment, attributable to a particular risk that could affect profit and loss.
- Contingent cash flowA foreign currency receipt or payment that may not happen at all — an unconfirmed order or an unsuccessful bid — for which the workbook prefers bought options to futures, because the loss is capped at the premium.
- Protective callBuying a call option to hedge a foreign currency payable: it caps the purchase rate at strike plus premium, while leaving the importer free to benefit if the currency falls.
- Exchange Rate RiskThe risk that an investment’s value, measured in the home currency, changes because foreign exchange rates move. A falling rupee raises returns on foreign assets; a rising rupee cuts them.
- Delta hedgingOffsetting an option position's delta with the underlying or futures so the combined delta is zero, then buying or selling as delta changes to keep it there — the option trader's way of managing risk.
- Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.
- Zero sum gameThe principle that every derivative long has a matching short, so one side's gain is exactly the other side's loss and the net value of all derivative positions is zero.