Hedging

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.

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).

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 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:

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.

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.

• 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.