HOW CAN IMPORTER MANAGE CURRENCY RISK
THROUGH BSE CURRENCY FUTURE CONTRACTS
Any individual or business that deals with foreign currency is exposed to forex risk. An importer or a foreign currency borrower has payables in foreign currency and he should hedge his business against weakening of rupee. Future contracts may be categorized based on the underlying market of commodities, interest rates, equity indices, currency, metals, and even weather. An importer has a dollar payable at a future date. Therefore, he needs to ensure that INR does not depreciate much as it will mean that he will require more Indian Rupees to get the equivalent amount of dollars. Usually Importer needs to make payment in 3-4 months. During that period USD/INR can go up or down which is unpredictable so he should hedge this risk by buying the USD-INR futures. BSE has introduced weekly and monthly future contracts . No one knows about future so ,it is better to hedge the Currency Risk. For instance when we buy a new car, we take an insurance keeping in mind any future risk .
FX Risk Involved while importing is as follows :
- Transaction Exposure: This concerns with the risk of losses due to adverse foreign exchange rate movement that may affect the domestic currency value of import and export contracts denominated in foreign currency. (Payment in future period)
- Translation exposure: It is a pure accounting issue involving risks that may arise due to adverse currency movements, likely to affect the value of assets, liabilities and other income statement transactions while preparing the consolidated financial statements.
- Economic(operating) exposure: It refers to the risks of firm’s cash flows, foreign investments, and earnings being negatively impacted due to fluctuating foreign currency exchange rates.
- Margin: Importer has to give margin to bank for doing transactions of currency conversion.
- Costing: Due to currency fluctuation costing is affected if currency risk is not hedged.
- Premium: Interest rate differential. Any change in interest rates may result in an increase in premium thus increasing the forward rates if left unhedged.
- Credit Risk: This refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by the counterparty. This is not a real problem in currency futures as there is clearing corporation guarantee.
M/s Anuj Timbers imports wood from Africa and supplies to Indian companies for making furniture. He has got an order to import teakwood. He enquires from his supplier and finds that the total cost of wood is $ 1,000,000. His Payment terms are to make import payment on receiving shipping documents which is normally 4 to 5 days.
Current Spot rate is 73.56 and 1 week future contract in BSE is at 73.63, He assumes a cost of Rs.73.75 per dollar as his cost and quotes a rate of 73.80, keeping a profit margin of 5 paise. The Risk he carries is if Dollar rupee goes above 73.75 in 1 week then his profit will start getting reduced and if it crosses 73.80, he incurs a loss in his deal.
Amount USD 1,000,000 1 lot = $ 1,000 No of lots = 1,000
He Buys 1,000 lots of BSE Weekly future, Expiry 24 Dec 2020 at 73.63 thus locking a profit of 0.17 paise in this deal
In the above chart we can see that when importer hedges his position ( blue line) , he is incurring profits if market goes above 73.80. If he does not hedge currency Risk ( bank ) then he is going into losses. In case of hedging, net P & L is constant (Green line)
|73.75||73.75-73.63 = 12 paise PROFIT||73.80 – 73.75 = 5 paise Profit||0||73.80 – 73.75 = 5 paise Profit|
|74.00||74.00-73.63 = 37 paise PROFIT||73.80 – 74.00 = 20 paise Loss||0||73.80 – 74.00 = 20 paise Loss|
|74.50||74.50-73.63 = 87 paise PROFIT||73.80 – 74.50 = 70 paise loss||0||73.80 – 74.50 = 70 paise loss|
|75||75.00-73.75 = Rs 1.37 Profit.||73.80 – 75.00 = 1.27 paise loss||0||73.80 – 75.00 = 1.20 paise loss|
As we can see that by hedging on BSE currency futures, the company is able to protect 17 paise profit in the trade.
We recommend importers having short term exposures to use Weekly future contracts for managing risk more efficiently.
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