MANAGING IMPORT RISK BY
USING CURRENCY CALL SPREAD
One of the biggest risk factors involved in operating an Import Business is that while the overseas purchase and local sale is in progress the value of Indian Rupee may change in comparison to the value of the U.S. dollar (assuming Import is with USA). This means that the business is open to risk in terms of adverse movement of US Dollar against INR. Companies doing imports are exposed to foreign currency risk (Risk of Dollar Rupee going up). They can manage this risk by using the following tools
- Buying Currency Futures
Currency futures is an exchange-traded contract that specifies the price of one currency at which another currency can be bought or sold on a future date. Currency future contracts are legal binding. Currency Futures are non-deliverable contracts and need to be cancelled on or before expiry date. If the Company does not cancel the contract, then the contract is automatically cancelled at RBI Reference Rate on Expiry Date.
For details on this strategy read my article dated 04 January 2021 Click here
- Buying Call Option
Call option is a contract giving owner the right, but not the obligation, to buy a specified amount of an underlying security at a pre-determined price (Strike Rate) on a specified date (Expiry date). Call option hedges the upside risk fully while keeping the downside open. It has a limited loss and unlimited gain potential.
For details on this strategy read my article dated 18 January 2021 Click here
- Buying Call Spread
Call spread is an option spread strategy that is created when equal number of call options are bought and sold simultaneously with different Strike Price for same Expiry Date. Unlike the call buying strategy, the upside risk is not fully hedged. The profit potential is unlimited and it is cheaper to buy in comparison to simple Buy Call strategy.
M/s Bharat Steels gets a contract to supply steel in India. They will import it from Japan. The cost of steel is $ 600 per ton. The current rate is 73.00 which is spot rate and future rate for 30 days is 73.30. The company keeps a cushion of 20 paise for currency fluctuation and assumes 73.50 as their landed cost. Landed cost in Rupee comes to be Rs. 43,800 per ton so they quotes 45,000 per ton locally. The company gets credit period from seller of 60 days and considering shipment time of 30-40 days, their currency risk is for 30 days.
Company decides to use Call Spread to Manage the Risk
Current Rate of 73.50 Call Expiry 26 Feb 2021 is 0.25 and 74.00 with same Expiry is 0.12.
- BUY 50 CALL Expiry 26 FEB 2021 at 0.25 paise (PAY)
- SELL 74.00 CALL Expiry 26 FEB 2021 at 0.12 paise (RECEIVE)
We can conclude that buying BSE Currency Call spread is also an option to hedge the Currency Risk for an importer. The upside risk is protected up to a point (74.00 in our case) and the importer gets an advantage if the market moves in his favor i.e. Dollar Rupee starts going down. The cash flow of hedged strategy is better than unhedged in case Dollar Rupee goes up. The net premium of Call Spread is 0.13 paise as compared to 0.25 paise in case of buy Call strategy. The strategy is to be used when the importer expects the market to go down with limited upside move. In our case M/s Bharat Steel is not expecting Dollar Rupee to go above 74.00 by Feb 2021 and they feel that 73.00 or 72.00 is more likely that is why they used this strategy.