Currency Derivatives and Foreign-Exchange Hedging

Foreign-exchange risk is the possibility that exchange-rate changes will alter the rupee value of a firm's foreign-currency payments, receipts or liabilities. Currency derivatives are contracts whose value depends on an exchange rate; firms use them to offset an underlying currency exposure and make future cash flows more predictable.

How a hedge offsets currency exposure

A firm takes a derivative position that gains when exchange-rate movements adversely affect its underlying transaction. An effective hedge matches the exposure's currency, amount and timing.

• An importer with a future dollar payment loses from rupee depreciation, so it can contract to buy dollars at a predetermined rate.
• An exporter expecting dollar receipts loses from rupee appreciation, so it can contract to sell those dollars at a predetermined rate.
• A firm servicing foreign-currency debt can hedge interest and principal payments to reduce uncertainty about their rupee cost.

Main instruments and their uses

• A forward contract fixes today the exchange rate for a specified future currency transaction. It is generally negotiated over the counter and can be tailored to the exposure.
• A currency futures contract is standardised and exchange-traded, with margin requirements and daily settlement of gains and losses.
• A currency option gives its buyer the right, but not the obligation, to exchange currency at a specified rate. The buyer pays a premium for protection while retaining the benefit of favourable exchange-rate movements.
• A currency swap exchanges cash flows in different currencies according to agreed terms and can help align debt servicing with the currency of operating revenues.

An illustrative forward hedge

Suppose an importer must pay $100,000 after three months and enters a forward contract to buy dollars at ₹83 per dollar. The payment's rupee cost is fixed at ₹83 lakh, apart from transaction costs.

• If the rupee depreciates to ₹86 per dollar, buying the dollars without a hedge would cost ₹86 lakh; the forward protects against the ₹3 lakh increase.
• If the rupee appreciates to ₹80 per dollar, the firm must still honour the forward and forgoes the cheaper market rate.

Benefits and limitations

Hedging supports predictable costs, profit margins and debt servicing, but risk reduction is not guaranteed profit.

• Premiums, transaction costs and margin requirements can make hedging costly or create liquidity needs.
• Imperfect matching can leave residual exposure, while counterparty default can undermine protection.
• Speculation creates exposure to profit from exchange-rate movements; hedging offsets an existing or anticipated business exposure.