Tools to protect against the risk

Hedging can be done through two avenues. One, through the Over the Counter (OTC) market, that is through banks and two, through stock exchanges. Though various hedging instruments are available, only a couple of them are widely used.

They are forward contracts and options contracts. Forward contracts are available only in the OTC market while options contracts are available both in OTC and on the exchanges.

Apart from these two, futures contracts on the exchanges and different swap agreements like currency swaps, interest rate swaps, etc., are the other instruments available for hedging.

Here’s a closer look at the most widely used hedging instruments, the forwards and options. According to market participants, forward contracts are the more popular of the two, with 80 to 90 per cent of overall hedges done with these instruments.

Forward contract

A forward contract can be obtained only in the OTC market. By definition, it is a contract between two parties (an exporter or an importer and a bank in this case) to buy or sell a specific quantity of asset (currency in this case) at a specified rate and a specified time.

Banks add their margin to the forward premium. This, along with the bank charges, becomes the cost for the hedger.

At the moment, USD-INR forward has a premium of around 4.5 per cent. If the spot price of rupee is 65 against the dollar, then the forward rate would be 67.93. The difference of 2.93 (67.93-65) per dollar is the forward premium. So the total hedge cost would be the premium (2.93) plus the bank’s margin added to the premium along with bank charges.

Exporters earn the forward premium while they hedge as they sell the dollar whereas importers pay this premium when they buy the dollar. Forwards protect the hedger from volatility whenever the currency price moves adversely, but do not give the flexibility to change the rates if needed.

That is, from the above example, if the rupee appreciates to 64 or 63 in the next six months, then taking forward contract today will give the exporter a better rate of 67.93 after six months when the spot rate would be 64 or 63.

But conversely, if the rupee depreciates to 70 in the next six months, then it is a loss as the exporter had locked the rate at 67.93.

Options contract

This is an agreement between a buyer and a seller where the buyer of the options contract gets the right but not an obligation to either buy or sell the asset at an agreed price (called the strike price) on a future date.

An option contract that gives the purchaser the right to buy is called a “Call Option” while the one that gives the right to sell is called the “Put Option”. Options are available both in OTC as well as the exchanges. Like forwards, a premium is charged in option contracts too. On the exchange, the brokerage and other exchange related charges mark up the hedge cost and are to be paid upfront.

For instance, an importer fears that the rupee could depreciate sharply below 70 against the dollar, say, by December. If an option contract is available at, say, 68.5 for December, the importer can buy a call at 68.5 and hedge himself against a sharp fall in the rupee.

In case the rupee appreciates to, say, 63 by December, which is contrary to the earlier expectation, the importer need not execute the option and instead buy from spot market to meet his obligation.

Futures contract

Four currency pairs (USD-INR, EUR-INR, JPY-INR, GBP-INR) are available as futures contract on the exchanges. There is a margin amount, that is, a certain per cent of the total contract value (generally between 3 and 6 per cent) that has to be deposited with the broker. Other charges like the brokerage, exchange charges, etc, add to the overall cost.

The major disadvantage here is the “margin calls”. That is, if your position exceeds a certain loss limit (mark to market) you will be asked to pay more margin amount. Since the mark-to-market is calculated on a daily basis, you may have to pay additional sums almost daily if the position moves into a loss.

Forwards or Options?

Your expectation regarding the currency movement will determine whether you should use forwards or options. In a trending market, when the currency is either falling or rising, taking a forward contract will work well. Say, if the trend in rupee is up, then an exporter can book a forward contract and lock the prices. At the same time the importer can keep the exposure open and cover at market rate whenever required.

On the other hand, whenever the rupee is depreciating, an importer should take a forward contract while the exporter can keep his exposure open and cover at market rate. Options can be used when the market is trading sideways. That is when the trend is not clear.

Vikram Murarka, Chief Currency Strategist, Kshitij Consultancy Services, says “When the trend is clear and if it is in your favour, then keep the exposure open. But hedge with forwards if it is not in your favour.”

He also adds that it is good to buy an option when the market is range-bound at which time the volatility is low and hence the option premium is low. “Conversely, when the market is trending, volatility tends to be high and so does the option premium. This will be the time when one should sell an option instead of buying an option,” adds Vikram.

Exchange vs OTC

Hedging on the OTC or through the exchange traded has its own pros and cons. The biggest advantage hedging on the exchange is the transparency in prices.

The exchange rate that you see on your computer or on the exchange website is applicable for all. There is no room for negotiation.

But OTC, the prices are opaque. The premium charged can vary from case to case depending on the relationship you have with the banks. Big players and a large hedge amount could fetch better rates when compared to small corporates with less hedge amount.

Apart from this factor, OTC scores better in comparison to the exchange. The exchange traded instruments are available only for a fixed maturity date towards the end of each month. So a perfect hedge, that is the actual time of hedge requirement and the contract expiry, may not match.

But OTC offers you the flexibility to hedge for any period, for any specific date on which the transaction is to take place. This results in a perfect hedge.

Limits are applicable if you want to take a position on the exchange. For the USD-INR contract, it is $15 million and for other contracts together (EUR-INR, GBP-INR and JPY-INR) it is $5 million.

Beyond this limit you will have to provide evidence of the underlying to take positions. In OTC, there is no such limitations and any quantum of amount can be hedged.

You will have to pay the hedge cost, that is, the premium, and other charges upfront on the exchange. Also, the risk of paying the mark-to-market (MTM) margin on a daily basis is present on the exchange if you use futures for hedging your position and the position goes against you. This would add to your hedge cost.

Such hassles can be avoided on the OTC if you have a good credit-line and the banks does not ask for any margin amount until the loss in the hedge position exceeds 80 or 90 per cent of the credit line.

There is no liquidity problem in OTC. On the exchanges, the liquidity is good only on the near-month contracts, especially the one month. Cancellation of the contract is possible in OTC whereas on the exchange it is not possible.

Broadly taking into consideration the flexibility on the OTC and the limitations on the exchanges, hedging through the OTC could be ideal for corporate.

Source : Business line

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