USDINR Hedging using Futures and Options for Importers

Any business involved in the export and import of goods and services is exposed to foreign exchange risk as the payment and receipts are quoted in foreign currency and there is a need to convert them into local currency. For an exporter, depreciation in the local currency against foreign currency is beneficial while for an importer appreciation in local currency against foreign currency is beneficial. Since currency movement is dependent on various factors such as interest rate parity, supply, and demand of currencies, monetary and fiscal policies as well as Balance of Payment. To mitigate currency market fluctuations there are various tools available such as forwards and options in the OTC market, futures, and options in exchange platform. 

In any asset class, hedging is a method for reducing or transferring risk to protect one's portfolio or business from price volatility. A player who enters a trade with the goal of safeguarding an existing position from an unexpected currency shift is said to have constructed a forex hedge in the foreign exchange market.

For importing goods or services, an importer always has a dollar payable at a future date once the transaction is completed. Therefore, importers need to ensure that the local currency should not weaker much. If the local currency depreciates too much, then the importer ends up paying higher local currency against foreign currency. To protect his benchmark, importers can hedge currency risk through currency derivatives i.e., futures and options. In the case of currency futures, an importer hedges his risk by buying USDINR futures. When the rupee depreciates, the dollar will appreciate and therefore the value of the USD-INR futures will go up. Any loss on his dollar payable due to weaker INR will be compensated by the long futures on the USD-INR.

Currency Hedging using Futures&nbsp

Let's say a gold importer wishes to buy $1,000,000 worth of oil and placed an order on January 17, 2022, with a three-month delivery date. USDINR spot is at Rs 74.2500 when the contract is placed. However, if the Indian rupee depreciates to Rs 76 per dollar by the time the payment is due in April 2022, the importer's payment will be worth Rs 76,000,000 instead of Rs 74,250,000.

In order to protect his benchmark, gold importer buyers USDINR April futures at Rs. 75.2075 on the date of placing import order. Following are the 2 scenarios, how the hedged position minimizes the currency risk.

Scenario 1: If the USDINR Depreciates to Rs. 76.000 after 3 months

When the gold importer hedges his currency risk using futures, he could effectively protect his benchmark price against market fluctuations. In the case of USDINR depreciation, with hedging, the gold importer would make a dollar payment at Rs. 75.2075 in a hedged transaction against Rs. 76.0000 in the un-hedged transactions.

Additional Read: What is Derivative Trading in the Share Market?

Scenario 2: If the USDINR Appreciates to Rs. 73.000 after 3 months

In case of USDINR appreciation, he gains in paying dollar at lesser Indian Rupee against his original transaction. Since he has taken a long position in USDINR futures, he incurs losses in squaring off his positions when the actual payment is made. In any way, the importer hedges his risk of currency fluctuations.

Currency Hedging using Options

The same gold importer placed the order to import gold worth Rs. 1,000,000 and the material will be delivered in 3 months. An increase in the exchange rate of USD results in increasing the price of gold. To protect from such an increase, the gold importer buys a USDINR Call Option at a strike price of Rs. 75.0000 and the current spot price is Rs. 74.2500. The premium of Rs. 75.0000 strike price with 3-month expiry is 0.6500 and lot size is 1000 dollars. 

Now, let us see what happens when the USDINR appreciates and depreciates in 3-months.

Scenario 1: USDINR Depreciates to Rs. 76.0000

Importer bought the call option when the spot price was at Rs. 74.25000 and on the date of expiry, the spot USDINR is quoting at Rs. 76.0000. The strike price was Rs. 75.0000, hence, the payoff for the importer is as follows

{(Closing Price of USDINR on expiry-Strike Price)-(Premium)} X Lot Size

{(76.0000-75.0000)-(0.6500)}*1000 = 350

 Scenario 2: USDINR Appreciates to Rs. 74.0000

Importer bought the call option when the spot price was at Rs. 74.25000 and on the date of expiry, the spot USDINR is quoting at Rs. 74.0000. The strike price was Rs. 75.0000, hence, the payoff for the importer is as follows

{(Closing Price of USDINR on expiry-Strike Price)-(Premium)} X Lot Size

{(74.0000-75.0000)-(0.6500)}*1000 = -1650

Since options are the derivative instruments, which gives the right but not the obligation to exercise the contract so the gold importer will get the opportunity of the contract to expire worthlessly. Hence, the premium of Rs. 650 will only the loss to the importer. 

Additional Read: Chapter 1: Introduction to Derivatives

Conclusion

Currency derivatives—futures and options—are efficient risk management tools for the businesses engaged in international trading. When the importer wishes to book his forward rate against his import order in the OTC market, the importer needs to submit his exposure to the banks, which is not the case with exchange-traded currency derivatives. An importer can hedge his risk to the tune of USD 10 million without submitting his import order with the exchange. Further, options are getting more traction amongst investors, traders, importers, and exporters. With an availability weekly option on USDINR, the short-term hedging can also be done rather than taking monthly futures and options contracts.