Question

Assume that John own a company with fx exposure, how John using forward contract to hedge the foreign exchange rate risk. Illustrate it with a scenario.

Answer 1

Risk is a probability of unfavorable outcome. An entrepreneur has to safeguard its business against multiple risks in today's environment to be competitive and efficient. Risks are many and numerous. It’s nearly impossible to anticipate all the risks, measure them and mitigate them. However, we can understand them and take an informed call or decision to mitigate them or get rid of them or to go ahead with them.

Hedging refers to taking off-setting position in two separate but related financial instruments such that the impact of the risk factor is mitigated or eliminated. A very simple example is: Say a company completes a delivery today but payment will be received in a foreign currency a month later but based on exchange rate today. A company should immediately hedge this position by entering into a transaction where payment by it has to be made in the same foreign currency a month later but based on exchange rate today. If this happens, the company receives payments in the foreign currency a month later and pays out the same amount in the second transaction thus without incurring any gains / losses due to exchange rate fluctuation. Hedging can be natural or (intellectual) man made.

An artificial hedge is by taking the offsetting position in derivative market by making use of options, futures, forwards or even swaps. Hedging can be used to manage risks arising due to fluctuations in prices, interest rate, or foreign exchange rates. Commonly used instruments are future contracts, options (Call and Put option on the stock of two different companies operating in same sector), sale and purchase of rights to goods and services for delivery at different dates.

Forward Contracts

• Not exchange traded, customized products, traded over the counter and hence called OTC products.
• A customized agreement between two parties to buy or sell a particular asset (tangible/intangible) at a future date for an agreed price without any initial payment.
• Both parties are obliged to honour the agreement. So it’s an obligation for both the parties.
• Buyer is said to be “Long a forward contract” while seller is said to be “Short a forward contract”.
• These contracts are most commonly used for foreign exchange or commodity transactions.
• The counterparty in Forward contracts are most often a bank, a dealer or a foreign exchange trader. Sometimes, they also serve as market makers and facilitate private contract between two parties.
• A long position holder benefits if the price of underlying asset increases during the period of the contract and loses if the prices of underlying asset decreases. As the payoffs are symmetrical in forward contracts, Short position holder’s gains and losses are inverse to long position holder.
• As the Forward contracts are not traded on an exchange, default risk from the counterparty exists.

Hedging refers to taking off-setting position in two separate but related financial instruments such that the impact of the risk factor is mitigated or eliminated. A very simple example is: Say a company completes a delivery today but payment will be received in a foreign currency a month later but based on exchange rate today. A company should immediately hedge this position by entering into a transaction where payment by it has to be made in the same foreign currency a month later but based on exchange rate today. If this happens, the company receives payments in the foreign currency a month later and pays out the same amount in the second transaction thus without incurring any gains / losses due to exchange rate fluctuation. Hedging can be natural or (intellectual) man made. A natural hedge is by taking offsetting positions in two securities. For example: Buying shares of India Cements and shorting (selling) shares of another cement company say J K cement. A natural hedge is a method of reducing risk by investing in two different items whose performance tends to cancel each other. A natural hedge does not involve the use of sophisticated financial tools such as derivatives or futures contracts. It’s a natural hedge. Gain in one will offset the loss in other. Insurance is a natural hedge. An artificial hedge is by taking the offsetting position in derivative market by making use of options, futures, forwards or even swaps. Hedging can be used to manage risks arising due to fluctuations in prices, interest rate, or foreign exchange rates. Commonly used instruments are future contracts, options (Call and Put option on the stock of two different companies operating in same sector), sale and purchase of rights to goods and services for delivery at different dates. Let’s look at an example below. Example: Sundaram Corporation has agreed to deliver an automobile 3 months down the line to a customer. The company has estimated that 60% of the cost of the automobile is towards steel whose prices fluctuate in international market. Company has used current steel prices to do the costing and has quoted a price which has been agreed by the customer. Sonali Sundaram, the Chief Procurement Manager has pointed out that in order to complete delivery 3 months down the line, the company needs to buy steel components around 2.5 months down the line to ensure sufficient time for assembly and shipment. What should Sonali Sundaram do to make sure the company doesn’t lose on account of foreign exchange fluctuations? Solution: Sonali Sundaram has got two alternatives available with her: She buys all the steel components today itself at today’s prices, keep them in inventory and use them 2.5 months down the line for assembly. This is a naïve method but will eliminate the price fluctuation risk completely. However, this will lead to a significant inventory carrying cost to the company. Sonali Sundaram enters into a hedging using futures contract. She enters into a future contract to buy steel at today’s price 5 months down the line. Let’s say steel price today is Rs. 100 / unit. Sundaram Corporation has done the entire costing using this rate. Steel components are required 2.5 months down the line. The future contract is entered into for delivery at Rs. 100/unit (today’s price). Case I: Let’s say 2.5 months down the line, the day on which steel components are to be bought and the day on which future contract expires, steel price has moved to Rs. 120 / unit. Due to increase in steel price, there is a loss in the customer order = Rs. 120 – 100 = Rs. 20/unit. However, since she has a future contract that enables her to buy steel at Rs. 100 / unit. She calls for delivery of steel at predetermined price of Rs. 100 / unit. She sells the delivered steel in the spot market on that very day at Rs. 120/unit and makes a profit = Rs. 120 – 100 = Rs. 20/unit. This profit will offset the loss she has incurred in the customer order. Case II: Let’s say 2.5 months down the line, the day on which steel components are to be bought and the day on which future contract expires, steel price has moved to Rs. 90 / unit. Due to decrease in steel price, there is an incremental profit in the customer order = Rs. 100 – 90 = Rs. 10/unit. However, since she has a future contract that enables her to buy steel at Rs. 100 / unit. She is forced to get delivery of steel at predetermined price of Rs. 100 / unit. She has no option but to sell the delivered steel in the spot market on that very day at Rs. 90/unit and thus incur a loss of = Rs. 100 – 90 = Rs. 10/unit. This loss will be offset by the profit she has incurred in the customer order. This demonstrates in the simplest of the term, how hedging is done. Irrespective of the actual price on the day of purchase, the offsetting positions nullify the impact of price fluctuations. What Sonali did above was she bought future. This is called “Long Future” strategy. Similarly the counterparty has taken the position called “Short Future” or sell future.