Question

While deciding on the strategy for the coming year, Nitin is faced with the challenge on how to mitigate the currency risk. In the past, there have been instances where Nitin has quoted the price at the prevalent currency rate and by the time the export proceeds were realised, he received a lesser value for his goods. Nitin extracted the data of Foreign Exchange Rates for the past year and, on analysis, found that there had been an average 5-7 per cent fluctuation in the foreign currency rates against the Indian Rupee on a daily basis. Nitin was unable to decide whether to hedge the foreign currency or not. Narayan advised Nitin that there were two ways of hedging the currency risk:

1. A forward contract between a bank and a customer calls for a delivery, at a fixed future date, of a specified amount of one currency against another currency at an exchange rate fixed at a time the contract is entered into.

2. An option is a financial instrument that gives the holder the right but not the obligation to sell or buy another financial instrument at a set price and expiration date.

Recommend the best method of hedging currency risk and explain why you chose it.

Answer 1

There had been an average 5-7 per cent fluctuation in the foreign currency rates against the Indian Rupee on a daily basis.

In a forward contract, the exchage rate is fixed at the start of the contract. Although, the forward contract has an initial cost of 0 to enter into, Nitin will find that he loses out a lot if the change in the exchange rate is his favour at maturity. He will still have to execute the deal at the forward price.

In an option contract,however, there is a premium to be paid for buying options initially. The advantage however, is that the option payoff is 0, if the exchange rate is in favor of Nitin's transaction and the payoff will be equal to the losses if the exchange  rate is not in favor of Nitin's transaction, hence hedging the losses.

In short, there is a limited downside risk while hedging through options whereas in forward the downside risk is huge. Given the extremely high volatility of the Indian Rupee on a daily basis, it is advisable for Nitin to hedge the currency risk using options.

Here, since Nitin has has receivables from the foreign country in foreign currency, he benefits if the Indian Rupee depreciates and loses out if the Indian Rupee appreciates. Hence, he should buy a call option on the Indian Rupee, so that any appreciation in the Indian rupee will result in a positive payoff to Nitin to compensate for his losses from the export receivables. If the Rupee depreciates, the put option will have a 0 payoff and Nitin and also benefit from the export receivables.