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C ATC H T H E F U T U R E

BRIEFING ON CURRENCY DERIVATIVES

CURRENCY FUTURES
Currency Risk Exposure and Advantage of Hedging for Importers, Exporters, and SMEs
December 2008

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The movement of the US dollar (USD) against other currencies is a major cause of concern for the financial markets all over the world. In the past six months, the Indian rupee (INR) has been very volatile against the US dollar, moving from Rs 45/USD to Rs 39/USD and again to Rs 50/USD. The strengthening of INR by 13 percent has taken away the Indian cost advantage for exporters but at the same time benefited the importers. On the other side, the depreciation of the rupee by 28 percent has affected the importers adversely while benefiting the exporters.

Foreign Exchange Exposures

Foreign exchange exposure is a measure of the potential for a firm's profitability, net cash flow, and market value to change because of a change in exchange rates. It is of three types: Transaction Exposure: It measures changes in the value of outstanding financial obligations due to a change in exchange rates. Translation Exposure: Translation exposure occurs while 'translating' foreign currency financial statements of foreign subsidiaries into worldwide consolidated financial statements of the company in the domestic country. Operating Exposure: It measures the change in the present value of the firm resulting from any changes in future operating cash flows of the firm caused by an unexpected change in exchange rates.

This insight analyses transaction exposure in detail to understand currency risk to importers, exporters, and SMEs.
USD/Mn 300000

Increasing Imports & Exports

250000

200000

150000

100000

50000 Imports 0 2004-2005 Exports 2005-2006 2006-2007 2007-2008

Event Appreciation of USD or Depreciation of INR Depreciation of USD or Appreciation of INR

Importer Loses Gains

Exporter Gains Loses

The appreciation of USD or depreciation of INR will result in loss to an importer and gain to an exporter. The importer will have to pay more for his purchases whereas the exporter will receive more in rupee terms for selling the same goods or services. On the other side, if INR appreciates or USD depreciates, the importer will gain and the exporter will lose. The importer will have to pay less for his imports whereas the exporter will receive less in rupee terms for the same goods or services.
Payoff 6 (Long Position) 4

Payoff without Hedging

Payoff

USD/INR 40 41

42

43

44

45

46

47

48

49

50

-2

-4 Exporter -6 Importer (Short Position)

What is Hedging?
Hedging is taking a position in the futures market, a position that is opposite to the already existing position in the cash market. The objective of hedging is to minimize risk associated with unpredictable changes in the USD/INR rate. In this process, it should be observed that the objective is to lock in a particular USD/INR rate and not to be exposed to favourable as well as unfavourable exchange rate movement.

Cash Market Gains / Losses in Cash Market

Futures Market Losses / Gains in Futures Market Risk Mitigation by locking in the USD/INR rate

A long futures hedge is appropriate when you know you will buy any foreign currency in the future and want to lock in the price. A short futures hedge is appropriate when you know you will sell any foreign currency in the future and want to lock in the price. The profit (loss) in the cash position is offset by equivalent loss (profit) in the futures position.

Importers :
The importer is affected by volatility in the foreign currency rate (USD/INR) in which the payment is to be made. If INR appreciates, he makes a profit by buying the goods / services at a lower price. But if INR depreciates, he incurs loss by buying the same goods / services by paying more in rupee terms. Hence, such volatility in currency rate exposes the importer to currency risk.

Impact of Volatility in USD on P&L A/c of an Importer Event On April 1, 2008, an importer enters into a contract to import Crude Oil worth $ 550,000 (of which 10% is his margin) and to make the paymenton August 1, 2008. The USD/INR rate on April 1, 2008, is 43.50 Movement in USD/INR USD/INR rate remains constant, i.e., USD/INR = 43.5 till August1, 2008 USD appreciates by August 1, 2008,i.e., USD/INR = 48.5 INR appreciates, by August 1, 2008,i.e., USD/INR = 39.5 Impact on P& L A/c Nil (margin Rs 21,75,000)

Margin decreases to 8.85% (Rs 19,25,000) Margin increases to 10.92% (Rs 23,75,000)

For example, say, on January 1, 2008, an Indian importer enters into a contract to import 1,000 barrels of oil with payment to be made in USD on June 25, 2008. The price of each barrel of oil has been fixed at USD 110/barrel at the prevailing exchange rate of 1 USD = INR 39.41. The cost of one barrel of oil in INR works out to be Rs 4,335.10 (110 x 39.41). The importer has a risk that the USD may strengthen over the next six months causing the oil to cost more in INR. On June 25, 2008, the INR actually depreciates and the exchange rate stands at 1 USD = INR 43.23. He has fixed his price in dollar terms, i.e., USD 110/barrel, however, to make payment in USD, he has to convert the INR into USD on the given date and the exchange rate stands at 1USD = INR 43.23. Therefore, to make payment for one dollar, he has to shell out Rs 43.23 as against Rs 39.41. Hence the same barrel of oil that was costing Rs 4,335.10 on January 1, 2008, will cost him Rs 4,755.30 on June 25, 2008, which means 1 barrel of oil ended up costing him Rs 420.20 more (Rs 4755.30 - Rs 4335.10 = Rs. 420.20). Hence 1,000 barrels of oil have become dearer by Rs 4,20,200.
USD/INR (January 1, 2008 to June 25, 2008)
Date of Payment USDINR @ 43.23

43

USDINR

42

USD appreciated by Rs. 3.82 (Currency Risk)

41 Exposure inititaion date USDINR @ 39.41 40

39 Time

This means that when INR weakens, the importer makes a loss, and when INR strengthens, the importer makes a profit. As the importer cannot be sure of future exchange rate developments, he has an open position in the cash market, which can affect the value of the firm's operating cash flows, income, competitive position, and hence market share and stock price. Hedging strategy : Suppose the same Indian importer pre-empted that there is good probability that INR will weaken against USD given the current macro-economic fundamentals of increasing current account deficit and FII outflows and decides to hedge his exposure on an exchange platform using currency futures. Since he will have to buy USD in future, he is concerned about appreciation in USD, hence he will go long on currency futures, which means he purchases a USD/INR futures contract as a hedging strategy. This protects the importer because strengthening of USD would lead to profit in the long futures position, which would effectively ensure that his loss in the physical market would be mitigated. The mechanics of hedging using currency futures is explained below:

Time t1

Is short on USD 1,10,000 in the spot market Is long on (buys) 110 USD/INR futures contracts

Oil Importer

Sells USD/INR futures contracts to square off transaction Buys USD to meet import

Time t2
Spot Market USDINR 1-Jan-08 25-Jun-08
Market S pot Futures Entry Date 1-Jan-08

Date

Futures Market June USDINR Contract 39.90 43.72

Total Value 4335100 4389000 Exit Date 25-Jun-08 Market Price/ Settlement rate 43.23(L) 43.72(S ) Total Value 4755300 4809200 Profit / Loss -420200 420200

39.41 43.23
Market Price 39.41(S ) 39.90(L)

The loss in the spot market is set off by profit in the futures market. By hedging, the importer has locked in the price, i.e., Selling price in spot market Rs 47,55,300 - profit from Futures market Rs 4,20,200 = Rs. 43,35,100

Result : Following a 9.7% rise in the spot price for USD, the US dollars are purchased at the new, higher spot price, but profits on the hedge foster an effective exchange rate equal to the original hedge price.

Exporters :
In anticipation to meet the demand and to fulfill the sales commitment, an exporter produces the finished goods/services to be exported to a foreign country (say, the US) at a later date and receive payment in foreign currency (USD). The exporter is affected by volatility in the foreign currency rate (USD/INR) in which he receives the payment. If INR appreciates, he incurs a loss due to selling goods/services at a lower price. But if INR depreciates, he makes a profit by selling the goods / services at a higher price. Hence the adverse movements in currency rates expose the exporter to currency risk.

Impact of Volatility in USD P&L A/c of an Exporter Event On March 1, 2008, an exporter enters a sale contract and expects a receivable of $ 4,20,000 (of which 5% is his margin) on June 1, 2008. The USD/INR rate on March 1, 2008,is 42.50. Movement in USD/INR USD/INR rate remains constant, i.e., USD/INR = 42.5 till June 1, 2008 USD appreciates by June 1, 2008, i.e., USD/INR = 48.5 INR appreciates by June 1, 2008, i.e., USD/INR = 39.5 Impact on P& L A/c Nil (profit is Rs 8,50,000)

Margin increases to 5.71% (Profit = Rs 9,70,000) Margin decreases to 4.65% (Profit = Rs 7,90,000)

For example, say, on March 1, 2008, an Indian copper exporter enters into a contract to export 1,000 MT of copper with payment to be received in the US dollar (USD) on June 25, 2008. The price of each MT of copper has been fixed at USD 7,200/MT at the prevailing exchange rate of 1 USD = INR 44.05. The price of one MT of copper in INR works out to be Rs 3,17,160 (7,200 x 44.05). The exporter has a risk that the INR may strengthen over the next three months causing the copper to give less revenue in INR. However, he decides not to hedge his position. On June 25, 2008, the INR actually appreciates against the USD and the exchange rate stands at 1 USD = INR 40.30. He has fixed his price in dollar terms, i.e., USD 7,200/MT; however, the dollar that he receives has to be converted into INR on the given date and the exchange rate stands at 1 USD = INR 40.30. Every dollar that he receives is worth Rs 40.30 as against the contract price of Rs 44.05. So the same MT of copper that initially would have fetched him Rs 3,17,160 will realize Rs 2,90,160, which means 1 MT of copper ended down fetching him Rs 27,000 less (Rs 3,17,160 Rs 2,90,160 = Rs 27,000). Hence 1,000 MT of copper have become cheaper by Rs 2,70,00,000.
USD/INR (Mar 1 - June 25, 2008) 45 Exposure inititaion date USDINR @ 44.05

44

US D IN R

43

42

USD depreciated by Rs. 3.75 (Currency Risk) Date of Payment USDINR @ 40.30

41

40 Time

This means that when INR strengthens, the exporter makes a loss and when INR weakens, the exporter makes a profit. As the exporter cannot be sure of future exchange rate developments, he has an entirely speculative open position in the cash market, which can affect the value of the firm's operating cash flows, income, competitive position, and hence market share and stock price. Hedging strategy : Suppose the same Indian copper exporter pre-empted that there is good probability that INR will strengthen against USD given the current macro-economic fundamentals of reducing fiscal deficit, stable current account deficit, and strong FII inflows and decided to hedge his exposure on an exchange platform using currency futures. Since he will have to sell USD in future, he is concerned about depreciation in USD, hence he will go short on currency futures, which means he sells a USD/INR futures contract as a hedging strategy. This protects the exporter against weakening of USD as it would lead to offsetting profit in the short futures position. The mechanics of hedging using currency futures is explained below:

Time t1

Is long on USD 72,00,000 in the Spot market Is short on (sells) 7,200 USD/INR futures contracts

Copper Exporter

Time t2

Buys back USD/INR futures contracts to square off transaction Sells USD in the spot market

Date
1-Mar-08 25-June-08
Market Spot Futures

Spot Market USDINR 44.05 40.30

Market Price 44.05 (L) 44.20 (S)

Futures Market June USDINR Contract 44.20 40.45

Total Value 317160000 318240000 Exit Date 25-June-08 Market Price/ Settlement rate 40.30 (S) 40.45 (L) Total Value 290160000 291240000 Profit / Loss -27000000 27000000

Entry Date 1-Mar-08

The loss in the spot market is set off by profit in the futures market. By hedging, the exporter has locked in the price, i.e., Selling price in spot market Rs 29,01,60,000 + profit from Futures market Rs 2,70,00,000 = Rs. 31,71,60,000

Result : Following an 8.51% fall in the spot price for USD, the US dollars are sold at the new, lower spot price; but profits on the hedge foster an effective exchange rate equal to the original hedge price.

Small and Medium Enterprises :

Small and medium enterprises (SMEs) represent over 90% of enterprises worldwide. They are the driving force behind a large number of innovations and contribute to the growth of the national economy through employment creation, investments, and exports. In India, the SME sector plays a pivotal role in the overall industrial economy of the country. It is estimated that in terms of value, the sector accounts for about 39% of the manufacturing output and around 33% of the total export of the country. Further, in recent years the SME sector has consistently registered higher growth rate compared to the overall industrial sector. The major advantage of the sector is its employment potential at low capital cost.

SMEs have an established standing in the following Indian industries :

Food processing Agricultural inputs Chemicals and pharmaceuticals Engineering Electricals and electronics Electro-medical equipment Textiles and garments Leather and leather goods Meat products Bio-engineering Sports goods Plastics Computer software

As a result of globalization and liberalization, coupled with the WTO regime, Indian SMEs have been passing through a transitional period. Due to the nature of their businesses, SMEs are generally involved in trades denominated in a currency pair, i.e., large volumes of imports/ exports. Hence SMEs are also exposed to exchange rate fluctuations as explained earlier. Importers, exporters, and SMEs can minimize their exposure in terms of exchange rate fluctuation by hedging using derivative instruments on a currency futures exchange. Since the regulators RBI and SEBI have given the green signal to start currency futures exchanges in India, they all have a platform open for them to mitigate their risk.

A currency exchange has the following advantages :

Contract Size: In a currency futures exchange, the contract size is very small, with lot size of USD 1,000. Hence, it is easy for small participants to enter the market and hedge their risk. In OTC markets, the contracts are of large size, with minimum size of $1 million. Smaller contracts are also available but at a higher cost. Transaction Cost: The transaction cost, i.e., brokerage, in this market is relatively low, regulated, and transparent. With increase of liquidity in currency futures market, impact cost is expected to reduce further. Standardized Contracts: The currency futures contracts on all the currency exchanges in India are standardized and have the same contract specifications. Price Transparency: Complete price transparency exists in currency futures exchanges, whereas in the OTC market, lack of transparency and differential pricing prevail. Generally, in the OTC market, the price quoted varies from party to party and also different from the prevailing inter-bank rate. Thus, the prices prevailing on currency futures exchanges are transparent and are same for everyone across the country. Underlying: It is not necessary/ mandatory to have underlying exposure to trade in this market. Default Risk: Trading on a currency futures exchange gives a guarantee for settlement of transaction. In this market, the exchange assumes the risk and work on the principle of Novation, i.e., the Clearing House becomes the counterparty to the trade. Margins: By paying a small percentage as margin money, you can take huge position/exposure in the currency futures market. This leads to fewer blockages of funds and contributes to risk management by the exchange. The margins levied in currency futures markets are relatively lower than equity markets. Cancellation: Terminating the contract in currency futures exchange is as simple as creating a new one. You can, at any point of time, square off your position and get out of the market with money credited to your account in case of profit and debited from your account in case of loss. You don't have to wait for the contract to expire to get your money credited/debited. Regulatory Oversight: Exchange transactions are highly regulated through the rules and regulations of the exchange. Even small players can participate and trade settlement is guaranteed. This eliminates the counter-party default risk.

Disclaimer:
This is a market insight from FT Knowledge Management Company Limited (FTKMC). The content has been developed based on sources believed to be reliable but is not guaranteed by FTKMC as to its accuracy or completeness. The insight has been made available on the condition that errors or omissions shall not be made the basis for any claims, demands, or cause of action. Readers using the information contained herein are solely responsible for their action. FTKMC or its representative will not be liable for the reader's investment/business decision based on this insight.