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Exchange-traded currency futures are used to hedge against the risk of rate volatilities in the foreign exchange markets. Here, we give two examples to illustrate the concept and mechanism of hedging: Example 1:
Suppose an edible oil importer wants to import edible oil worth USD 100,000 and places his import order on July 15, 2008, with the delivery date being 4 months ahead. At the time when the contract is placed, in the spot market, one USD was worth say INR 44.50. But, suppose the Indian Rupee depreciates to INR 44.75 per USD when the payment is due in October 2008, the value of the payment for the importer goes up to INR 4,475,000 rather than INR 4,450,000. The hedging strategy for the importer, thus, would be:
Current Spot Rate (15th July '08) Buy 100 USD - INR Oct '08 Contracts on 15th July ’08
44.5000 (1000 * 44.5500) * 100 (Assuming the Oct '08 contract is trading at 44.5500 on 15th July, '08)
Sell 100 USD - INR Oct '08 Contracts in Oct '08 Profit/Loss (futures market)
44.7500 1000 * (44.75 – 44.55) * 100 = 20,000
Purchases in spot market @ 44.75 Total cost of hedged transaction
Example 2: A jeweller who is exporting gold jewellery worth USD 50,000, wants protection against possible Indian Rupee appreciation in Dec ’08, i.e. when he receives his payment. He wants to lock-in the exchange rate for the above transaction. His strategy would be:
One USD - INR contract size
Sell 50 USD - INR Dec '08 Contracts (on 15th Jul '08)
Buy 50 USD - INR Dec '08 Contracts in Dec '08
Sell USD 50,000 in spot market @ 44.35 in Dec '08 (Assume that initially Indian rupee depreciated , but later appreciated to 44.35 per USD as foreseen by the exporter by end of Dec '08)
The net receipt in INR for the hedged transaction would be: 50,000 *44.35 + 15,000 = 2,217,500 + 15,000 = 2,232,500. Had he not participated in futures market, he would have got only INR 2,217,500. Thus, he kept his sales unexposed to foreign exchange rate risk.