A note on foreign currency hedging for MSMEs.
Did you know the Indian Rupee (INR) has dropped more than 7% in the first half of this year against the US Dollar (USD) as against a drop of 2% during 2021? (Source: xe.com). Such a significant drop in the value of the INR in less than six months can adversely impact the country’s economy, considering that our imports are way more than our exports (Source: Money Control).
What is Foreign Currency Risk?
Foreign Currency Risk, also known as currency risk, FX risk, and exchange-rate risk, refers to the chance of losses in foreign exchange transactions due to fluctuations in exchange rates.
To understand foreign currency risk better, let us consider the case of an MSME importer who imports electronic components from China and pays for his imports in US dollars. On April 1st, the exchange rate is Rs. 77.92 per US dollar. Assuming his product costs US$1,000 per unit, his landed cost is Rs. 77,920 per unit. He sells the product at a 10% markup (Rs. 7,792/-) to cover his costs and profit. So the final price works out to Rs. 85,712 per unit, and his customer accepts the price.
He then places an order for one unit, which will be delivered three months from the date of the order (i.e., on July 1st), with payment due on delivery. Everything goes as planned if the exchange rate is unchanged on the delivery date. However, let us look at two other scenarios: the exchange rate has increased 2.5% to Rs. 79.87 and a scenario wherein the exchange rate has decreased 2.5% to Rs. 75.97.
Scenario 1 – the Exchange rate has increased 2.5% to Rs. 79.87 per US Dollar:
In this case, the importer has to pay Rs. 79,870/- for the unit and then sell it for Rs. 85,712/- to his customer. His profit margin is now only Rs. 5,842/- as opposed to Rs. 7,792/- he had budgeted when he had placed his import order. After meeting his expenses, he will find that his net profit is significantly lower.
Scenario 2 – the Exchange rate has decreased 2.5% to Rs. 75.97 per US Dollar:
Now, the importer is in a much better position as he only has to pay Rs. 75,970/- to his supplier while he collects Rs. 85,712 from his customer. His profit margin has gone up to Rs. 9,922/- which is better than expected.
Thus we see uncertainty about the price the MSME pays as measured in his home currency (Indian Rupees). This risk or uncertainty which may cause losses is foreign currency risk.
How can Foreign Currency Risk be managed?
Foreign Currency Hedging techniques can manage foreign currency risk. Foreign currency hedging assumes prime importance because of the volume of (oil) imports in our economy and, therefore, sensitivity to the USD/INR exchange rate. Foreign currency hedging is also of great importance to MSMEs as they tend to have smaller profit margins and are, therefore, more susceptible to fluctuations in exchange rates.
We will now discuss how MSMEs can minimize the risk of loss due to unfavorable exchange rate movements using foreign currency forward contracts and thereby protect profitability.
What is Foreign Currency Hedging?
In simple terms, foreign currency hedging is protecting oneself against unfavorable changes in exchange rates by entering into contracts to offset movements in exchange rates. Foreign currency hedging is like taking an insurance policy against fluctuations in exchange rates. MSMEs can hedge their foreign currency risk in two ways: Natural hedging and Financial hedging, i.e., using financial instruments.
What is Natural Hedging?
Natural hedging is done by creating the opposite transaction in the same foreign currency pair so that the foreign exposure nets out.
For instance, an Indian exporter with receivables in US Dollars can hedge by creating payables in US Dollars to protect them against fluctuations in the US Dollar exchange rates.
This can be done by taking a loan in US dollars and paying off the loan using export proceeds, thereby minimizing exposure to USD/INR exchange rates. Likewise, an Indian importer can create a natural hedge by exporting goods in the same currency as their exports, reducing exposure to USD/INR exchange rates.
However, natural hedging may not always be possible for everyone exposed to foreign currency. The exporter may be unable to avail of a loan in foreign currency due to a lack of creditworthiness. The importer may be unable to export due to a lack of connections to overseas buyers.
Moreover, the natural hedge must match the initial exposure in magnitude and timing to be a perfect hedge. This means that the payable and receivable should be of the same amount and due on the same date to be a perfect hedge. This may not always be possible. Due to these shortcomings, MSMEs may consider foreign currency hedging using financial instruments available in financial markets.
What are some of the tools for Financial Hedging?
Forwards, futures and options are financial instruments that MSMEs can use to hedge foreign exchange risk. In the remainder of this blog post, we will take a quick look at how MSMEs can use these financial instruments for foreign currency hedging. Foreign exchange futures and forward contracts are quite similar but also have significant differences.
Hedging with forward contracts:
One of the most popular ways of hedging is using Forward contracts. Forward contracts (or forwards) require delivery of specified units of one currency at a future value date in exchange for specified units of another currency. The exchange rate and the delivery date are determined at the time of the agreement, but the payment and delivery are made on the maturity date.
The forward contract confers both the right and the obligation on both parties to abide by the terms of the agreement. There are no upfront costs to enter into a forward contract. MSMEs can enter into forward contracts only with commercial banks in India. Since forward contracts are provided over the counter of commercial banks, they are known as Over The Counter (OTC) contracts. For a more detailed look at hedging with forward contracts, please refer to the blog post – Foreign Currency Hedging using Currency Futures and Forwards.
Hedging with foreign exchange futures:
One of the easier ways MSMEs and individuals in India can hedge forex risk is by using the currency futures contracts traded in the stock exchanges. Both BSE and NSE offer currency futures in major currency pairs like USD/INR, EUR/INR, JPY/INR, and GBP/INR, with one currency futures contract expiring every month for the next 12 months.
Since the futures contracts are traded on the stock exchange, they are standardized and carry no risk of default by the counterparty. Like a forward contract, there are no upfront costs to enter into a futures contract. Each USD/INR, EUR/INR, and GBP/INR contract has an underlying of USD 1,000, EUR 1,000, and GBP 1,000, respectively. The JPY/INR contract has an underlying of JPY 100,000. For a more detailed look at hedging with currency futures, please refer to the blog post – Foreign Currency Hedging using Currency Futures and Forwards.
Hedging with Foreign Currency Options:
Another tool for foreign currency hedging is using an instrument called foreign currency options. Unlike forwards and futures, the option contract allows the buyer to exercise the option, as the name implies. The option provides the buyer the right but not the obligation to exercise the option. In contrast, the option seller only gets the obligation to fulfill the contract terms if called upon by the option buyer. As compensation, the option buyer pays the option seller an option premium when purchasing the option contract. The option premium is an upfront cost involved in hedging with options, unlike forward and futures contracts.
Foreign Currency Options are available on stock exchanges and in the OTC market. For a more detailed look at currency futures, please refer to the blog post – Foreign Currency Hedging using Currency Options.
Why hedge? Is currency hedging worth the risk?
A common question from MSMEs is whether currency hedging is worth the risk? The risk, in this case, is the chance that the MSME may have to forgo a favorable exchange rate in the market (scenario 2 in the above example) because they have booked a forward contract. We would like to remind our readers that there is no way of accurately predicting the future exchange rate. As such, it is better to be hedged and make money in your business rather than going unhedged and trying to make money from foreign exchange rate fluctuations.
Another comment we often hear from MSMEs is that they do not want to speculate in foreign exchange. They would prefer to leave their foreign exchange positions unhedged and bear the foreign exchange loss. However, leaving positions unhedged is a form of speculation in that they expect the rate to be favorable to them in the future. The only way to avoid speculation is to hedge the risk entirely.
You can read more about foreign currency hedging using forward contracts here. You can also read about SME IPOs to learn more about how MSMEs can raise equity from the stock markets here. In the meantime, if you want to learn more about foreign currency hedging, please reach out to us at joe@tjconsulting.in or +91-900 557 845.