Foreign currency hedging using forwards: An easy guide for MSMEs

Foreign currency hedging using forwards for MSMEs.

In our previous post, we discussed Foreign currency risk and the need for hedging. Now, we will discuss how to hedge using forwards. Foreign currency hedging using forwards helps MSMEs manage their foreign exchange risk. Foreign exchange forwards are contracts that allow MSMEs to lock their exchange rate for a payment in the future. Forwards confer both the right and the obligation on both parties to perform as per the contract regardless of the market price on the contract’s maturity date. Thus, the MSME can plan their other receivables and payables knowing there is no uncertainty in foreign currency rates.

To understand foreign currency hedging using forwards 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. 77.90 per US dollar. Assuming his product costs US$1,000 per unit, his landed cost is Rs. 77,900 per unit. He sells the product at a 10% markup to cover his costs and book a profit. So, the final price works out to Rs. 85,690 per unit.

The importer is aware that the exchange rate keeps fluctuating, and there is a chance that he may make a loss on the deal if the US$ appreciates against the Indian Rupee. To avoid loss, he decides to book a forward contract to buy US$1,000 on July 1^st to make his import payment. The bank quotes a forward rate of 78.50 for the USD/INR delivery on July 1st. This means the importer can buy US$1,000 for Rs. 78.50 per US$ on July 1^st. 

Using this forward rate as his cost, he adds a 10% profit margin and quotes a final price of Rs. 86,690/- to his client. The client accepts the price and the importer places an order for one unit, which will be delivered three months from the date of the order (i.e., on July 1^st), with payment due on delivery.

Let us look at two different exchange rate scenarios on the delivery date of July 1^st: the exchange rate has increased to Rs. 79.00, and the exchange rate has decreased to Rs. 77.00.

Scenario 1 – On July 1^st, the Exchange rate has increased to Rs. 79.00 per US Dollar:

The exchange rate has now moved against the importer. However, since he has done foreign currency hedging using forwards, the bank has to provide the importer a sum of US1,000 at an exchange rate of INR 78.50 per US$. Accordingly, the importer pays the bank Rs. 78,500 to make the import payment on his behalf. He then sells the unit to his customer for Rs. 86,350/- and books his profit of Rs. 7,850. Without the forward contract, he would have had to pay Rs. 79,000/- for the import, which would have reduced his gross profit to 7,350/-, a loss of Rs. 500/-. In this case, foreign exchange hedging using forwards has increased his gross profit by Rs. 500.

Scenario 2 – the Exchange rate has decreased to Rs. 77.00 per US Dollar:

Now, the exchange rate has moved in favor of the importer. However, as he has done foreign exchange hedging using forwards, he has to buy US$1,000 from the bank at an exchange rate of INR78.50 per US$. So, he pays the bank Rs. 78,500 to make the import payment of US$1,000 on his behalf. He then sells the unit to his customer for Rs. 86,350/- and books his profit of Rs. 7,850. Without the forward, he would have paid only Rs. 77,000/- for the import means his gross profit would have been higher by Rs. 1,500. In this case, foreign exchange hedging using forwards has caused him a decrease in gross profit of Rs. 1,500.

Thus, we see that by foreign currency hedging using forwards, the importer can lock his future exchange rate and protect himself against loss but may also have to forgo a part of the profit if the market moves in his favor.

The breakeven point in the forward contract is when the exchange rate in the market is equal to the rate on the forward contract, i.e., the USD/INR rate is Rs. 78.50. We can better understand this by looking at the payoff graph of a forward contract.

At the breakeven point, the importer is indifferent to buying US$ from the market or buying from the bank under the forward contract. However, for every paise drop in exchange rate, he makes a paise loss due to the forward contract. Likewise, for every paise rise in the exchange rate, he makes a paise profit due to the forward contract.

However, we should remember that forward contracts are used to remove the uncertainty in the exchange rate or risk of loss due to unfavorable movements in the exchange rate. Therefore, forward contracts are only used to remove risk, i.e., to be used for hedging against currency risk and not to make a profit.

Exporters can also do foreign currency hedging using forwards with some difference in the payoffs. In the case of an exporter who is getting paid in US$, the payoff would be reversed as the exporter sells US$ and therefore stands to gain when the US$ appreciates against the Indian Rupee. The exporter would book forward contracts to sell US$ at a future date. The forward contract would give the exporter a positive payoff whenever the US$ depreciates against the Indian Rupee and a loss otherwise.

The breakeven point in the forward contract is when the exchange rate in the market is equal to the rate on the forward contract, i.e., the US$/INR rate is Rs. 78.50. This can be better understood by looking at the forward contract payoff graph for an exporter with the forward contract booked to sell dollars at Rs. 78.5 per US$.

Salient Features of Foreign Exchange Forward Contracts:

1. Forward contracts on foreign currencies must be booked with commercial banks. Foreign exchange forwards are customized to the importer’s or exporter’s needs – the delivery date and the notional amount of the contract can be customized to the merchant’s requirements.
2. As forward contracts are sold over the counters of commercial banks, they are also known as Over-The-Counter (OTC) contracts.
3. There is no upfront cost to booking a forward contract.
4. Forwards confer both the right and the obligation on both parties to perform as per the contract.
5. The forward contract specifies a delivery price as the price the buyer pays on the maturity date for the foreign currency.
6. A bank offering forward agreements to its customers is exposed to counterparty risk in that the customer may not keep its side of the contract if the exchange rate in the market is firmly in its favor. So, banks require customers to either have credit limits or place fixed deposits with the bank to cover the counterparty risk.

Foreign Exchange Futures Contracts:

Futures contracts are similar to forward contracts in that they are contracts that allow a party to either buy or sell foreign Exchange at a pre-agreed price on a future date. But there are significant differences as well. As futures contracts are traded on stock exchanges like the National Stock Exchange (NSE) in India, they are also known as Exchange Traded contracts.

Futures contracts traded in exchanges have a uniform notional amount of US$1,000, EUR1,000, GBP1,000, and JPY 1,00,000 and have an expiry date of two working days before the last working day of the month. Any individual or MSME can buy and sell these contracts through a trading account with any broking firm in India.

Since futures contracts are traded on exchanges, they are standardized contracts with the same notional amount and expiry date, unlike forward contracts, which can have any notional amount and expiry date depending upon the requirement of the merchant.

This means that futures contracts do not work as perfect hedges as they cannot be customized to merchants’ requirements. So, futures contracts are used more for speculation in foreign currency than for foreign currency hedging. As such, we will not discuss futures contracts any further as we are only concerned with hedging currency risk and not speculation in the foreign currency markets. In case you are interested, you can find more information about currency futures on NSE’s website here.

You can read more about Foreign Currency Hedging here. Our next article will discuss how to hedge foreign exchange risk using options contracts. You can also read about SME IPOs in our previous blog post here. In the meantime, if you want to learn more about foreign currency hedging, please get in touch with us at joe@tjconsulting.in or +91-900 557 845.