Currency Hedging I

Forwards

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Need for Derivatives

Hedging Decision I (A):Indian importer (M) imported 1000 units from US @ 10$ per unit. Today: 1$ = 44 / 45 INRTotal payment (in todays terms) = 45 * 10000 = 4,50,000 INRBut the actual payment would be made after 2 month from now.

What is the risk faced by the company M in this scenario?

After 2 months, if 1$ = 45.5 / 47 INRActual payment for M = 47 * 10000 = 4,70,000 INR

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Need for Derivatives

Hedging Decision I (B):Indian exporter (X) exported 2000 units from US @ 20$ per unit. Today: 1$ = 44 / 45 INRTotal receivables (in todays terms) = 44 * 40000 = 17,60,000 INRBut the actual payment would be made after 2 month from now.

What is the risk faced by the company M in this scenario?

After 2 months, if 1$ = 43 / 44 INRActual receivables for X = 43 * 40000 = 17,20,000 INR

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Forwards

A non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed todayIt is an obligation (not an option)CashTomSpot

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Need for Derivatives

Hedging Decision I (A):Indian importer (M) imported 1000 units from US @ 10$ per unit. But the actual payment would be made after 2 month from now.

How to hedge?

M to buy 2 month USD / INR forwardLet today, if 2 month USD / INR forward = 44 / 44.8M has locked the rate 1$ = 44.8 INRSo after 2 month, M will buy 10000$ @ 44.8 (per $)Total payment = 4,48,000 INR (Fixed)

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Need for Derivatives

Hedging Decision I (B):Indian exporter (X) exported 2000 units from US @ 20$ per unit. But the actual payment would be made after 2 month from now.

How to hedge?

X to sell 2 month USD / INR forwardLet today, if 2 month USD / INR forward = 43.8 / 44.3X has locked the rate 1$ = 43.8 INRSo after 2 month, X will sell 40000$ @ 43.8 (per $)Total receivables = 17,52,000 INR (Fixed)

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Key Points

It is an obligationNo price no premium payment is requiredWhether you are in profit / loss, you have to fulfill your obligationWhich means your upside and downside both are restricted, that too at same level. What if I only want to restrict downside (loss) and not upside (profit)Will this also be available at no price??

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Currency Hedging II

Options

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Need for Derivatives

Hedging Decision II (A):Indian importer (M) imported 1000 units from US @ 10$ per unit.But the actual payment would be made after 2 month from now. Can buy 2 month USD / INR forward @ 44 / 44.8Wants to restrict only downside (loss) and not upside (profit)

What to do?

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Option

A non-standardized contract, under which buyer of the contract gets the right (option) but not an obligation to buy or sell an asset at a specified future time at a price agreed today.For this right, buyer has to pay some price called as premiumThis price is received by seller of the contract

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Types of Options

There are two basic types of options:

A call option which gives the holder of the option the right to buy an asset by a certain date for certain price.

2. A put option gives the holder of the right to sell an asset by a certain date for a certain price.

Option TypeBuyer of OptionWriter of Option

(Long Position) (Short Position)

Call Right to buy an asset Obligation to sell asset

Put Right to sell an asset Obligation to buy asset

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Difference between forward and options

ForwardsBoth the parties have committed to some action.It costs a trader nothing (except for the margin requirements) to enter into forward or futures contract.OptionThe holder of the option has the right but not the obligation to some action.Purchase of an option requires an upfront fees.

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