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:

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:

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.

Hedging against Indian Rupee appreciation

Suppose an Indian IT exporter receives an export order worth, say, 100,000 from a European Telecom major with the delivery date being in 3 months time. At the time when contract is placed, the Euro is worth say Rs.64.05 in the spot market, while on MSE a futures contract for an expiry date that matches with order payment date is trading, say, at Rs.64. This puts the value of the order, when placed, at Rs.6,405,000. However, if the domestic exchange rate appreciates significantly (to Rs.63.20) when the order is paid for (which is one month after the delivery date), the firm would receive only Rs.6,320,000 rather than Rs.6,405,000.

To insure against such losses, the firm can, at the time it receives the order, can enter into 100 Euro futures contract of 1000 each to sell at Rs.64 a Euro, which involves contracting to sell a foreign currency on expiry date at the agreed exchange rate. Suppose on payment date the exchange rate is, say, Rs.63.20, the exporter would receives only Rs.6,320,000 on selling the Euro in the spot market, but gains Rs. 80,000 (i.e. 64 - 63.20 * 100 * 1000) in the futures market. Thus, overall the firm receives Rs.6,400,000 and protects itself from the sharp appreciation of domestic currency against Euro.

In the short term, firms can make gains or losses from hedging. But the basic purpose of hedging is to protect against excessive losses and to benefit from knowing exactly how much it was going to get from its export deal to avoid the uncertainty associated with future exchange rate movements.

Hedging against Indian Rupee depreciation

An organic chemicals dealer in India placed an import order worth, say, 100,000 with a German manufacturer. The current spot rate of Euro is, say, Rs.64.05 and at this rate the value of the order is Rs.6,405,000. The importer is worried about sharp depreciation of Indian Rupee against Euro in coming months when the payment is due and brought 100 Euro futures contract (1000 each) on MSE, say, at Rs.64 a Euro. Suppose, at expiry date, Rupee depreciated to Rs.65 the importer would have to pay Rs.6,500,000, but he would gain Rs.100,000 (i.e. Rs.65 - 64 * 100 * 1000) from the futures market and the resultant outflow would be only Rs.6,400,000.

In the short term, firms can make gains or losses from hedging. But the basic purpose of hedging is to protect against excessive losses and to benefit from knowing exactly how much it was going to pay for the import order to avoid the uncertainty associated with future exchange rate movements.