Importing Italian Suits
Imagine you are the owner of a small fictional high-end clothing store, Bharat Italiano, which prides itself on having high caliber Italian clothing exclusively available for Indian customers. In order to stockpile your store with the latest, most fashionable pure Italian clothing available, you decide to enter into an agreement with a fictional Italian clothing store Milano Fabrics. Milano Fabrics agrees to exclusively manufacture and sell 1000 suits at an average price of 100 Euros to your company in 3 months. Therefore, you will need to pay 100,000 Euros in 3 months. Milano Fabrics suggests to you that you incorporate Currency Hedging as a strategy to protect yourself from price fluctuations. You're asking yourself the question: what in the world is currency hedging?
You know the basics: you are an Indian based company that deals in Rupees. You will need to obviously convert Rupees to Euros, and Milano Fabrics demands payment at the time of delivery, which is in 3 months. Presently, the exchange rate (EURINR) between Indian Rupees (INR) and Euros (EUR) is 71.83. In layman’s terms, this means that one Euro, right now, is worth 71.83 Rupees. This means that if the order was to be placed today, you would need to pay 71.83 Rupees for each Euro, meaning a total order amount of Rs. 71,83,000 (71.83 lakh). You are comfortable paying this much right now; but what about in 3 months after prices can fluctuate? What if the Rupee appreciates or depreciates against the Euro? You are scratching your head. A slight fluctuation in prices can cause a heavy loss or a handsome profit in 3 months.
Let’s take two examples: one with the Rupee appreciating against the Euro in 3 months, and another with the Rupee depreciating against the Euro in 3 months. In the first example, let’s assume that the Rupee appreciates against the Euro so that the exchange rate is 71 Rupees per Euro in 3 months. This is fantastic!!! Originally, you were planning on paying Rs. 71,83,000 for the order; now you would only be obligated to pay Rs. 71 x 100,000 = Rs. 71,00,000 for the order in 3 months. This is a saving of Rs. 83,000!
But what if the Rupee was to depreciate in 3 months? The exact opposite would occur. Assume that in 3 months, the Rupee depreciates to 72.5 Rupees per Euro. The consequence would be that you would be obligated to pay Milano Fabrics a whopping Rs. 72,50,000 for the order. You would thus incur a Rs. 67,000 loss (Rs. 71,83,000 - Rs. 72,50,000). This will surely hurt your business. What to do?
The Savior: Currency Hedging to the Rescue
Aha! This is where Currency Futures can become your life savior! You check out the NSE Currency Futures prices for EURINR for the 3-month contract- it is trading at 71.85. You now have the wonderful opportunity of taking advantage of Currency Hedging. Your sole objective is to ensure that you get delivery of those 1000 pure Italian fabric suits at a price as close to Rs. 71.83 as possible. You are not looking to gamble and allow a price appreciation or depreciation ruin your order! You have a business to maintain, customers to keep satisfied, and gambling is not your cup of tea.
So you purchase 100 Euro Futures Contracts on the NSE (EURINR, each contract being the equivalent of 1000 Euros) at a price of 71.85 (71.85 Rupees per Euro). You are now locked into to a contract that will protect you against price movements. In 3 months, assume EURINR is trading at 74. The calculations would be as follows:
EURINR Futures Contract: (74 – 71.85) x 100,000 = Rs. 2,15,000 Profit
Payment to Milano Fabrics in 3 months: 74 x 100,000 = Rs. 74,00,000 Debit
Net: Bharat Italiano makes a payment of Rs. 71,85,000 to Milano Fabrics in 3 months.
This is exactly what you wanted. Your original budget was approximately 71.83 lakh, and now no matter how prices fluctuate between the Rupee and the Euro in the next 3 months, you will pay no more than 71.85 lakh.
You can now take a deep breath and relax 🙂 Congratulations; you have now been introduced to the world of Currency Hedging.