Exposure to exchange rate risk is known as an open position. Hedging refers to avoidance of an exchange rate risk; it means covering of an open position.
Hedging may be resorted to by both recipients and payers of foreign exchange in the future by incurring a type of ‘premium cost’. In each case, an arrangement is made to ensure that exchange rate risk is avoided.
Note that hedging is not needed by a party which is to receive or make a payment in domestic currency. We may clarify it further by an example.
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The Payer:
Let us assume that an importer has to make a payment of $200,000 three months hence. Current (spot) exchange rate is $ 1 = Rs. 45, so that $200,000 = Rs. 90,00,000. However, three months hence, rupee may be cheaper and he may have to pay more than Rs. 90,00,000.
He therefore, borrows Rs. (200,000 * 45 = 90,00,000) today, buys $200,000 in the spot market, deposits these dollars with a bank, and pays his party three months hence after encasing the deposit on its maturity.
This way, his cost of covering or hedging himself equals the interest which he has to pay on his borrowings of Rs. 90,00,000 for three months minus the interest which he receives on his deposit of $200,000 for three months. Normally, this is a very small cost.
An open position is an exposure to exchange rate risk. Hedging is “covering” or protecting oneself against this risk.
The Recipient:
Suppose, an exporter is to receive a payment of $200,000 three months hence. Current (spot) rate is $ 1 = Rs. 45. But three months hence, dollar may be cheaper, and he may get less than Rs. 90,00,000.
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To ensure that he does receive Rs. 90,00,000, he can borrow $200,000 today, sell the dollars for Rs.90,00,000 and deposit the amount with a bank.
After three months, he receives the payment of Rs. 90,00,000 and pays his dollar debt. Thus, his cost of hedging equals interest which he pays on his loan of $200,000 minus the interest which he earns on his deposit of Rs. 90,00,000 for three months.
Alternatively, buying and selling foreign currency in forward market also provides the requisite hedging against exchange rate risk. Choice between the two alternatives depends on which appears to be the more attractive of the two options.
The Payer:
Thus, in our example above, the payer may buy $200,000 in the forward market at today’s three-month forward rate. If dollar is at a three- month forward premium of 1 % p.a. (or 0.25% for three months), he will have to pay (spend) Rs. 90,22,500 (Rs. 90,00,000 plus 0.25% of it) three months hence to receive $200,000 three months hence.
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His hedging cost will be Rs. 22,500. In contrast, if dollar is at a three-month forward discount of 1% p.a., he will pay only Rs. 89,77,500 (Rs. 90,00,000 minus Rs. 22,500).
The Recipient:
Similarly, a recipient can sell his $200,000 (which he is to receive three months hence) in the forward market. If the dollar is at a three-month forward discount of 1% p.a., the exporter will get Rs. 89,77,500 (Rs. 90,00,000 minus Rs. 22,500) for $200,000 which he shall deliver three months hence.
In contrast, if the dollar is at a 1% p.a. three-month forward premium, our exporter will receive Rs. 90,22,500 (Rs. 90,00,000 plus Rs. 22,500).