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B. Venkatesh

THE RBI's recent Monetary and Credit Policy review has urged companies to hedge their foreign currency borrowings. Why should companies hedge and how does hedging impact the spot market?

Assume a company has to pay $5 million as interest on its foreign currency debt every half-year for 10 years. The company can buy this amount every half year in the spot market. But that would be risky. Why? If the dollar appreciates against the rupee, the company would need more rupees to buy $5 million.

The company can control this risk by hedging with forward dollars. Suppose the company buys six-month forward dollars at Rs 47. This essentially means that the company contracts to buy dollars at Rs 47 in six months no matter what the spot rate is then. Thus, the company will lose only if the spot rate then is lower than Rs 47.

Now, how do forward dollars affect the spot price? If the demand for forward dollars is very high, the spot dollar may appreciate against the rupee. Why?

After entering into the forward contract, the bank will have to hedge its exposure. Otherwise, the bank runs the risk of having to buy dollars at a higher rate in the spot market six months hence to deliver to the company.

To hedge its risk, the bank will first buy dollars in the spot market. This ensures that the bank can deliver dollars to the company six months hence. If more such banks demand dollars, the spot dollar price may rise.

But the bank does not need these dollars now. And holding dollars for 6 months is costly. So, it enters into a forward contract to receive $5 million six months hence. Simultaneously, it sells the spot dollars bought earlier. Six months later, the bank receives dollars from its counter party to delivers to the company.

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