The Hindu Business Line : Taking hedging forward

“Gentlemen,” began the MD as they assembled in the conference room the following Friday. “As you are aware we had a discussion last week as to whether our company needs to implement a hedging strategy, given the fact that the rupee has been appreciating steadily against the dollar, as a consequence of which our export-related revenues in rupees are way below what we had anticipated at the beginning of the financial year.

“A number of issues were raised. Rahul mentioned the possibility of using derivatives such as forward contracts and options as hedging tools. Sunder was uncomfortable with the fact that the outcome of a hedging strategy may not always be superior to that of an un-hedged position. Given the fact that most of us are not very familiar with hedging as a risk-mitigation strategy and are not well-versed with the use of derivatives, I have asked Rahul to give a brief presentation on what hedging is, and the role played by derivatives in a hedging strategy.”

Presentation on hedging

“Go on Rahul.”

“Morning everyone,” began Goatee cheerfully. “Before I go on to discuss the need for hedging and its mechanics, I thought I would briefly discuss the nature of derivative products and their uses.”

“Okay. Who smokes in this room?” And Rahul immediately put his hand up. The MD pulled out a packet of Benson & Hedges from his pocket and raised his hand. “Don’t worry Balaji,” said Rahul. “I won’t inform your wife.” Balaji winced.

Curd Rice glared at everybody. Smoking and drinking were what he termed as ‘Bombay Vices’. In his opinion the whole LPG (Liberalisation, Privatisation, and Globalisation) policy was responsible for the corruption of the impressionable youth of Chennai by the value systems of outsiders.

“I wonder why he has been designated as Vice-President,” Goatee once remarked. “He doesn’t seem to have any conceivable vice.” Wilma had smiled. Curd Rice’s daughter and Wilma were batchmates in college and had partied together on more than one occasion.

“Well sir, let me use you for my illustration,” continued Rahul gesturing to the MD. “How do you typically buy a cigarette? You obviously go to a pan wallah and ask for a packet. He will quote, say, Rs 100. You wil l pay the money and get the cigarettes. This is what can be termed as a spot or a cash transaction. That is, the buyer and the seller negotiate the terms of the sale, and once the terms are settled, the money is paid immediately by the buyer and the possession of the goods is handed over at once by the seller.”

“Now, let us take a situation where you approach a pan wallah and ask for a packet of cigarettes to be sold to you on Independence Day. Suppose he agrees to do so and quotes Rs 105 for a packet. The crucial difference as comp ared to the spot transaction is that although the terms of the sale are negotiated at the outset, neither is the money paid immediately nor is the possession of the goods handed over. The actual transaction will take place on August 15 as per the terms that are negotiated right now. This is what is termed as a forward contract.”

“In our case since we are dealing in foreign currency and not cigarettes, we will need to approach a bank to enter into such an arrangement. For instance, if we are anticipating a remittance of $50,000 after two months, we can negotiate an agreement with the bank to sell the dollars to it after two months at a rate that is fixed today itself.

“Let us assume that the bank quotes a rate of Rs 41.50 per dollar. If we accept the terms we would have locked in a receivable of Rs 20,50,000 irrespective of what the actual exchange rate after two months happens to be.”

“I was reading an article about foreign exchange futures contracts that are traded on the Chicago Mercantile Exchange,” said the MD. “What exactly are futures contracts? Can we use them for hedging our foreign exchange exposure?”

Over-the-counter

“Sir, the primary difference between futures and forward contracts is that futures contracts are exchange traded products while forward contracts are OTC,” said Rahul.

“What is OTC?” asked Balaji.

“OTC is an acronym for over-the-counter, which means that the products are not traded on an organised exchange.”

“Are forward contracts always OTC?” asked the MD. “What are other over-the-counter products?”

“Yes forward contracts are always traded OTC,” said Rahul. “As far as other products are concerned, foreign exchange itself is an OTC product. There is no centralised trading arena for foreign currency like there is in the case of stocks. The market is made up of a network of banks and other authorised dealers. Bonds are also primarily traded OTC in most countries.”

“As far as futures contracts are concerned, it is not an option for us because foreign exchange futures contracts are not traded in India.

“Even if they were to be available we may still prefer to use forward contracts because they can be customised to our requirements.”

Forward vs futures

“I don’t understand why someone may prefer a forward contract to a futures contract. Please elaborate,” said Curd Rice.

“A futures contract is a standardised product in the sense that the features of the contract are spelt out by the exchange. For instance, each futures contract on pounds at the Chicago Mercantile Exchange (CME) is for 62,500 pounds, because the exchange has specified it as such. Consequently one can trade only in multiples of 62,500 pounds. Therefore if we wanted to sell 50,000 pounds, a futures contract will be unsuitable for us. Second, futures contracts expire on a date fixed by the exchange, and are available for only certain months of the year. For instance, on the CME, contracts expire on the second business day prior to the third Wednesday of the expiration month. Consequently if we wanted to transact on the first of a given month, we will be unable to do so.”

“In what way are forward contracts different?” asked Curd Rice.

“In the case of a forward contract the agreement can be for any amount of the currency and not necessarily a multiple of a standard amount. Second, the transaction can be scheduled for any date that the buyer and the seller both agree upon.”

“We are running out of time. I have a flight to catch at 5:30,” said the MD. “I think we need to have at least a few further rounds of discussion before we are comfortable with hedging and hedging tools. I think I am free on Monday afternoon. Wilma please check my schedule and send an e-mail to everyone.”

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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