How Is Foreign Currency Hedging Linked With Forex Gain or Loss?

How Is Foreign Currency Hedging Linked With Forex Gain or Loss?

14 Nov 2019 02:54 PM

To understand how foreign currency hedging is linked to foreign exchange gain or loss, better, it is necessary to first understand what foreign currency hedging means. Simply put, hedging is an attempt to minimize or offset risk due to adverse movement in prices. It protects your finances from a risky event or situation. Basic keywords being – protect and risk. So the aim is to limit the probability of loss from volatility in the price movement of any asset – commodity, equity or currency.

Thus any uncalled for movement or crisis in the foreign exchange markets can lead to massive losses especially when there is leverage involved. So if any currency losses its value, then one should be able to limit the loss incurred. Now the aim is to protect capital and limit loss. There are several tools which are used for hedging and then strategized as per situations.

Foreign exchange is when converting home currency for goods and services sold in a foreign currency. The value of the foreign currency varies in the foreign exchange market as it depends on several economic, non-economic, sentiments, geo-political, etc factors.

Foreign exchange market movement’s affect the corporate business

All companies doing business overseas are affected by changes in the foreign exchange rate. Some sell their products and services while some buy products and services from abroad. There are some who have both buying and selling in the same currency over the same period – thus offsetting the effects of currency fluctuations. With dynamic currency rates, the chance of price changes is high from when the billing is done to when the money is realized in the account.

For example, an Indian automaker sells his customized vehicle to a client in US. He has to get his revenue from the client in US Dollars (USD) while his home currency is Indian Rupee (INR). He sends an invoice worth $1000 and his client upon receiving the vehicle makes the payment after 15 days. The probability of USD/INR moving is high in those 15 days, thus the seller may end up receiving more or less for the same invoice due to changed in the exchange rate.

When the home currency is converted to a foreign currency at rate FC1 at time T1, and after some time T2, the value changes to FC2, then the gain (or loss) is FC1-FC2. For example, USD was converted to INR at 11am at the rate 72.00 and at 11.10am, the same currency was quoted at 71.90, then the opportunity gain is 72.00-71.90 = 0.10 INR. In the above example, if at 11.10am, the USDINR rate is 72.10, then the opportunity loss is 72.10-72.00 = 0.10 INR.

The point to be understood is that when one converts USD to INR at 11am, the realized amount should be checked with the benchmark (costing) value and not where the market is heading to after the conversion. So if the costing of the product sold is at 71.50, then irrespective of where the USDINR spot moves after conversion at 11am, the profit is made of INR 0.10 for every dollar sold.

A foreign exchange transaction is recorded in the books of accounts at an exchange rate though the payment is made at a different exchange rate. This leads to transactional foreign exchange loss or gain.

Foreign exchange losses or gains for a trader

When dealing with a corporate, benchmarking is important but when a currency trader is in the foreign exchange market, there are many ways in which he can contain the losses by hedging. The popular method of hedging is of applying stop loss thus cutting deeper losses. Alternate ways are to hedge using derivatives like forward, futures, options, structured products, etc. Even simply diversifying the investment portfolio, hedges risk of one asset from another. For example, gold is used as a hedge when inflation rises or during uncertain times in the global markets when value of the global currency USD falls. Or even when securities markets are in for a fall, the gold or bond is generally seen gaining fancy.

Currency trading offers profitable opportunities, but has enough challenges which a well informed investor is likely to understand. So before getting deeper in trading, one should understand its pitfalls due to volatility in the round-the-clock foreign exchange market.

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