Diversification Series 3 - Hedge the currency and interest rate risk

Hedge the currency and interest rate risk through currency and interest rate futures

Fluctuations in the exchange rates and interest rates influences businesses and investments and calls for mechanisms to manage these risks. Hedging of these risks is now feasible with the help of the currency and interest rate futures (IRFs). Apart from the conventional asset’s classes and avenues, both these derivative products can be good addition to the portfolio for diversification purpose. Apart from hedging these avenues are also used for the speculative purpose to make bets on the future rate changes. While we will discuss the features of both these in this article but they are ideally meant for hedgers (exporters and importers), traders or savvy investors who have the knowhow and wherewithal to manage these avenues. Just like equity these avenues too are market linked and calls aligning it with your own risk profile and choosing of the right broker who can provide the required research and help in executing the timely trades.

Merits of currency and interest rate futures

Source: Financial website

Currency futures

Currency futures also known as FX futures is a type of the futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. These contracts are traded in the different exchange in India like NSE, BSE and MCX-SX. The market is open from 9.00 am to 5.00 pm and requires demat account opening with the broker and deposit of the margin amount (this amount varies across time frames).  The resident individuals or companies like banks and financial institutions trade these contracts to deal with the volatility associated with the currency movements in India by reducing the downside risk. Contrary to the over the counter (OTC) currency market, the futures market offers much more transparency, liquidity, smaller bid-ask spread, better computerised trading platforms facilitating trading from anywhere in the country for the foreign exchange management. 

Futures contract is available for USD-INR, EUR-INR, GBP-INR and JPY-INR currencies. There are Cross Currency Futures & Options contracts on EUR-USD, GBP-USD and USD-JPY are also available for trading. Exporters and importers having exposure to different currencies across countries uses the currency futures wherein the create positions in the derivative market and create hedge to mitigate the risk. Remember, the rupee appreciation benefits the importer as the cost of the imports declines when the rupee gains strength. But in this scenario the exporters suffer as they will benefit when the rupee depreciates against the dollar.  

Example:

Exporter wants to safeguard against the future rupee appreciation when he is likely to receive payment of $25,000 for his export order 6 months later. If the current exchange rate is Rs 74.50 per dollar then this translates into Rs 18.63 lakhs.  Now if the rupee appreciates to Rs 73 per dollar then the exporter would get only Rs 18.25 lakhs which can be big loss. To hedge the currency movement risk, exporter sells 50 lots wherein each lot is of $1000 priced at Rs 74.50.  6 months down the line if the rupee actually appreciates to Rs 73 while the exporter receives the remittance when converted amounts to Rs 18.25 lakhs but selling of the USD-INR futures gives him gains of Rs 75,0000 (50*1000*(74.50-73)).  

Importer will do the reverse as they would hedge the risk by buying of the USD-INR futures contract. Losses on the importer’s dollar payable due to weakness in the rupee will be compensated by the long futures on the USD-INR. This is just a simple example, currency futures trading in reality calls for thorough research, in-depth knowledge, understanding broker and exchange related requirements and formulate strategies to minimise losses.  Reducing the losses is the prime objective and not optimising profits. Yes, at times there will be profit making opportunities but given the currency fluctuations amid dynamic economic and market conditions reducing the downside risk is key.  

Interest rate futures

Interest rate futures (IRFs) refers to an agreement to buy or sell the value of an underlying debt instrument at a specified future date at a price that is fixed today. The underlying instrument of the IRFs is either government Bond or 91-Day treasury bill (T-Bill) and the mark-to-market settlement in these contracts is done in cash.  What is purpose of the interest rate futures?  Interest rate in an economy tends to fluctuate over a period of time which impacts the portfolio of the banks, insurance companies, primary dealers, mutual funds, provident funds, corporates, non-banking financial companies (NBFCs) and traders.  

Interest rate changes can also impact the investment and debt obligations.  To mitigate this interest rate risk and reduce the uncertainty - traders, institutional players use IRFs. Given the inverse relation between yield and bond prices i.e., as yield increases the price of the bond decreases and vice-versa. For instance, an individual with the home loan burden anticipates rise in the interest rate in the economy consequently his EMIs will also rise so he will go short (sell the IRFs) in the futures market to hedge the risk. When the interest rate rises the yields of the IRFs would also rise which will be profitable for the individual. On the flipside in this case if the interest rate falls, IRF investor stands to lose money but the EMI burden also reduces.  At times traders who expect cash flow in future date finds current yield attractive and so he decides to lock the current yield through long hedge.  When he receives the money, he squares of the IRF position which he had locked and invest in underlying bonds.  Investors need to make a note of the margin money and all the transaction cost involved before investing.

Summing up

Not just optimising returns but mitigating and managing risk is crucial in the investment world. Evident from the product features of the currency and interest rate futures, both the avenues can be good addition to investment portfolio to hedge the currency and interest rate risk. Its usefulness to all types of players in the economy, well-regulated, transparency, lower transaction costs and easy accessibility makes it attractive option. However, it is prudent to venture into these products only after acquiring expertise and seeking the expert guidance.