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Hello Friends,

First of all thank you very much for your lovely response to my earlier forex parts.

Click below for earlier parts of forex.

Forex - Part 1 (Basic)

Forex - Part 2 (Basic)

Forex - Part 3 (Parity relationships)

Today we will move to advance concepts of forex i.e. hedging.

Before go to hedging first we have to understand meaning of HEDGE.

TO HEDGE MEANS REDUCE THE RISK.

In currency market there are many risks, some of them we saw in earlier part. Interest rate fluctuation, Inflation, Expectations of Currency participants etc etc. are the risks in currency market and because of these currency rate fluctuates.

Now, how to avoid these risks or how to reduce these risks ?

---> There are various methods which can help us to reduce the risks in currency market.

Now, next question arises, what are the methods to reduce the risks ?

---> There are various methods, we will saw some of them.

a. Forward Contract

b. Options contract

c. Money Market Hedge

d. Leading and Lagging

e. Matching and Netting

f. Future Contract

g. Home Currency Invoicing

By using above method / methods we can reduce the risks. We will discuss some of them in this discussion and rest in next discussion.

Today we will discuss on Forward contract and Money market hedging

(While reading please note that don't think that hedging is difficult, be positive you will get solution automatically)

a. FORWARD CONTRACT:

There is no need to think what is the meaning of forward contract, its name itself gives us meaning of it.

It is a contract which is entered into today for the settlement on some future date i.e. on forward date.

Now you might be thinking that settlement on future date means whether its time of settlement is fixed or something else?

I have solution of your querry,

Such forward contract can be classified in 2 categories :

i) Fixed date forward contract and

ii) Option forward contract (it is not option which is covered in derivative)

i) Fixed date forward contract:

It means, CURRENCY WILL BE EXCHANGED ON PREDECIDED DATE AT PREDECIDED RATE.

ii) Option Forward Contract:

In this case, OPTION IS NOT FOR GIVING OR TAKING DELIVERY OF FOREIGN CURRENCY RATHER OPTION IS FOR DATE OF SETTLEMENT WHICH CAN BE AT ANY TIME DURING PREDECIDED FIXED PERIOD.

(it is not like derivative that i have right to buy or not, here I have only choice of settlement i.e. date of settlement but finally I have to settle)

In forward contract there are 4 possibilities:

1. Settlement on Due date

2. Early delivery of forward contract

3. Rolloverof forward contract

4. Cancellation of forward contract

b. MONEY MARKET HEDGING:

It is one of the most important method of hedging, I will try to discuss this method in easy way with the help of an example.

Example : A Ltd purchased a machine from US for $ 3000 and I have to make payment after 90 days. Interest rate in US is 4% (deposit rate) and 6% (borrowing rate), whereas in India interest rate is 9% (deposit rate) and 13% (borrowing rate). Spot rate is $1 = Rs 60.

Ans ---> Now, here I purchased a machine for $ 3000 and I have to pay such amount after 90 days but I have risk of currency rate fluctuation after 90 days. Such rate can be increased or decreased. Now, I want to reduce such currency rate fluctuation risk, but how ?

Now, I have to go by 2 types of steps 1. transaction steps (means how transaction will take place) and 2. Calculation Step (how to do calculation)

1. Transaction Steps :

a. Borrow the amount (which is payable) in domestic country,

b. Convert domestic currency into foreign currency and invest in foreign country

c. with the interest we will be having desired amount in investment account after 90 days and withdraw the amount from the investment account and make the payment

d. and then repay the borrwings in domestic country with interest.

2. Calculation Steps:

Now guys, we saw in transaction step that first we have to borrow the amount (which is payable) in domestic country but did you observe that how it will come to know me that how much amount I should borrow ? Hence in calculation steps first we will calculate the amount which I need to borrow in domestic country.

Step 1: Amount to be deposited in foreign country

Amount payable in US after 90 days                      $ 3000

Applicable interest rate                                          4% p.a.

(deposit rate of foreign country)                            

Amount to be deposited in US                               *$ 2970.30

*

$ 3000               

 [1+(0.04*90/360)]

Note: From Step 1 we got the amount which should be deposited in US in $, now step 2 is, I want to calculate amount that I should borrow in domestic currency TODAY (highlighted ''today'' word because rate will be spot rate that I will borrow)

Step 2 : Amount to be borrowed in Domestic Country

Amount to be deposited in foreign country                 $ 2970.30

(from step 1)

Applicable spot rate                                                   $1 = Rs 60

Amount to be borrowed in home country in Rs          Rs 178218

($ 2970.30 * Rs 60)

Note : From step 2 we got the amount which should be borrowed from domestic country in domestic currency. Now step 3, interest payable on repayment of borrowings.

Step 3 : Amount repayable on borrowings

Amount borrowed in domestic country              Rs 178218

(as per step 2)

Applicable interest rate                                     13% p.a.

(borrowing rate of domestic country)

Amount repayable after 90days                       *Rs 184010 (approx)

*Rs 178218 * [1+(0.13*90/360)]

I hope you guys are getting the concepts, it will be beneficial for you if you solve the questions after reading the concepts, it is not possible for me to solve questions here but I am trying my best to clear your concepts. If you face any problem then please ask me at siddharthbumb@gmail.com without hesitation.

(Above information is as per my best knowledge, but there may be typing mistake while writing this article, if you find the same then please let me know. )

Thank You.

Regards,

Siddharth Bumb

siddharthbumb@gmail.com

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