Forex trading and Hedging strategies - 3

This is part 3 of the article: Forex trading and Hedging strategies - 1. Please read the first part before continuing with this one.

To understand the market terminology, the Future contract that I will get into will be called a Microsoft March Future (similarly we can have different futures like Reliance March Future, Wipro February futures, etc). The March future will have a future price, which in this case is $33 for Microsoft March Future. Same way you will have Wipro February future price that may be 515, and so on. So what you might see on the business news channel everyday, where they say that “Reliance January Future is trading at 2800 as against the spot price of 2750” – it means that the future contract of Reliance stock expiring in January has been agreed for trading at 2800. The spot price is the today’s market price of reliance. In this case, since the future price is higher that the spot price, it is said that the future is trading at a PREMIUM of 50 (2800-2750) or for Microsoft, it will be $3 ($33 - $30). Sometimes, when we have the future price below the spot price, it is said to be trading at a DISCOUNT.

Now, let’s take some more examples from the investment companies or forex currency risk. Let’s say Infosys (Infy) knows that it is going to receive $ 1billion in 3 months time, because it will deliver a software product to a US based client. Since Infy is based in India, it will need to convert that money in Indian Rupees. Hence, if the USD-Rupee forex currency rate decreases, then Infy will receive less rupees for the $ 1 billion – there is a RISK. Hence, what it does is that it gets into a future contract with another party, let’s say a bank trading in forex currency, and fix a FUTURE exchange rate. Suppose the current exchange rate is Rs. 40 per dollar, and the agreed future price is Rs. 40.5 per dollar between Infy and the bank, then on the expiry date 3 months down the line, Infy will give 1 billion dollars to the forex trading bank, and bank will give 1 billion * 40.5 Rs to Infy, irrespective of the then existing market rate.

Hence, by using this kind of future contracts, the companies try to hedge their cash flows and income. What is more important here is the security that one gets, the certainty that one wishes, that he will definitely receive this much amount of money irrespective of which way the prices go. This is the whole heart and soul of hedging – avoid uncertainty and fix the prices right now!

When you are looking at a company which has significant cash flows from foreign presence, do try to find out whether it is using hedging or not. Usually it is clearly indicated in the annual report. Even if it is not mentioned in the annual report, then you should look at the past declared results of the company. If they have used hedging or forex currency trading contracts in the past, then it will be mentioned in the past reports in terms of future price contracts, etc. And hence, there is a high chance that the the company will continue to use hedging against forex price fluctuations in the future as well. For e.g., companies like TCS managed to show good profit last quarter because they were already using hedging strategies for forex reserves.

Where does the disappointment come in?
The problem is with the expectations. For e.g., If the dollar again becomes stronger to the rupee, then the profits of Indian companies will increase. But since they may be using future contracts to hedge their forex price fluctuations, they may appear to be loosing as compared to the existing market price. Therefore, when the street or investors are expecting some fabulous results from a company, the company may not be able to deliver the expected results if it is hedged using some such future contracts. So ultimately, it may fall either way. It all works RANDOMLY.

A typical case is the Airline industry. Historically, it has been observed that most of the airline companies run in losses. That includes state run airlines as well as private airline players. Even if the handfuls of airlines are in profit, their returns on investment is not as good as other sector companies. The reason is simple. An airline like Lufthansa having presence in more than 40 countries, how long can it hedge? And against how many different currencies by trading in forex currency?

One investor may feel proud that his investment is a company like Infosys is set to grow because infosys is having presence in more than 30 countries (just an example). The fact is that more dependency you have, the more problems a finance officer faces in hedging. It all depends upon luck and randomness. Trade in forex, get into currency trading, hedge your position and future cashflows, ultimately, you will fall victim to efficient markets – the markets that work randomly.

However, it is always good to keep an eye on what the company management is doing in terms of hedging –especially the forex trading. It’s better to take pennies as profit by getting into a future contract, instead of sitting with unexpected huge dollar loss exposures!

Table of Contents