As we all know international trade happens on a continuous basis and hence traders are always exposed to currency risk for exports and imports. To overcome this currency risk, traders subscribe to a service knows as “hedging” offered by banks. Banks via hedging service provide currency fluctuation protection to traders by charging a fee. This fee is floating and is determined by considering factors such as rate of currency fluctuation occurring in world economy.To exemplify, let’s take an example of a trader in India selling goods to United States (US). Let’s say he sells goods worth Rs. 61 million to a buyer in US on credit period of 6 months. Now this buyer is to get $1 million taking 1USD/INR= 61.00. Now assume INR becomes strong in this six months time and the exchange rate becomes 1USD/INR=58.00. When the buyer pays, this translates to only Rs.58 million which causes a loss of Rs. 3 million to the Indian exporter. Similar case can be for an importer when INR weakens. Now if this trader subscribes to hedging service offered by a bank, the bank would pay the loss of additional Rs.3 million to the trader nullifying his loss. This is a kind of risk absorption service offered by bank. Not only goods and services but borrowings are also hedged for risk minimization.
What traders do is when they expect the currency to be stable, they do not hedge which they consider as an unnecessary expense and expose their trade/borrowings to currency risks. But this can cause huge losses even resulting into collapsing of businesses as happened during economic recession in 2008.
Hedging is pivotal to international trade and it is important that businesses adopt a balance between hedged and un-hedged and strike a balance for optimizing their profits with minimized currency risks.Thanks for reading!!