"How to have my foreign currency income converted at a fixed exchange rate vis-a-vis INR?"
Exchange rates have been a worry for a lot of us for a variety of reasons. The most common cause of concern with foreign currency income is the fluctuating nature of the currency which at a lower exchange rate would translate into fewer Rupees. This is no brain-jammer, its relatively a simple problem to deal with and that's exactly what this post is all about.
This is mostly useful when the Rupee is already quite depreciated, i.e. when you get more of INR for every USD as is the case now. The current Ex Rate is Rs. 46.81 / USD. Now, if you are happy with this exchange rate and are not willing to take a risk with the possible Rupee appreciation, you can even lock your future USD income at this rate. That is, even if the rupee appreciated to Rs. 45/USD when you get your next month salary, you can still have the USD converted at Rs. 46.81! Basically, when Rupee appreciates, it means the value of Rupee has increased, which in turn means, with the same amount of Rupees that you used to buy a commodity before the appreciation, you can now buy more of the same commodity. In other words, the purchasing power of the Rupee has increased. A simple example is, before appreciation it took Rs. 46.81 to buy one USD, whereas after the Rupee appreciated it only takes Rs. 45. Similarly, when the Ex Rate moves from 46.81/USD to say, 48.5/USD, then it means the Rupee has depreciated, as we now need Rs. 48.5 to buy one USD.
Now, how do you lock in at a particular exchange rate? In India, USD/INR trading started in Aug 2008 and it has an overwhelming response from traders across the country. This is similar to stock market trading. Firstly, you need to open a currency trading account which is very similar to your share trading account. Ask your stock broker if he deals with currency trading and if yes, then get the documents signed and open a currency trading account. If not, then find another broker. Once this is done, you can buy/sell currencies using this account, and what you will be trading in is called 'Currency Futures', to lock in your Exchange Rate. Currently, in India, we can only trade in USD, EUR, GBP and JPY. Trading in EUR, GBP and JPY were introduced recently in jan 2010.
Currency Futures are contracts that exist between 2 parties, one of whom believes, the USD/INR rate at the end of next month would be an X amount and the other party doesn't believe so. This contradiction in belief would attract the 2 parties to enter into a contract. When you buy a Currency Futures contract, you have not bought the currency (USD). You have only bought a contract (a derived instrument from the actual underlying instrument, USD) that says, you will buy the currency at the end of the contract. If you don't want to end up buying it, you can enter into a Sell contract anytime before the end of the contract term, so that the position is neutralised. When you trade using your trading account you don't have to find another counterparty to trade with. Instead the trading platform does that for you. It lists the current price at which the other party would like to sell this contract and if you're willing, you can buy it at that rate from him/her. When you buy a Currency Futures contract, say, 1000 units USD/INR Aug 2010 contract at Rs. 46.81, you have committed to the counterparty that you will buy 1000 units of USD at the rate of Rs. 46.81/USD at the end of August 2010. You're belief is that, this rate would go higher, i.e. Rupee would depreciate. Now, you will buy a USD/INR contract when you can buy USD at the end of the month. But, in case of your income being in USD, you'd rather want to sell a USD/INR contract. In which case, you can simply sell an August 2010 contract at Rs. 46.81. A natural question is "How can I sell this contract first before buying it?". In stock market, you can even sell something that you dont currently hold! It's called 'short selling'. You sell first when the price is high, and buy later when the price drops.
Let's take a practical example. If you want to send say, 10,000 USD to your Indian bank account at the end of Sep 2010, then short-sell 10,000 units of USD/INR Sep 2010 contract. Let's assume, currently the contract trades at Rs. 46.85. Usually, the term used is 'Lots' for quantity and one lot of USD/INR is 1000 units, in this case, 1000 USD. And you can buy/sell in multiples of lots. Once you've short-sold, it means, you have a counterparty that has agreed to buy all 10 lots of USD (10,000 USD) at the end of Sep 2010 at an exchange rate of Rs. 46.85. By short-selling this contract, you will have to buy the same amount of Sep 2010 USD/INR contract anytime before the end of Sep 2010, as every buy transaction is associated with a sell transaction and vice-versa.
Now, whatever the exchange rate is by the end of Sep 2010, you have a buyer to buy it at Rs. 46.85/USD. If the counterparty defaults and doesnt oblige to the contract, then the exchange steps in and fixes your losses, so there's nothing to worry about suffering a default.
We need to discuss 2 cases here:
Case 1: The INR appreciated to, for example, Rs. 45/USD at the end of Sep 2010.
This is what you feared in the beginning of the contract. If this happened, you're belief came true and you have succeeded in entering into the contract. At end of Sep 2010, you would transfer the 10,000 USD to your Indian Bank account, at Rs. 45/USD, amounting to, Rs. 4,50,000. But, you have also short-sold Sep 2010 USD/INR contract worth 10,000 USD at Rs. 46.85, which means you are yet to buy the contract back in order to neutralize your position. Now that the exchange rate has fallen to Rs. 45/USD, you can simply buy it back from the market, at this rate. At the end of the contract, you have made a profit of 46.85-45 = 1.85. 1.85x10,000 (10 Lots) = Rs. 18,500. So, the total amount you would have at the end of Sep 2010 is, 4,50,000+18,500 = Rs. 4,68,500/- for the 10,000 USD (which is nothing but an exchange rate of Rs. 46.85/USD).
Case 2: The INR depreciated to, for example, Rs. 48/USD at the end of Sep 2010.
This is contrary to what you believed. Eventhough the rate is now, Rs. 48/USD, you have an obligation to sell 10,000 USD at Rs. 46.85 or buy the contract the same contract back at the end of Sep 2010 to neutralize your current short position. Since you short sold the contract, you have to buy it back from the market now at Rs. 48/USD. You're loss here is, 48-46.85 = 1.15/USD, i.e., Rs. 11,500. But, the 10,000 USD that you would now transfer to your Indian Bank account at the end of Sep 2010, would naturally be done at the current exchange rate of Rs. 48/USD and you'd receive, Rs. 4,80,000 (for 10,000 USD). Effectively, 4,80,000 - 11,500 = 4,68,500/- (which is again nothing but an exchange rate of 46.85/USD).
There you go! Whatever happened to the USD/INR exchange rate, you got it locked at the rate that you wanted!
The finance concept behind this set-up of protecting yourself from a particular risk is called 'hedging'. And this is a practical example of hedging against currency risk that you could do for yourself.
The thumb rule is, if you are happy in the beginning of the contract, then be happy at the end as well. After all, your motive was not to make a profit but to protect your income from a possible loss.
Happy hedging!
Exchange rates have been a worry for a lot of us for a variety of reasons. The most common cause of concern with foreign currency income is the fluctuating nature of the currency which at a lower exchange rate would translate into fewer Rupees. This is no brain-jammer, its relatively a simple problem to deal with and that's exactly what this post is all about.
This is mostly useful when the Rupee is already quite depreciated, i.e. when you get more of INR for every USD as is the case now. The current Ex Rate is Rs. 46.81 / USD. Now, if you are happy with this exchange rate and are not willing to take a risk with the possible Rupee appreciation, you can even lock your future USD income at this rate. That is, even if the rupee appreciated to Rs. 45/USD when you get your next month salary, you can still have the USD converted at Rs. 46.81! Basically, when Rupee appreciates, it means the value of Rupee has increased, which in turn means, with the same amount of Rupees that you used to buy a commodity before the appreciation, you can now buy more of the same commodity. In other words, the purchasing power of the Rupee has increased. A simple example is, before appreciation it took Rs. 46.81 to buy one USD, whereas after the Rupee appreciated it only takes Rs. 45. Similarly, when the Ex Rate moves from 46.81/USD to say, 48.5/USD, then it means the Rupee has depreciated, as we now need Rs. 48.5 to buy one USD.
Now, how do you lock in at a particular exchange rate? In India, USD/INR trading started in Aug 2008 and it has an overwhelming response from traders across the country. This is similar to stock market trading. Firstly, you need to open a currency trading account which is very similar to your share trading account. Ask your stock broker if he deals with currency trading and if yes, then get the documents signed and open a currency trading account. If not, then find another broker. Once this is done, you can buy/sell currencies using this account, and what you will be trading in is called 'Currency Futures', to lock in your Exchange Rate. Currently, in India, we can only trade in USD, EUR, GBP and JPY. Trading in EUR, GBP and JPY were introduced recently in jan 2010.
Currency Futures are contracts that exist between 2 parties, one of whom believes, the USD/INR rate at the end of next month would be an X amount and the other party doesn't believe so. This contradiction in belief would attract the 2 parties to enter into a contract. When you buy a Currency Futures contract, you have not bought the currency (USD). You have only bought a contract (a derived instrument from the actual underlying instrument, USD) that says, you will buy the currency at the end of the contract. If you don't want to end up buying it, you can enter into a Sell contract anytime before the end of the contract term, so that the position is neutralised. When you trade using your trading account you don't have to find another counterparty to trade with. Instead the trading platform does that for you. It lists the current price at which the other party would like to sell this contract and if you're willing, you can buy it at that rate from him/her. When you buy a Currency Futures contract, say, 1000 units USD/INR Aug 2010 contract at Rs. 46.81, you have committed to the counterparty that you will buy 1000 units of USD at the rate of Rs. 46.81/USD at the end of August 2010. You're belief is that, this rate would go higher, i.e. Rupee would depreciate. Now, you will buy a USD/INR contract when you can buy USD at the end of the month. But, in case of your income being in USD, you'd rather want to sell a USD/INR contract. In which case, you can simply sell an August 2010 contract at Rs. 46.81. A natural question is "How can I sell this contract first before buying it?". In stock market, you can even sell something that you dont currently hold! It's called 'short selling'. You sell first when the price is high, and buy later when the price drops.
Let's take a practical example. If you want to send say, 10,000 USD to your Indian bank account at the end of Sep 2010, then short-sell 10,000 units of USD/INR Sep 2010 contract. Let's assume, currently the contract trades at Rs. 46.85. Usually, the term used is 'Lots' for quantity and one lot of USD/INR is 1000 units, in this case, 1000 USD. And you can buy/sell in multiples of lots. Once you've short-sold, it means, you have a counterparty that has agreed to buy all 10 lots of USD (10,000 USD) at the end of Sep 2010 at an exchange rate of Rs. 46.85. By short-selling this contract, you will have to buy the same amount of Sep 2010 USD/INR contract anytime before the end of Sep 2010, as every buy transaction is associated with a sell transaction and vice-versa.
Now, whatever the exchange rate is by the end of Sep 2010, you have a buyer to buy it at Rs. 46.85/USD. If the counterparty defaults and doesnt oblige to the contract, then the exchange steps in and fixes your losses, so there's nothing to worry about suffering a default.
We need to discuss 2 cases here:
Case 1: The INR appreciated to, for example, Rs. 45/USD at the end of Sep 2010.
This is what you feared in the beginning of the contract. If this happened, you're belief came true and you have succeeded in entering into the contract. At end of Sep 2010, you would transfer the 10,000 USD to your Indian Bank account, at Rs. 45/USD, amounting to, Rs. 4,50,000. But, you have also short-sold Sep 2010 USD/INR contract worth 10,000 USD at Rs. 46.85, which means you are yet to buy the contract back in order to neutralize your position. Now that the exchange rate has fallen to Rs. 45/USD, you can simply buy it back from the market, at this rate. At the end of the contract, you have made a profit of 46.85-45 = 1.85. 1.85x10,000 (10 Lots) = Rs. 18,500. So, the total amount you would have at the end of Sep 2010 is, 4,50,000+18,500 = Rs. 4,68,500/- for the 10,000 USD (which is nothing but an exchange rate of Rs. 46.85/USD).
Case 2: The INR depreciated to, for example, Rs. 48/USD at the end of Sep 2010.
This is contrary to what you believed. Eventhough the rate is now, Rs. 48/USD, you have an obligation to sell 10,000 USD at Rs. 46.85 or buy the contract the same contract back at the end of Sep 2010 to neutralize your current short position. Since you short sold the contract, you have to buy it back from the market now at Rs. 48/USD. You're loss here is, 48-46.85 = 1.15/USD, i.e., Rs. 11,500. But, the 10,000 USD that you would now transfer to your Indian Bank account at the end of Sep 2010, would naturally be done at the current exchange rate of Rs. 48/USD and you'd receive, Rs. 4,80,000 (for 10,000 USD). Effectively, 4,80,000 - 11,500 = 4,68,500/- (which is again nothing but an exchange rate of 46.85/USD).
There you go! Whatever happened to the USD/INR exchange rate, you got it locked at the rate that you wanted!
The finance concept behind this set-up of protecting yourself from a particular risk is called 'hedging'. And this is a practical example of hedging against currency risk that you could do for yourself.
The thumb rule is, if you are happy in the beginning of the contract, then be happy at the end as well. After all, your motive was not to make a profit but to protect your income from a possible loss.
Happy hedging!
very informative... thanks a lot dhiraj
ReplyDeleteAjay Kedare
Glad you found it informative, Ajay! :)
ReplyDeletekeep writing....
ReplyDeletereally good practical example thank you!!
ReplyDeletevery nice explanation
ReplyDelete