Managing Currency Risk with Derivatives: A Simple Guide for Indian Businesses

Introduction: Why Currency Risk Matters

In today’s interconnected global economy, Indian companies that engage in international trade often face a hidden challenge: currency risk. This risk arises when companies receive payments or make payments in foreign currencies. Fluctuations in exchange rates can lead to unexpected losses or reduced profits. So, how can Indian businesses protect themselves from these unpredictable shifts in currency values? The answer lies in using derivatives—a powerful financial tool to hedge against such risks. Let’s dive into how derivatives work and how they can help Indian companies manage their currency risk.

The Scenario: An Indian Company Selling to an American Buyer

Imagine an Indian company sells a high-tech laser cutting machine to a buyer in the United States. The contract price is in US Dollars (USD), but the company’s costs are in Indian Rupees (INR). The challenge? If the USD/INR exchange rate changes by the time payment is received, the company might not get as much INR as expected, resulting in a financial loss. This is where currency risk comes into play.

How Derivatives Can Protect Against Currency Risk

To protect itself from this risk, the company can use derivatives. These financial contracts allow the company to set future exchange rates today, effectively locking in the amount of money they will receive—no matter how exchange rates change in the future.

1. OTC Derivatives (Over-the-Counter)

For companies that need tailored solutions to their specific currency risk, OTC derivatives are the ideal choice. These contracts are customized to fit the company’s exact needs. For example, the Indian company can enter into a forward contract to sell US Dollars (USD) at a predetermined exchange rate against INR. This ensures that when the payment is made, the company knows exactly how much INR it will receive, regardless of fluctuations in the exchange rate.

2. Centrally Cleared OTC Derivatives

Alternatively, if the company wants added security, it can choose a centrally cleared OTC derivative. In this case, a central counterparty (CCP) becomes involved, guaranteeing that both parties fulfill their obligations. This greatly reduces credit risk, as the CCP ensures that if one party defaults, the other will still receive their money.

Which Market Should the Company Choose?

The company now needs to decide between two options: OTC derivatives and Exchange-Traded Derivatives (ETDs).

• OTC Derivatives: These are customized contracts, making them ideal when the company needs flexibility to manage its specific currency risk. These contracts can be adapted to the company’s needs and help address unique challenges.

• ETDs (Exchange-Traded Derivatives): These contracts are standardized, meaning they are less flexible than OTC derivatives. While they provide transparency and ease of trading, they may not perfectly match the company’s requirements. This makes them a better fit for businesses with simpler hedging needs.

Managing Credit Risk with Derivatives

When using derivatives, it’s essential to consider credit risk. Here’s how it works:

1. A: The company faces credit risk if its counterparty fails to meet its obligations under the contract.

   • This is true for centrally cleared OTC derivatives. If one party defaults, the CCP steps in to handle the situation. The company’s credit risk is thus minimized because the CCP guarantees the contract’s fulfillment.

2. B: The company creates credit risk for its counterparty if it fails to fulfill its obligations.

   • If the company fails to meet its obligations, it could create credit risk for the counterparty, especially if the contract is not centrally cleared. However, with centrally cleared derivatives, the CCP assumes this risk.

3. C: The company creates credit risk for a derivative contract user with the opposite position.

   • This is incorrect because in centrally cleared contracts, the CCP takes on the risk and ensures that counterparties don’t directly bear credit risk from each other.

Why Should Indian Businesses Use Derivatives?

In today’s volatile market, currency fluctuations are inevitable. But with derivatives, Indian companies don’t have to face these fluctuations unprepared. Here’s why derivatives are essential:

1. Protection Against Uncertainty: Derivatives allow businesses to lock in exchange rates today for future transactions, ensuring they know exactly what they will receive or pay, regardless of currency fluctuations.

2. Customization: Through OTC derivatives, Indian companies can tailor contracts to their unique business needs, offering a more effective way to hedge against currency risk.

3. Security and Reliability: With centrally cleared OTC derivatives, the involvement of a central counterparty (CCP) minimizes credit risk, providing greater security for both parties involved.