Let us understand this with the help of an illustration. Assume that Sethia Traders Ltd. has an export inward remittance that is receivable on 30th September for $50,000/-. While Sethia knows the dollar amount that they will get on 30th September, they are not too sure about how about how much INR that will translate into as it will depend on the USD-INR exchange rate on that particular date. For the purpose of our understanding let us assume that the exchange rate is Rs.64/$. That means at this rate it will actually translate into a rupee inflow of INR 32 lakhs on September 30th. Raghav has certain commitments on October 10th and is comfortable with the exchange rate of 64/$ on the settlement day. But rates change and at times can change drastically.

However, Sethia has been advised by their banker that due to heavy FPI inflows into India, the INR may actually appreciate to 62/$ by September 30th. That will mean that the export earnings of $50,000 will merely translate into Rs.31 lakhs in rupee terms. Sethia is apprehensive that this will leave them with a shortfall in meeting their outflow commitment on October 10th. The company, therefore, needs to hedge its inward dollar risk. How can Raghav Exports do this?

Simply put, Raghav Exports can hedge this risk by selling 50 lots (each lot is worth $1000) of the USD-INR pair at a price of Rs.64. This will give them a perfect protection. This is how it will work. On the inward date of 30th September, let us assume that the INR has actually appreciated to 62/$. When Raghav Exports receives its remittance of $50,000/- on September 30th, the converted value will be Rs.31 lakhs. However, Sethia, as advised by the banker, has also sold 50 lots of the USD-INR futures at Rs.64. Essentially, Sethia Traders is short on the USD vis a vis the Indian rupee. Since the price is now down to 62, Raghav exports will make a profit of Rs.1 lakh on that position. Thus the total receivable will now be Rs.32 lakh (Rs.31 lakh from conversion and Rs.1 lakh from the short USD-INR futures). Effectively, Raghav exports has managed to hedge its conversion price at Rs.64/$. Of course, for the purpose of simplicity we have not considered transaction costs but that can be factored in and anyways these costs are quite marginal to really impact the profitability in a big way. At least the risk of a strong rupee is managed for Sethia.

The counter question is what happens if the INR depreciates to Rs.68. In the normal course, Raghav Exports would have made a profit but due to the hedge it will be locked in at Rs.64/$. This will result in a notional loss of Rs.4, but the intent here is to protect your downside risk, not to make profits. There are two ways this can be overcome. Either, one can hold the USD-INR pair with a strict stop loss or the hedging can be done through put options instead of futures so that the maximum risk can be contained to the extent of the option premium. In fact, options trades have been seeing a rise in volumes as more and more traders are seeing the benefit of using options for hedging their currency risk.