Vinu: Manu, I keep hearing about something called "unhedged foreign currency exposure." What does that mean?

Manu: Great question, Vinu! Unhedged foreign currency exposure refers to the risk an individual or company faces when they have financial transactions in a foreign currency, but they haven’t taken steps to protect themselves from exchange rate fluctuations.

For example, suppose an Indian importer buys goods from a U.S. exporter and has to pay in U.S. dollars (USD). If the Indian importer doesn’t hedge this payment, they’re exposed to the risk of changes in the USD-INR exchange rate. This is what we call an unhedged exposure.

Vinu: Okay, so if the exchange rate changes, the cost could go up or down. Could you explain how that works with a small example?

Manu: Absolutely! Let’s say our Indian importer has to pay $10,000 to the U.S. exporter in 3 months. At the current exchange rate, let’s assume 1 USD = ₹75. If the importer pays today, they would need ₹7,50,000.

Vinu: So, by not hedging, the importer is essentially gambling on the exchange rate?

Manu: Exactly, Vinu! They’re exposed to fluctuations, which can either increase or decrease their costs. If the importer had hedged the payment, say, by entering into a forward contract, they could lock in today’s rate of ₹75 per dollar. That way, they would know for sure they’ll pay ₹7,50,000 in 3 months, regardless of how the exchange rate changes.

Vinu: I see. So, hedging gives certainty, and unhedged exposure means taking on the risk of changes in the currency rate.

Manu: Precisely. For businesses, unhedged exposure can lead to significant unexpected costs, which can affect profitability. That’s why many importers, like the one in our example, prefer to hedge their foreign currency transactions.