Hedging is the protection of risk. While any investor in the stock market is exposed to a variety of risks like the price risk, macro risk, company risk etc, NRIs have an additional risk to worry about and that is the currency risk. Most NRIs earn in dollars or Euros or Dirham and convert it into Indian rupees to invest in India. During this period, they would prefer that the rupee remains either stable or strong. Any sustained weakness in the rupee can effectively harm the effective dollar returns that the NRI would earn.
How NRIs can hedge rupee risk in equities?
NRIs are currently allowed to trade in equity, equity futures, and equity options and also in currencies. We shall deal with currency hedging by NRIs separately and let us first focus on rupee risk hedging through the equity and F&O market. Here is how.
The simplest way to hedge price risk in equities is through diversification. Here diversification refers to spreading your equity holdings across sectors and themes so that at any point of time you can have some story to fall back upon.
The more complex form of risk hedging can be done through futures and options. Let us talk about futures first. Remember, futures and options can be traded by NRIs only through the NRO account which is non-repatriable. If NRIs have a long equity position in a stock, they can hedge the risk by selling futures against that. This can either be to book a profit or to make regular arbitrage profits.
NRIs can also hedge their equity risk using index and stock options. For example, an NRI can purchase put options against their long stock holdings. This way, they not only cap their risk but also make profits on the put option if the markets move down.
Hedging of currency risk by NRIs
This remains a big challenge for the NRIs and thanks to the SEBI and RBI permitting the NRIs to indulge in currency trading in India, through currency derivatives market, the NRIs are in a position to pick either rupee pairs or cross currency pairs as per their choice and hedge their currency risk. This is how currency risks hedging works.
The USDINR is a rupee/dollar pair which uses the USD as the base currency and the INR quoted currency. The USDINR is always traded in terms of number of units of the quote currency for one unit of base currency. If the NRI is expecting the dollar to appreciate or the rupee to weaken, then the best way to hedge is to buy the USDINR futures.
Similarly, if the NRI is expecting the dollar to weaken or the rupee to strengthen, then the best way to hedge is to sell the USDINR futures. All trades are done in lot size of $1000. Similar trades can be structured with the Euro, Pound and Yen also.
Shift in hedging facility for NRIs
In the past, NRIs were only permitted to hedge their rupee currency risk through the OTC market or the forward market through the banks. This was a cumbersome process. A simpler way is the exchange traded derivatives market where the trades can be put through the NSE or the BSE. This allows the NRIs to hedge currency risk arising out of their investments in India and it offers an additional currency hedging option apart from the already existing price hedging options.
Of course, the permission for NRIs to participate in the currency derivatives market comes with some checks and balances. For example, NRIs would have to designate an authorized bank for the purpose of monitoring and reporting their combined positions in the OTC and ETCD segments. The currency limits apply to their combined positions in the OTC market and the Exchange market put together. Also, NRIs can take positions in the currency futures/exchange traded options market to hedge the currency risk only as permissible under the FEMA (Foreign Exchange Management Act) Regulations, 1999.
There is an important point that NRIs must remember about currency hedging. The onus of ensuring the existence of the underlying exposure rest with the NRI concerned. That effectively means; NRIs can only hedge against an existing position and naked trades are not permitted for NRIs. In case of any contravention, the NRI shall be personally liable for any action as deemed fit by the RBI under provisions of FEMA Act.
READHERE about impact of currency movement on NRI online trading gains.