Vinu: Hey Manu, I came across the term "unhedged foreign currency exposure" in a finance article. Can you explain what it means?

Manu: Sure, Vinu! Unhedged foreign currency exposure refers to a situation where a company is exposed to fluctuations in foreign exchange rates without any protective measures in place. This can lead to financial risk if the currency values move unfavorably.

Vinu: Hmm, that sounds risky. Can you give me an example, maybe with an Indian company?

Manu: Absolutely. Let's say there's an Indian company called ABC Ltd. that imports machinery from the US. They have to pay their US supplier in dollars. Now, suppose ABC Ltd. is expecting to make a payment of $1 million in three months.

Vinu: Okay, I follow so far. So how does unhedged exposure come into play?

Manu: If ABC Ltd. doesn't take any steps to protect itself against fluctuations in the exchange rate, it has an unhedged foreign currency exposure. For example, if the current exchange rate is 1 USD = 75 INR, the payment would be 75 million INR today. However, if in three months the exchange rate changes to 1 USD = 80 INR, ABC Ltd. would now need to pay 80 million INR instead of 75 million INR. This unanticipated increase in cost is due to the unhedged exposure.

Vinu: Ah, I see. So, they could end up paying more if the rupee weakens against the dollar.

Manu: Exactly. On the other hand, if the rupee strengthens, the company could benefit and pay less. But it's a gamble, and most companies prefer to avoid this kind of uncertainty.

Vinu: So how do companies typically hedge against this risk?

Manu: Companies often use financial instruments like forward contracts, options, or futures to hedge against currency risk. For instance, ABC Ltd. could enter into a forward contract to buy dollars at a fixed rate of 1 USD = 75 INR in three months, thus locking in their cost and eliminating the risk of unfavorable currency movements.

Vinu: That makes sense. So, hedging provides stability and predictability in financial planning.

Manu: Exactly, Vinu. It helps companies manage their financial risk more effectively and focus on their core business operations without worrying about exchange rate volatility.