Forex fluctuations on imports & exports: A

profitability analysis of SMEs.

Kushaal SubramonySony Saju George

Remya Josephine AntonySreeja Sukumaran

Teby C BaabyGangaveer Singh

A Paper PresentationBy

INTRODUCTION• India is among one of the prominent importers and exporters of the world.

• The engagement in imports has exposed businesses to exchange rate risk, which acts in favour of the importer sometimes while other times can lead to a financial havoc.

• Last year due to recession, Indian Rupee depreciated greatly, impacting Indian importers immensely as it lead to an increased cost of product acquisition.

• Unstable exchange rates affect businesses tremendously and it is difficult to difficult to change the prices of products accordingly.

• A number of banks and government organisations help companies that are extensively involved in importing activities.

• SMEs are adversely affected by the exchange rate fluctuations.

• Exchange rate movements are driven by Demand and Supply principle.

• Some of the important factors affecting the demand and supply of any currency are as follows:-

Interest Rate parity

Law of one price

Macro-Economic Environment

Stock Market

Political Factors

Market Forces and its Impact on Exchange rate movements.

LAW OF ONE PRICE

INTEREST RATE PARITY

Any disparity between the interest rates of two countries is equalized by the movement in their currency exchange rates.

• Sometimes known as the International Fisher effect.

• When one makes investments in two different currencies the return on both the investments are the same even though the interest rates may be different in absolute terms.

• The same goods should be sold at the same price anywhere in the world.

• Either the price of the goods or exchange rate must be adjusted to adopt the same price.

MACRO-ECONOMIC ENVIRONMENT

• A positive macro-economic environment also increases the demand for a currency.

• The economic data about the below indicators are also likely to cause fluctuations in exchange rates are :-

1. Consumer Price Index

2. Producer Price Index

3. Gross Domestic Product

4. Productivity

5. Industrial Production

6. International Trade

POLITICAL FACTORS

STOCK MARKET

Reasons

Role of RBI in FOREX

• Sales and purchase of foreign exchange

• Intervention has changed over the years from BrettonWoods system

•To influence the trend movement in exchange

• To maintain export competitiveness

• To manage volatility to reduce risk

• To protect currency from speculative attack

• Increased importance of capital flows

•IMF principle of 1977 regarding central bank intervention only for disorderly market conditions

•Sterilised intervention – Offset government debt

•Non sterilised intervention – Without offset

• Studies show that intervention can contain exchange rate volatility

• To match demand and supply of foreign currency

August 1997 – August 1998(Volatility)

March 1993 – July 1995(Stability)

• Dual exchange rate to Unified exchange rate• Capital inflows tended appreciating pressure on rupee• Reserve bank foreign asset raised to $20 Billion• Preserving competitiveness and building reserves

•South East Asian currency crisis• High volatility• Adoption of stringent monetary and administrative measures in spot and futures

Quantitative Measures

• Foreign Exchange Exposure Limit (FEEL)

• Basically restricts the banks to keep a net asset

(long) or net liability (short) position in foreign

currencies.

• Presently FEEL for each bank is set at 10 %10 % of

it’s paid up capital.

• In the presence of FEEL, banks’ net purchases

or net sales in foreign exchange on a given day

have to be within their FEEL.

How does RBI manages exchange rate in the interbank market?

Physical intervention

• Direct selling or buying of foreign exchange by State Bank in the interbank market.

• Such sale/purchase can be in spot or forward value

• It can have two objectivesTo provide support to the market for

lumpy paymentsTo manage the Rs/$ parity

• Intervention may be direct or indirect. Currently RBI only indirectly intervenes in the market.

Impact of forex fluctuation on SMEs

• Wild foreign exchange fluctuation has been taking a toll on India Inc and has not only caused losses, but also created a huge confusion over the hedging solution.

• Both exporters and importers are concerned about the uncertainty caused by the volatility.

Impact of the appreciation of the rupee on various sectors

Industry % of imported content

% of exports impact

Leather Low High Adverse

Refineries High Low Beneficial

Auto Medium Low Beneficial

Engineering Medium Low Beneficial

Airlines High Low Beneficial

Gems and Jewellry

High High Neutral

IT Low High Adverse

handicraft low high Adverse

Impact on Importers

Impact on exporters

• Currency appreciation adversely impact exporters while currency depreciation benefits exporters.

• Currency appreciation impacts the importers favorably as it reduces the cost of imported goods

Impact on Borrowers

• Indian firms are availing of loans in foreign currencies as these loans are cheaper than Rupee loans. However, when taking a foreign currency loan, there is a risk related to exchange rate fluctuations.

CURRENCY FUTURES

What are Currency Futures?

• Futures are

– standardized,

– negotiable, and

– exchange-traded contracts to buy or sell an

underlying asset

• In case of Currency Futures the underlying asset is the

exchange rate.

– In India only those contracts based on USD/INR

are traded.

Why Currency Futures?

• Exchange Rate fluctuates

• Expose investors to currency risks.

– If domestic currency depreciates (appreciates)

against the foreign currency, the exposure would

result in loss (gain) for importers and gain (loss)

for exporters.

• Currency futures enable traders to hedge their

FX risks.

– taking a position in the future market that is

opposite to a position in the physical market

How Currency Futures can Help?

• Unhedged Exposure: Let’s say on March 1, 2008, an Indian

refiner enters into a contract to export 1000 barrels of oil with

payment to be received in US Dollar (USD) on June 1, 2008.

The price of each barrel of oil has been fixed at USD 80/barrel at

the prevailing exchange rate of 1 USD = INR 44.05; the price of

one barrel of oil in INR works out to be is Rs. 3524 (80 x 44.05).

On June 1, 2008, the INR actually appreciates against the USD

and now the exchange rate stands at 1 USD = INR 40.30.

Hence the same barrel of oil that initially would have garnered

him Rs. 3524 (80 x 44.05) will now realize Rs. 3224, which

means 1 barrel of oil ended up selling Rs. 3524 – Rs. 3224 = Rs.

300 less and hence the 1000 barrels of oil has become cheaper by

INR 3,00,000.

Courtesy :NISM

Hedged

Since he is concerned that the value of USD willfall he decides go short on currency futures, itmeans he sells a USD/INR future contract. Thisprotects the importer because weakening of USDwould lead to profit in the short futures position,which would effectively ensure that his loss inthe physical market would be mitigated. Thefollowing figure and exhibit explain themechanics of hedging using currency futures.

Courtesy: NISM

Currency Futures-An effective risk management

tool

• Currency Futures is very important risk management tool, in face of wide fluctuations in FOREX Rates.

• Small exporters don't have right risk management policy. Currency Futures and its adoption by the SMEs can help in remedying these.

Risk exposure strategies

• Foreign currency receivables holdings.

• Price competitive markets

• Price variance clauses with customers

• Cash flow position

• Fluctuation and significant effect on profits

• Which currencies are you exposed to?

Risk mitigation strategies

• No hedging

• Selective hedging

• Systematic hedging

Risk mitigation tools

• Currency diversification

• Forward contracts

• Swaps

• Call and put options

SOLUTIONS OFFERED BY BANKING & FINANCIAL

INSTITUTIONS

SPECIALISED PRODUCTS OFFERED

• Interest Rate Product – Principal Only Swap (POS)

• Exchange Rate Product – Forward Booster

Interest Rate Product – Principal Only Swap (POS)

• Change a liability of interest.

• Example of POS

Exchange Rate Product –Forward Booster

• It is an option contract

• Example of exchange rate product

Thank you