Tools for Hedging Foreign Exchange

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Tools for Hedging Foreign Exchange & Foreign Currency Risk/Exposure Management

Case study any IT Company

Currency risk orexchange rate risk is a form offinancial riskthat arises from the potential change in theexchange rateof

onecurrencyin relation to another. Investors or businesses face an exchange rate risk when they have assets or operations

across national borders or if they have loans or borrowings in a foreign currency.

An exchange rate risk can result in an exchange gain as well as a loss. To neutralize the risk of a loss (but at the same time

forgoing any potential exchange gain), some businesseshedgeall their foreign exchange exposure or exposure beyond some

predetermined comfort level, which is a way of transferring the risk to another business prepared to carry the risk or has a

reverse risk exposure. Hedging can involve the use of aforward contract.

Contents

[hide]

1 Types of

currency risk

2 Consequences of

risk

3 See also

4 References

[edit]Types of currency risk

There are two basic types of currency risk:

Transaction risk is the risk that an exchange rate will change unfavourably over time.

Translation risk is an accounting concept. It is proportional to the amount of assets held in foreign currencies.

Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings

in that currency.

A currency risk exists regardless of whether investors invest domestically or abroad. If they invest in the home country, and the

home currency devalues, investors have lost money. All stock market investments are subject to a currency risk, regardless of

the nationality of the investor or the investment, and whether they are in the same or different currency. Some people argue

that the only way to avoid currency risk is to invest in commodities (such as gold) which hold value independently of the

monetary system.[citation needed]

[edit]Consequences of risk

The currency risk associated with a foreign denominated instrument is a significant consideration in foreign investment. For

example, if a U.S. investor owns stocks in Canada, the return that will be realized is affected by both the change in the price of

the stocks and the change of the Canadian dollar against the US dollar. Suppose that the investor realized a return on the
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stocks of 15% but if the Canadian dollar depreciated 15% against the US dollar, then the movement in the exchange rate would

cancel out the realized profit on sale of the stocks.

If a business buys or sells in another currency, then revenue and costs can move upwards or downwards as exchange rates

between the transaction currency changes in relation to the home currency. Similarly, if a business borrows funds in another

currency, the repayments on the debt could change in terms of the home currency; and if the business has invested overseas,

the returns on investment may alter with exchange rate movements.

Currency risk has been shown to be particularly significant and particularly damaging for very large, one-off investment

projects, so-called megaprojects. This is because such projects are typically financed by very large debts nominated in

currencies different from the currency of the home country of the owner of the debt. Megaprojects have been shown to be

prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays,

unforeseen foreign currency and interest rate increases, etc. the costs of servicing debt becomes larger than the revenues

available to do so. Financial restructuring is typically the consequence and is common for megaprojects.[1]

Hedging means reducing or controlling risk. This is done by taking a position in the futures market that

is opposite to the one in the physical market with the objective of reducing or limiting risks associated

with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will

be countered by changes in the value of a futures position. For instance, a wheat farmer can sell

wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the

cash market position will be countered by a gain in futures position.

How hedging is done

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of

ensuring certainty in the cost of production or revenue of sale.

The futures market also has substantial participation by speculators who take positions based on the

price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits

whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and

futures remain correlated.

Example - case of steel

An automobile manufacturer purchases huge quantities of steel as raw material for automobile

production. The automobile manufacturer enters into a contractual agreement to export automobiles

three months hence to dealers in the East European market.

This presupposes that the contractual obligation has been fixed at the time of signing the contractual

agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing

steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures

contracts, which would mature three months hence. In case of increasing or decreasing steel prices,

the automobile manufacturer is protected. Let us analyse the different scenarios:
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Increasing steel prices

If steel prices increase, this would result in increase in the value of the futures contracts, which the

automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But the

automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This

means that he faces a corresponding loss in the physical market.

But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the

physical market, the automobile manufacturer can square off his position in the futures market by

selling the steel futures contract, for which he has an open position.

Decreasing steel prices

If steel prices decrease, this would result in a decrease in the value of the futures contracts, which theautomobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the

automobile manufacturer needs to buy steel in the physical market to meet his export obligation.

This means that he faces a corresponding gain in the physical market. The loss in the futures market

is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical

market, the automobile manufacturer can square off his position in the futures market by selling the

steel futures contract, for which he has an open position.

This results in a perfect hedge to lock the profits and protect from increase or decrease in raw

material prices. It also provides the added advantage of just-in time inventory management for the

automobile manufacturer.

Understanding the meaning of buying/long hedge

A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge

a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an exposure in

the physical market and want to lock- in prices, use the buying hedge strategy.

Benefits of buying hedge strategy:

To replace inventory at a lower prevailing cost. To protect uncovered forward sale of finished products.

The purpose of entering into a buying hedge is to protect the buyer against price increase of a

commodity in the spot market that has already been sold at a specific price but not purchased as yet.

It is very common among exporters and importers to sell commodities at an agreed-upon price for

forward delivery. If the commodity is not yet in possession, the forward delivery is considered

uncovered.

Long hedgers are traders and processors who have made formal commitments to deliver a specified

quantity of raw material or processed goods at a later date, at a price currently agreed upon and who


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do not have the stocks of the raw material necessary to fulfill their forward commitment.

Understanding the meaning of selling/short hedge

A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to hedge.

Uses of selling hedge strategy.

To cover the price of finished products. To protect inventory not covered by forward sales. To cover the prices of estimated production of finished products.

Short hedgers are merchants and processors who acquire inventories of the commodity in the spot

market and who simultaneously sell an equivalent amount or less in the futures market. The hedgers

in this case are said to be long in their spot transactions and short in the futures transactions.

Understanding the basis

Usually, in the business of buying or selling a commodity, the spot price is different from the price

quoted in the futures market. The futures price is the spot price adjusted for costs like freight,

handling, storage and quality, along with the impact of supply and demand factors.

The price difference between the spot and futures keeps on changing regularly. This price difference

(spot - futures price) is known as the basis and the risk arising out of the difference is defined as basis

risk. A situation in which the difference between spot and futures prices reduces (either negative or

positive) is defined as narrowing of the basis.

A narrowing of the basis benefits the short hedger and a widening of the basis benefits the long

hedger in a market characterized by contango - when futures price is higher than spot price. In a

market characterized by backwardation - when futures quote at a discount to spot price - a narrowing

of the basis benefits the long hedger and a widening of the basis benefits the short hedger.

However, if the difference between spot and futures prices increases (either on negative or positive

side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the

case of narrowing.

What Does Foreign-Exchange RiskMean?

1. The risk of an investment's value changing due to changes in currency exchange rates.

2. The risk that an investor will have to close out a long or short position in a foreign currency at a

loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate

risk".

Investopedia explains Foreign-Exchange Risk

This risk usually affects businesses that export and/or import, but it can also affect investors making


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international investments. For example, if money must be converted to another currency to make a

certain investment, then any changes in the currency exchange rate will cause that investment's

value to either decrease or increase when the investment is sold and converted back into the original

currency.

SwapAn arrangement in which two entities lend to each other on different terms, e.g., indifferent currencies, and/or at different interest rates, fixed or floating.

Copyright 2011, Campbell R. Harvey. All Rights Reserved.

Swap

The exchange of twosecurities,interest rates, orcurrencies for the mutual benefit of the exchangers.For example, in aninterest rate swap, the exchangers gain access to interest rates available only tothe other exchanger by swapping them. In this case, the two legsof the swap are afixed interest rate,say 3.5%, and afloating interest rate, sayLIBOR+ 0.5%. In such a swap, the only things traded arethe two interest rates, which are calculated over a notional value. Each party pays the other at setintervals over the life of the swap. For example, one party may agree to pay the other a 3.5% interestrate calculated over a notional value of $1 million, while the second party may agree to pay LIBOR +0.5% over the same notional value. It is important to note that the notional amount is arbitrary and isnot actuallytraded.

Farlex Financial Dictionary. 2009 Farlex, Inc. All Rights Reserved

swap

A contract in which two parties agree to exchange periodic interest payments. In the most common type of swap

arrangement, one party agrees to pay fixed interest payments on designated dates to a counterparty who, in turn,

agrees to make return interest payments that float with some reference rate such as the rate on Treasury bills or the

prime rate. Also called interest rate swap. See also counterparty risk.

swap

To trade one asset for another. Also called exchange,substitute,switch.

Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott.

Copyright 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rightsreserved.

Swap. When you swap or exchange securities, you sell one security and buy a comparable onealmost simultaneously.

Swapping enables you to change the maturity or the quality of the holdings in your portfolio. You canalso use swaps to realize a capital loss for tax purposes by selling securities that have gone down invalue since you purchased them.

More complex swaps, including interest rate swaps and currency swaps, are used by corporations

doing business in more than one country to protect themselves against sudden, dramatic shifts incurrency exchange rates or interest rates.
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Dictionary of Financial Terms. Copyright 2008 Lightbulb Press, Inc. All Rights Reserved.

Swap

What Does Swap mean?

Traditionally, the exchange of one security for another for the purpose of changing the maturity(bonds), the quality of issues (stocks or bonds), or one's investment objectives. Swaps includecurrency swaps and interest rate swaps.

Investopedia explains Swap

If companies in different countries have regional advantages on interest rates, a swap will benefit bothfirms. For example, one firm may have a lower fixed interest rate while another has access to a lowerfloating interest rate. To take advantage of this situation, the companies would do an interest rateswap.

In finance, an option is aderivativefinancial instrumentthat specifies a contract between two parties

for a future transaction on an asset at a reference price.[1] The buyer of the option gains the right, but

not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to

fulfill the transaction. The price of an option derives from the difference between the reference price

and the value of theunderlyingasset (commonly a stock, abond, a currency or a futures contract)

plus a premium based on the time remaining until the expiration of the option. Other types of options

exist, and options can in principle be created for any type of valuable asset.

An option which conveys the right to buy something is called a call; an option which conveys the right

to sell is called a put. The reference price at which the underlying may be traded is called the strike

price or exercise price. The process of activating an option and thereby trading the underlying at the

agreed-upon price is referred to asexercisingit. Most options have anexpiration date. If the option is

not exercised by the expiration date, it becomes void and worthless.[1]

In return for assuming the obligation, called writingthe option, the originator of the option collects a

payment, thepremium, from the buyer. The writer of an option must make good on delivering (or

receiving) the underlying asset or its cash equivalent, if the option is exercised.

An option can usually be sold by its original buyer to another party. Many options are created in

standardized form and traded on an anonymous options exchange among the general public, while

otherover-the-counteroptions are customized ad hoc to the desires of the buyer, usually by

an investment bank.[2][3]

Nowadays, many investors' portfolios include investments such as mutual funds, stocksand bonds.

But the variety of securities you have at your disposal does not end there. Another type of security,called an option, presents a world of opportunity to sophisticated investors.
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The power ofoptionslies in their versatility. They enable you to adapt or adjust your position

according to any situation that arises. Options can be as speculative or as conservative as you want.

This means you can do everything from protecting a position from a decline to outright betting on the

movement of a market or index.

This versatility, however, does not come without its costs. Options are complex securities and can be

extremely risky. This is why, when trading options, you'll see a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature

and carry substantial risk of loss. Only invest withrisk capital.

Despite what anybody tells you, option trading involves risk, especially if you don't know what you are

doing. Because of this, many people suggest you steer clear of options and forget their existence.

On the other hand, being ignorant of any type of investment places you in a weak position. Perhaps

the speculative nature of options doesn't fit your style. No problem - then don't speculate in options.

But, before you decide not to invest in options, you should understand them. Not learning how options

function is as dangerous as jumping right in: without knowing about options you would not only forfeit

having another item in your investing toolbox but also lose insight into the workings of some of the

world's largest corporations. Whether it is tohedgethe risk of foreign-exchange transactions or to give

employees ownership in the form of stock options, most multi-nationals today use options in some

form or another.

This tutorial will introduce you to the fundamentals of options. Keep in mind that most options traders

have many years of experience, so don't expect to be an expert immediately after reading this tutorial.

If you aren't familiar with how the stock market works, check out theStock Basics tutorial.

Read more: http://www.investopedia.com/university/options/#ixzz1Y2tHIbwR

The right, but not the obligation, to buy(for a call option) or sell (for a put option) a

specific amount of a given stock, commodity, currency, index, or debt, at a

specified price(the strike price) during a specified periodof time. For stock options, the

amount is usually 100 shares. Each option has a buyer, called the holder, and a seller,

known as the writer. If the option contractis exercised, the writer is responsible for

fulfilling the terms of the contract by delivering the shares to the appropriateparty. In

the case of a securitythat cannot be delivered such as an index, the contract is settled

in cash. For the holder, the potentialloss is limited to the price paidto acquire the

option. When an option is not exercised, it expires. No shares changehands and
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the moneyspent to purchasethe option is lost. For the buyer, the upsideisunlimited.

Options, like stocks, are therefore said to have an asymmetrical payoffpattern. For the

writer, the potential loss is unlimited unless the contract is covered, meaning that the

writer already owns the security underlying the option. Options are most frequently as

either leverageor protection. As leverage, options allow the holder to control equityin a

limited capacityfor a fraction of what the shares would cost. The difference can be

invested elsewhere until the option is exercised. As protection, options can

guard againstprice fluctuations in the near term because they providethe right acquire

the underlying stock at a fixed pricefor a limited time. risk is limited to the option

premium(exceptwhen writing options for a security that is not already owned).

However, the costs oftradingoptions (including both commissions and the bid/ask

spread) is higher on a percentagebasis than trading the underlying stock. In addition,

options are very complexand requirea great deal of observation and maintenance. also

called option contract.

Read more: http://www.investorwords.com/3477/option.html#ixzz1Y2tb9blP

What Does Foreign DebtMean?An outstanding loan that one country owes to another country or institutions within that country.Foreign debt also includes due payments to international organizations such as the InternationalMonetary Fund (IMF). The debt may be comprised of fees for goods and services or outstandingcredit due to a negative balance of trade. Total foreign debt can be a combination of short-term andlong-term liability .

One relative measurement of foreign debt safety is that foreign exchange reserves should not be lessthan outstanding short-term foreign debts. Governments can lower their foreign debts by reschedulingtheir obligations or simply by paying them off. Foreign countries typically hold U.S. debt in the form ofshort- and long-term government-issued bonds.

Read more: http://www.investopedia.com/terms/f/foreign-debt.asp#ixzz1Y2vlUs00

In finance, a forward contract or simply a forward is a non-standardized contract between two

parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in contrast to

aspot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a

forward contract. The party agreeing to buy the underlying asset in the future assumes a long

position, and the party agreeing to sell the asset in the future assumes a short position. The price

agreed upon is called thedelivery price, which is equal to theforward priceat the time the contract is

entered into.
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The price of the underlying instrument, in whatever form, is paid before control of the instrument

changes. This is one of the many forms of buy/sell orders where the time of trade is not the time

where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with thespot price, which is the price atwhich the asset changes hands on the spot date. The difference between the spot and the forward

price is the forward premiumor forward discount, generally considered in the form of a profit, or loss,

by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange

rate risk), as a means ofspeculation, or to allow a party to take advantage of a quality of the

underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are

very similar to futures contracts, except they are not exchange-traded, or defined on standardized

assets.[2] Forwards also typically have no interim partial settlements or "true-ups" in margin

requirements like futures - such that the parties do not exchange additional property securing the

party at gain and the entire unrealized gain or loss builds up while the contract is open. However,

being traded OTC, forward contracts specification can be customized and may include mark-to-

market and daily margining. Hence, a forward contract arrangement might call for the loss party to

pledge collateral or additional collateral to better secure the party at gain.[clarification needed]

Forward ContractsForward contracts can help you to reduce the risks of fluctuations in the currency markets which affect

any business that trades or has assets overseas.

You can lock in an exchange rate for a specific amount of currency with a forward contract so

that you can use it at a later date, without having to use up valuable working capital.

If your business exports or imports has assets or operations in another country or simply sends and

receives money internationally you need to consider how you will protect yourself against changes in

foreign exchange rates and other foreign exchange risks. A small variation in the rate could cost your

business thousands of pounds if not managed properly. Our years of experience help to protect your

bottom line and asset base.

At Currencies Direct we offer two types of forward currency exchange contract:

Fixed forward contracts

You take delivery of your forward currency on a specific date in the future.

Open forward contracts

You can take delivery of all the foreign currency at once, or drawn down smaller amounts as you need

them - up to the amount of the value of the contract.

How does a Forward Contract work in practice?

Imagine you are a company with a need to purchase components worth 250,000 euros from a

German supplier in 5 months time. Based on a GBP/EUR exchange rate of 1.20 EUR, you havedetermined that supplies will cost you today GBP 208,333, meeting your budget and cash flow
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constraints. On this basis you commit to purchase the components, and you agree to sell them to a

client at a fixed price, generating GBP 10,000 of future profit to your business.

However, GBP might weaken against EUR during that five month period to a rate of 1.15, meaning

that your cost would increase to GBP 217,390 . This would negatively impact your budget, cash flow

and reduce your profit by GBP 9057 essentially eliminating all the profit margin.

In this case, if you booked a forward contract with Currencies Direct at the time you purchased the

components you would have been able to secure the exchange rate of 1.20 , fix the cost to your

business and avoid any unexpected impact on your profit margin. Of course, you would lose out if

GBP strengthened against the EURO, but exposing your business to currency risks may have a long

term effect , whereas if you buy forward you can guarantee an exchange rate based on where you

cost the order.

Currencies Direct forward contracts can also provide flexibility enabling you to take delivery of your

purchased currency in part or in full at any time between the contract date and maturity date. All

companies with foreign currency exposures need a strategy to manage the risk. Call your dedicated

dealer now who will tailor-make the contract to suit your business needs.

Important informationIf you do plan to book either a forward or time option contract you may be subject to additional

security payments in the event of adverse exchange rate fluctuations. Such security payments must

be received within 24 hours of notification. In the event you should have any questions please contact

your dedicated dealer at Currencies Direct where they will be more than happy to assist. Further

details and information is available to you please click here.

In finance, a futures contract is a standardizedcontract between two parties to exchange a specified

asset of standardized quantity and quality for a price agreed today (the futures price or the strike

price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on

afutures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the

contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the

contract, is said to be "short". The terminology reflects the expectations of the parties -- the buyer

hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will

decrease. Note that the contract itself costs nothing to enter; the buy/sell terminology is a linguistic

convenience reflecting the position each party is taking (long or short).

In many cases, the underlying asset to a futures contract may not be traditional commodities at all

that is, forfinancial futures the underlying asset or item can becurrencies,securities orfinancial

instruments and intangible assets or referenced items such asstock indexes and interest rates.

While the futures contract specifies a trade taking place in the future, the purpose of the futures

exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the

exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the

futures price will generally change daily, the difference in the prior agreed-upon price and the daily

futures price is settled daily also. The exchange will draw money out of one party's margin account

and put it into the other's so that each party has the appropriate daily loss or profit. If the margin

account goes below a certain value, then a margin call is made and the account owner must replenish

the margin account. This process is known as marking to market. Thus on the delivery date, the
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amount exchanged is not the specified price on the contract but the spot value (since any gain or loss

has already been previously settled by marking to market).

A closely related contract is a forward contract. A forward is like a futures in that it specifies the

exchange of goods for a specified price at a specified future date. However, a forward is not traded onan exchange and thus does not have the interim partial payments due to marking to market. Nor is the

contract standardized, as on the exchange.

Unlike anoption, both parties of a futures contract must fulfill the contract on the delivery date. The

seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is

transferred from the futures trader who sustained a loss to the one who made a profit. To exit the

commitment prior to the settlement date, the holder of a futures position can close out its contract

obligations by taking the opposite position on another futures contract on the same asset and

settlement date. The difference in futures prices is then a profit or loss.

What are the Differences between a Futures and a Forward Contract?

Although a Futures Contract is similar to a Forward Contract in that both are agreements to trade on aset future date, there are some significant differences.

Fututres contracts are highly standardized, while each Forward contract is personalized andunique.

Futures are settled at the end on the last trading date of the contract with the settlement price;whereas, the Forwards are settled at the start with a forward price.

The profit or loss on a Futures position is exchanged in cash every day. With the Forwardscontract, the profit or loss is realized only at the time of settlement so the credit exposure cankeep increasing.

The Futures contract does not specify to whom the delivery of a physical asset must bemade; in a Forwards contract it is clearly specified who recieves the delivery.

Futures are traded on an exchange, while Forwards are traded over-the-counter.

What are the Benefits of a Futures Contract?

A Futures Contract is a unique investment among alternative investments. It has severalcharacterisitics that make it attractive to the investors.

Simple and uncomplicated - Futures contract are very easy to follow - based on whether youbelieve prices are going to rise or fall, you sell and buy. Your broker will help you to do theneccessary transaction when it is advantageous to you.

Easy to short sell - With stock index Futures contract it is as easy to sell short as it is to buylong. There is no paper work involved or any high financial requirements to be met. WhenFutures Contract prices go up you sell, and when they go down, you buy. It is a very logical

strategy to follow.
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Easy entry and exit - In such a liquid market, it is very easy to enter and exit a transaction,especially now that it can be done online. If you so wish, it need involve only a low brokerage

Direct investment opportunities - A Futures Contract helps you to invest directly in the market.In other forms of investment you have to consider a lot of other factors like managementissues, market shares,

Currency Risk Managementby Richard Eliot

Order from Chaos

The impact of currency values on commercial operations is a familiar topic for the international executive. It is

a source of fascination for the armchair economist, and a favorite explanation for this quarter's variance.

Small and large players alike enjoy the glimmer of excitement when the latest rates are quoted, signaling the

lead in a global sweepstakes.

Much of the attraction of currency markets stems from its synthesis of all aspects of the world economydistilled into a single, digestible value. The significance of relative currency values rests primarily on their

relationship to world markets and their interaction with international trade, investment, and monetary

practices.

A given exchange rate, when viewed in isolation, may at first appear to be little more than an abstraction. Yet,

it exercises a significant influence on commercial relations as a pricing mechanism affecting every international

transaction. The impact of exchange rate fluctuations on domestic aggregates can also affect the course of

economic activity to the point that a sense of urgency is reached when dealing with volatile markets.

As long as currencies remain the medium of exchange for commercial transactions, market fluctuations of

relative currency values will continue to attract the attention of the exporter, the manufacturer, the investor,

the banker, the speculator, and the policy maker alike.

Exposure Defined

A currency is exposed to exchange rate fluctuations to the extent that it is used to conduct transactions with external

markets. The greater the proportion of intercurrency exchange to total monetary transactions for a given market, the

greater the exposure to changes in exchange rates.

Commercial operations conducting international trade are exposed to exchange rate fluctuations in proportion to their

total volume of transactions. As the magnitude ofintercurrency transactionsincreases relative to aggregate

transactions, a business unit realizes greater exposure to exchange rate fluctuations.

The transactions approach to exchange exposure has gained prominence in recent years. A lingering preoccupation

with currency translation for the measurement of operating performance, however, has tended to divert attention awayfrom productive commercial activity towards disingenuous, while flashy, hedging techniques. The clever money

manager can still generate significant cash gains from currency hedging without increasing the productive output of a

business unit.

By defining currency exposure as the proportion ofintercurrency transactions to total transactions, greater

management attention can be aimed at operating units with a high degree of exposed risk to exchange rate changes.

Operating Performance

Evaluating operations performance on a global scale demands a shift in perspective towards techniques based on

multilateral transactions analysis. An enterprise operating in a single market with single currency transactions can

easily be evaluated in theoperations currency, while one which is engaged in many markets and multiple currenciesrequires more extensive analysis.
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Common financial accounting practices require financial positions to be translated at current exchange rates fromthe operations currency into the reference currency. Despite the need to consolidate financial results on a consistent

basis, direct translation at current exchange rates continues to obscure actual operating results when the relativecurrency values fluctuate from period to period. As a result of these exchange rate fluctuations, and the extent of their

volatility, comparisons over a number of periods become completely invalid from the perspective of the referencecurrency.

A recurring theme throughout the deliberation of multicurrency financial accounting is that a commercial operationshould be evaluated from the perspective of the economy in which the unit is located, as measured by the operations

currency; this is the fundamental argument for establishing current rate translation accounting over historical ratetranslation methods. Resolving this dichotomy can be an extensive process so long as the need remains to translate

operating results for consolidation into a single currency of reference.

The task of evaluating performance in multiple currencies extends beyond contemporary financial accounting

practices. One approach is to separate the evaluation of operating results from their consolidation. A multi-tier

evaluation process then evolves as operations in an external market develop through a cycle from capital investment

to normal commercial operations. Ongoing business operations are evaluated in the operations currency, consolidated

enterprises from the reference currency, while the return on capital investment is measured in the investment

currency.

Yet all of these measures fail to consider the actual impact of exchange rate fluctuations on business activity

conducted between markets having different currencies.

When an enterprise imports raw materials and components from external markets, it is subject to currency transactions

exposure between the time the goods are ordered and when payment is disbursed. Exports to third markets are

affected by transactions exposure when their prices are denominated in third currencies; even when denominated in

the operations currency, the demand for exports is directly related to the price of the goods as measured by the

customer'sreference currency.

Transactions exposure for both imports and exports directly affect the overall level of business activity through its

impact on sales volumes, revenues, and production costs. It then becomes a practical matter to determine the most

appropriate means for interpreting transactions exposure between the business unit and external markets with which it

conducts trade.

In a global setting, where multiple international operations transact business between many different markets, the

transactions exposure of one operation may differ substantially from the exposure of other operations within the

enterprise. Aggregate transactions exposure of world-wide operations is determined by the consolidation

ofintercurrency transactions across the entire enterprise. Consolidation on the basis of currency, instead of by

location or legal entity, yields a more complete picture of the total currency transactions exposure.

Investment Risk

Decisions to expand into a specific marketplace are primarily influenced by the projected course of economic

developments within the market under consideration. Economic relationships between the external market and third

markets are also taken into consideration. Whereas prior exports to this external market were likely to have been

denominated in the base reference currency, a physical business presence in the external market entails an indefinite

term commitment measured by a new operations currency.

Capital investment in an external market depends largely upon the expected rate of return on the investment as

measured relative to the investment currency. The expected return is derived almost entirely from volume projections,

expenditure estimates, and the resulting cash flow in the operations currency. These projections are then translated

into the investment currency for comparison with other capital investment opportunities on an equivalent basis. As a

result, investment decisions rely almost entirely on translations exposure when considering currency risk.

Transactions exposure takes an entirely different perspective in the investment risk assessment. In addition to normal

economic risks which are present within a specific external market, transactions risk between markets is involved in

an investment decision.

The transactions exposure for capital investment comprises two main factors:
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Changing intercurrency exchange rates between the time theinvestment is under consideration, and the time the investmentcurrencyis converted to the operations currency.

Changing intercurrency exchange rates for dividend remittancesconverted from the operations currencyto the base investmentcurrencyspanning an indefinite period.

Once a commitment is made to a long-term market presence, management of exchange risk transfers from a focus on

translations exposure to one based on transactions exposure. The external market operations can then be assessed

according to the inherent economic risk factors (rates of market growth, price trends, technology developments, and

product competition) attributable to the local market. The total investment exposure to exchange rate fluctuations is

limited to the appropriations decision period and to the discounted dividend stream.

Economic Analysis

Critics often cite economic projections as inaccurate and unavailing for business operations. This criticism is sopervasive that economists themselves have come to evaluate their own performance by the degree to which specific

predictions match actual results. This fixation with the accuracy of economic predictions reflects the prominence ofshort term results over long term development.

The situation in international commerce and finance reflects many of the same characteristics. Many in the field tend

to view international operations and the world market as abstractions. Even those who normally function in a global

environment perceive it through the filter of electronic media, continuously updated and flashed upon a screen

terminal.

Concepts which are familiar to the financial economist in planning for international business operations may not be

readily apparent to specific functional units. Diminishing returns may seem to have little bearing in meeting sales

quotas; marginal productivity is rarely evoked during cost reduction consolidations; and, elasticity of demand is

hardly mentioned when preparing for facilities expansion.

The value of economic analysis is the assessment of a given course of action and a determination of the probability

that a decision will generate positive incremental economic activity. Economic activity is characterized by a numberof concepts relevant to operating in international markets, and tied to the opportunities and risks associated with the

generation of wealth across national boundaries.

It recognizes the fact that there are many factors beyond the control of the individual decision maker. If it were

possible to accurately predict the effect of these externalities, there would be little if any need for anyone to carry out

normal daily business decisions, since the results of these decisions would have already been predetermined. The

ability to achieve the desired economic results depends largely on the skill with which the associated risk is managed.

Liquidity and Valuation

When proceeds from financial instruments traded on one market are transferred to another market using a

different market currency, the resulting investment is subject to intercurrency transactions exposure. Capital flows

between world financial markets are subject to the sameintercurrency transactions exposure as commercialoperations. Yet the high liquidity of securities traded on financial markets reflects a significantly greater frequency

and aggregate value of these transactions.

The income derived from investment instruments traded on an external financial market is measured from the

standpoint of the currency of reference established by the individual investor. A divergence in portfolio valuation

occurs when the intercurrency exchange rate between the market currency and the reference currency moves in a

different direction (or at a different rate) than the native financial market securities prices.

Investors measuring income in a reference currency other than the market currency are concerned with two primary

issues relating to the transactions exposure of their investment positions:

Conversion of the instrument price from the market currencytothe reference currency; and,


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Dividend and interest proceeds converted from the marketcurrencyto the reference currency.

In some cases, however, the currency transactions exposure exhibits opposite characteristics. This involves equitysecurities which are traded on a financial market having a market currency different from the reference currency for

the underlying assets of the instruments.

A large number of publicly traded equity securities are listed in more than one financial market around the globe,

where they are traded in the respective market currency. The financial market with the largest trading volume in aspecific equity security generally determines the base trading price of the issue; arbitrage then results in a direct

conversion at the prevailing exchange rate in other markets.

In these cases, the individual investors trading in a reference currency native to the market currency, are subject to

transactions exposure without engaging inintercurrency transactions.

Organizations which issue securities in financial markets, with market currencies different from the issuer's reference

currency, often have tangible fixed assets and business operations in the same territory as the external financial

market. The related equity securities traded in these markets, however, are rarely secured by the assets situated in the

same market territory.

A given trading price for an equity security is a composite of all segments of the issuing organization (exclusive of

factors specific to the financial market) and includes those business segments conducted in markets other than

the reference currency. Variances between market capitalization and fundamental valuation of an equity security arise

when the world-wide assets pertaining to the equity appreciate, or depreciate in value.

Fundamental valuation of the equity security is thus subject to intercurrency transactions exposure relating to:

Sensitivity to exchange exposure relating to the internal cash flowof the issuing organization; and,

Correlated demand for the products of the issuing organizationtransacted in the world market.

As the exposure to exchange risk increases, the exposure to share price volatility should also increase. Investors would

agree that it is not feasible to identify the price of a specific security as a basket of fundamental equity values. (Who

would trade in a security priced as: 15 Dollars + 1,000 Yen + 5 Pounds Sterling? Which commercial organization

would remit dividends in similar proportions?) Clearly, it is the investor who assumes the risk of currency exposure

from the standpoint of the investment currency.

Whereas conventional economic risk factors are specific to an individual market, currency risk relates to

exchanges between markets. The volume and magnitude ofintercurrency transactions makes it by far the

largest market in the world. It thus assumes a unique significance when compared to other economic variables

affecting the course of commercial relations.

Historically, no currency has remained resolute to any specific marketplace, its acceptance determined by the

willingness to conclude transactions with a standard of value. As a measure of wealth, its exchange value

becomes a universal language in economic relations.

Currency Risk Management-Export Transaction

By Professor Harkirat Singh,IIFT,New Delhi

[email protected]
mailto:[email protected]:[email protected]


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Exchange rates of major currencies are fluctuating, in highly unpredictable manners under the

influence of demand and supply forces. Sometimes market witnesses very high percentage of change

in exchange rates in short periods. Adverse movements in exchange rate have potential to eliminate

profit factor from the export transaction.

Each exporter, invoicing in foreign currency, with condition to receive payment in future has

Transaction Exposure. This process has transferred the currency risk from the foreign buyer to the

exporter. Normally exposure period starts with conversion of Rupee cost to sale price in foreign

currency. Terminates, when actually export sale proceeds are credited to current a/c of the exporter by

the bank.

Exchange rates of foreign currency during the exposure period may change in favour or against the

interest of the exporter. Covering, the foreign exchange risk due to adverse change in exchange rates,

is termed as hedging the currency risk. If exporter does not want to hedge the currency risk it means

that view has been taken that future movement of exchange rates will be in favour of the exporter.

Depending on such views may lead to heavy losses due to adverse movements in exchange rates.

Management of Currency risk in export-trade transaction depends on factor as appended below:

Nature of Invoice Currency

Amount of Currency

Exposure Period

Hedging Instruments

Selection of Banks Branch

Hedging System

Nature of Invoicing Currency

Selection of invoice currency not only shifts the risk to exporter but also bring the responsibility of

managing currency exposure. Exports in USD, exposes to currency risk due to adverse movements of

USD/INR exchange rates only, during the exposure period. Whereas, invoice in non-USD exchange


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rates in Indian forex markets & second changes in USD/ Rupee exchange rates in international forex

markets during the exposure period.

Exporter should note that foreign currency for its trade transaction, at any point in time, will fall inone of the following market conditions:

a. Strengthening Trend With Forward Premiums

Both the factors are in favour of the Exporter. With Passage of time market will produce better

exchange rates for exporters. Hedging policy may be to wait and watch. Wait till exchange rates and

forwards margins are moving in the favour of the exporter. Cover the exposure on reversal of the

exchange rates trend in consultation with banker/forex expert.

b. Weakening Trend With Forward Discounts

Both the factors are against the business interest of the Exporter. Hedge the exposure immediately.

Delays may lead to avoidable losses. Banks provide free consultant service and share the forex marketinformation with suggestions.

c. Uncertain Trends

Selective hedging strategy in uncertain exchange rate movements has been found to be profitable.

Some portion of the exposure, based on short term forecasting, is covered and balance is retained as

uncover.

The portion of covered and uncovered exposures are changed by cancellation and rebooking the

hedge depending upon short-term exchange rate changes. Quantum & timing of hedge is based on

forex market condition & forecasting by the experts.

Bank is the cheap and best source of understanding market trends and provide support for risk coveroperations. Exporter should try to conduct business in strong currency.


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Amount of Exposure

Banks provide card exchange rates for small amount transactions. These rates are calculated by

loading heavy margins and are adverse for exporters. Bank quotes better exchange rates based on

ongoing market rates for higher amount export transaction. In case of market lots transaction, exporter

gets market rate loaded by a few paisa only. Better rate creates more cash flows for exporters.

Exporter should negotiate with banker in each export transaction, for Better exchange rate based on

ongoing market rate. Avoid where ever possible, the application of banks card rates.

Exposure Period

Normally exposure period starts with converting of Rupee cost to foreign currency sales price,

covering following activities/stages and ends with receipt of Rupee payment in banks account.

EXPOSURE PERIOD FOR EXPORT TANSACTION

Exporter should note carefully that Exposure Period is longer than tenor of the export bill or credit

offered to Foreign Buyer. Longer the Exposure Period higher the Uncertainty and Currency Risk.

In case invoiced foreign currency is on Premium against Rupee, take the benefit of higher exchange

rate than spot rate offered by banks. Longer the period of credit, better is the exchange rate for

exporter.

Long period, export receivable in case of premium currency must be hedged to avoid uncertainties &

loss due to adverse movement of exchange rate during exposure period. Some exporter hedge the

exposure risk, when they get better rate than forward exchange rate available on date of conversion of

costs to foreign currency sales price.


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Monitoring of exchange rate movements during exposure period also provide an opportunity to earn

extra profits by obtaining and lifting the hedge depending upon exchange rate trends.

From experience, it has been observed that exporters may cover exposure on Fridays, last weekdays

of fortnight or month end to get better exchange rates. Usually there is heavy demand for US in these

days causing upward trend in exchange rates & good timing for exporters to cover the risk.

Hedging Instruments

Various hedging instruments traded on the counter and at the exchange houses are available for

hedging the Currency Risk. Selection of hedging instrument for exports depends upon availability,

flexibility & cost. The most common and exporter friendly hedging instrument in India is Forward

Purchase Contract offered by the banks.

Forward Purchase Contract

Banks provide on the counter derivative, Forward Purchase Contract for Exporters. Forward Purchase

Contract is a firm agreement by the exporter to deliver fixed amount of Foreign Currency at future

date at prior & fixed exchange rate. It is a firm and binding contract Banks do not charge any upfront

commission and book the contract, from very small amount to large amounts. Only very small

handling charges approx. Rs. 250 per Contract is charged irrespective of the amount.

Exporter should take uncertainties pertaining to exchange rates movements as a Threat to Profit and

transfer the currency risk to Bank by booking forward purchase contract. During the cover period

exchange rates may move against the interest of the Exporter but it will get the contracted rate.

Main defect of forward Contact is that exporter is denied to take the benefit of favourable exchange

rate movement during covered period.

Booking of Forward Contract


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1. Only banks customers are eligible for booking the forward contracts.

2. Forward Contracts are offered by the banks for expected export proceeds already made or be made.

Where shipment is already made, forward contract shall be booked on the basis of export bills

tendered to banks. In other cases, forward contacts are booked on the basis of the track record of the

exporter.

3. Choice of currency and tenor of exposure period are left to requirement/decision of the exporter.

Further, maturity of the cover period should not exceed the maturity of the export transaction. The

maturity of export bills is calculated as under:

4. Cover Period=Period of Usance + Normal Transaction Period + Grace Period (if any)

5. Exporters are permitted to split the hedging to cover the exposure partially and balance to remain

uncovered.

6. Exporter is permitted to book forward contract with fixed date or option period delivery of foreign

exchange amount. Maximum option period of one month is given that too in last month.

7. Exporter is free to foreclose the Forward Contract at any time before maturity. Any loss or gain will

be passed on to the exporter. Some exporter have developed expertise in booking, cancelling &

rebooking of forward contacts to generate extra cash flows.

8. Forward purchase contracts may be freely booked, cancelled any time before maturity, rolled over

at the ongoing markets without any restrictions.

9. Exporters are permitted to transfer the exchange risk to third currency with objective to achieve

better exchange rates. An exporter having receivable in Rupee may use the third currency Yen for

hedging the currency risk. Third currency hedge and currency/INR hedge may be cancelled and

rebooked as per requirements.


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Selection of Banks Branch

Success of an Exporter depends upon the right choice of the Branch of the Bank. Exporter should

select a branch of the bank which is authorised to deal in foreign exchange business or international

banking division. Branch should have trained, experienced staff with SWIFT address and facility.

Develop professional relations with forex merchant dealer appointed in branch or forex dealer of the

bank. Visits to them will make exporter more wise and professional. Negotiate for better rate based on

ongoing market exchange rates for each export transaction. Bring cases of delayed export payments

and better exchange rates offered by other banks to improve upon these services by your bank. Market

competition will bring good results for your efforts. Bankers, normally take the benefit of knowledge

gaps of exporters, especially in the area of quoting better exchange rates for exports.

Best branch of the bank to deal with is A category branch in Metropolitan city with SWIFT facility

& having best-feedback form exporters.

Hedging Systems

Export organisation depending upon the resources, must develop some hedging system. Such system

will help in monitoring the exchange rate movements and to take timely hedge actions. It is found

from the experienced of exporters that even spending 15 to 20 minutes a week, spending on scanning

of currency rates will create more profits from export business.

For developing, currency risk management strategies and skills to take timely hedging action,

following reports have been found to be useful:

Daily Scan Reports of Exchange Rates

Prepare daily scan report with the help of the information obtained from your bank or inputs available

in daily financial newspapers. Give the responsibility to junior official in your organisation to prepare


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it on daily basis. Exporter may analyse on daily or weekly basis, this report to find out the trend or

factors affecting exchange rates of the currency in which you are or may be exporting in near future.

Exporters have to study & understand the markets and factor affecting exchange rates. Expertise hasto be developed in risk management to take right hedging decision at right time & to secure better

exchange rate to improve cash inflows Watch trade & political news, monitor economical & fiscal

policies of the major countries of the world & also those of countries in whose currency exporter do

business.

Daily scan report will help in developing currency view and timing of taking hedging decisions

Brief Market Comments

Mainly covering the factors influencing the exchange rate of currencies in the local and foreign

markets.

Monthly Risk Report

Monthly risk report should contain the information currency wise covering projections of export &

imports that will take place on monthly basis. Report will provide the net figure of monthly exports &

imports means gaps. Conservative exporter may take policy decision to hedge only gaps by booking

purchase or sale forward covers with bank. Aggressive exporter depending upon exchange rate

forecasting information may book export and import transactions separately on monthly basis.

Order sheet contains information on the basis of export orders obtained from foreign buyers. It also

contain the information about the budgeted rate which is the rate applied by exporter to convert the

costs into foreign currency sales price. Column for market forward exchange is provided to note

down the forward hedging rate available on the date of application of the budgeted rate.

Information contained in order sheet will help in:-


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- Taking decision to hedge the currency exposure.

- Measure the performance of the hedging action.

- Use booking, cancelling & rebooking facility to generate more cash inflows.

- Budgeted Rate & Market Forward Rate will be treated as reference rates for hedging

decision.

Summary

- Exchange rates of major currencies are fluctuating with change in demand & supply position of

concerned currencies

- Exchange rates has capacity to translate profit from international business transaction into loss or

vice versa

- Currency Risk depends upon Nature of Currency, Amount, Exposure period and use of internal andexternal hedging techniques Forward Contract instrument offered by commercial banks is used by

exporters/importers for currency risk management. It is easy to understand, cheap and latest RBI

relaxation provide opportunities to create wealth from exchange rate movements.

- To cover currency risk, company has to develop information input system as timely decisions are

essential for currency risk management and for wealth creation from exchange rate movements.

Hedging Instruments: Derivatives used for covering currency risk.

Booking Forward Contract: Exporter covering exchange risk with bank for export transaction.

Scan: Analysing daily exchange rates movements.

GAP: Difference between exports and imports transactions in a particular month.

Foreign Exchange Risk


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Management

F

oreign exchange (FX) is a risk factor that is often overlooked by small and mediumsized enterprises

(SMEs) that wish to enter, grow, and succeed in the global market

place. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy

foreign buyers today are increasingly demanding to pay in their local currencies. From the

viewpoint of a U.S. exporter who chooses to sell in foreign

currencies, FX risk is the exposure to potential financial

losses due to devaluation of the foreign currency against

the U.S. dollar. Obviously, this exposure can be avoided

by insisting on selling only in U.S. dollars. However, such

an approach may result in losing export opportunities to

competitors who are willing to accommodate their foreign

buyers by selling in their local currencies. This approach

could also result in the non-payment by a foreign buyer

who may find it impossible to meet U.S. dollar-denomi

nated payment obligations due to the devaluation of the

local currency against the U.S. dollar. While coverage for

non-payment could be covered by export credit insurance,

such what-if protection is meaningless if export oppor

tunities are lost in the first place because of the payment

in U.S. dollars only policy. Selling in foreign currencies, if

FX risk is successfully managed or hedged, can be a viable

option for U.S. exporters who wish to enter and remain

competitive in the global marketplace.


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Key Points

Most foreign buyers generally prefer to trade in their

local currencies to avoid FX risk exposure.

U.S. SME exporters who choose to trade in foreign

currencies can minimize FX exposure by using one

of the widely-used FX risk management techniques

available in the United States.

The volatile nature of the FX market poses a great risk

of sudden and drastic FX rate movements, which may

cause significantly damaging financial losses from

otherwise profitable export sales.

The primary objective of FX risk management is to

minimize potential currency

losses, not to make a profit from FX rate movements, which are unpredictable and

frequent.

chArActeristics of A

foreiGn currency

dominAted export sAle

Applicability

Recommended for use (a) in competitive markets

and (b) when foreign buyers ins

Tools for Hedging Foreign Exchange

Documents

Transcript of Tools for Hedging Foreign Exchange