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How to Avoid Foreign Exchange Risk back
(Exchange Rates, Forward Exchange Contracts, Currency Futures & Currency Options)

One of the added uncertainties of conducting trade on an international basis is the fluctuation of in exchange rates among currencies. The relative value between the Indian Rupee and the foreign currency may change between the time the deal is made and the payment is received. A devaluation or rise in the foreign currency against the rupee causes either a windfall or loss to one party or the other involved in the transaction.

Terms and Concepts :
International trade and the other transactions involving cross border flows of funds require the participants to enter the world of foreign exchange. Foreign exchange is defined as claims payable in a foreign country in a foreign currency. As a rule businesses and individuals operate using their own national currencies – money recognized and legally acceptable for transactions with in the particular currency zone.

How The Exchange Rates are Quoted and Calculated ?
Direct Vs Indirect Quotation
The exchange rates in India are quoted in a set pattern and before discussing the procedure of calculation of exchange rates it will be necessary to understand certain fundamental aspects involved in this regard. There are two systems of quotations as under :
  • Direct Quotation Where the price of foreign currency is quoted in terms of home or local currency. In this system variable units of home currency equivalent to a fixed unit of foreign currency is quoted.
    For Eg - US$1 = Rs.45.30
  • Indirect Quotation Where exchange rates are quoted in terms of variable units of foreign currency as equivalent to a fixed unit of home currency.
    For Eg. US$ 2.208 = Rs. 100
Inter Bank Rates and Merchant Rates
Merchant rates are exchange rates to be applied for transactions with the public and are calculated in accordance with the guideline circulated by FEDAI. Inter Bank rates are for transactions amongst the authorized dealers themselves and depend upon the market conditions.
Buying and Selling Rates
Foreign exchange rates are always quoted as two way price i.e. a rate at which bank is willing to buy foreign currency (buying rate) and a rate at which the bank sells the foreign currency (selling rate). Banks do expect some profit to exchange operations and there is always some difference in buying and selling rates. All exchange rates by authorized dealers are quoted in terms of their capacity as buyer or seller.
Spot and Forward Rates
Spot rates are applicable on the day of transaction i.e. same day (transaction to be completed physically within two working days) where as forward rates are the rates fixed in advance for a transaction which will mature at a specified date or during a specified period in future. Quotations for spot rates only are generally available and the customers have to enter in to specific contracts for forward rates.

Foreign Exchange Risk Management :
Foreign Currency Exposure
Exchange risk is logical sequence when conversions of currencies take place i.e. switching over from one currency to another. From a Corporate entity point of view, currency exposure is the extent of vulnerability which will affect its profit and loss figures and Balance sheet resulting purely from the exchange rate movements. Hence in a Corporate business strategy, foreign exchange risk management assumes great significance.
Foreign Currency Exposure can be divided in to three parts :
  • Transaction Exposure
  • Translation Exposure
  • Economic Exposure
Transaction Exposure : Whenever there is a commitment to pay currency at a future date, any movement in the exchange rates will determine the domestic currency value of the transactions. Importers are subjected to transactions exposure. With liberalization process set in the country, the exchange market has been subjected to full interplay of market forces. The transaction exposure would still increase if a long term trade agreement with a country has been entered in to and therefore the corporate would be not in the position to switch over its trade flow.
Translation Exposure : In case of domestic corporate with global operations they have to pay or receive money. Any large movement in exchange rate in either case would have its impact on domestic currency value of these transactions and if the exchange movements are wide and transactions are large it would have a serious impact on the financial position of the company. Between two Balance sheets dates, it may alter the net asset value and gearing ratio. In case of multinationals, the reported profits of overseas subsidiaries can be affected by the change in the exchange rate at which profit figures are translated in to domestic currency.
Economic Exposure : In cross border trade, the strength of currency of competitors, relative cost and prices in each country which have a bearing on exchange rate and the structure of the business itself gives rise to economic exposure which may put the companies at a competitive disadvantage. Though this is not a direct foreign exchange risk exposure but the underlying economic factors may become a risk factor.

How to Cover the Foreign Exchange Risk?
Covering the foreign exchange risk is term as hedging the risk. If the company does not want to hedge, it means it is taking a view that the future movements of exchange rates will move in its favor. Even if the company wants to adopt the policy of hedging everything, still economic exposure cannot be eliminated and this give rise to opportunity cost. If suppose the company hedged the exposure and if the spot rates moved in favor of the company due to shift in the economic factors between the date of invoice and conversion of currency, the company may lose out or incur and opportunity cost by hedging the exposure if the rates moved against.
Corporate Managers specially companies operating in several; countries have the advantage of containing the exposures by their own management techniques by
  • Opening foreign currency accounts where there are receivables payable in the same currency (our Foreign Exchange regulations permit opening of foreign currency A/Cs in certain cases).
  • Netting group exposure and reduce the risk by currency switches between asset and liabilities.
  • In case of manufacturing companies, switch the base of manufacturer so that cost and revenue are in the same currency.
Forward Exchange Contracts :
This is usual hedge extended to customers. Banks offer forward exchange contracts both for sale and purchase transaction to customer with a maturity date for a fixed amount at a determined rate of the exchange at the outset. Normally contracts are entered in India for a period where the maturity period of the hedge does not exceed the maturity of the underlying transaction. The customer has the option to choose the currency of the hedge and tenor. The option forward contracts are little more flexible in that the customer can exercise the option during the option period on any day. The disadvantage of the forward contract is that rate is locked in but where the transaction has a fixed maturity date, forward contract are handy. Even if the customer wants to cancel the contract, he can do so subject to cancelation charges and interest on outlay of funds incurred by the bank, if any. Hence in case of fixed forward exchange contracts also there is a certain amount of flexibility.
As per current regulations in India, forward contracts involving rupee as one of the currencies, once cancelled shall not be re-booked although they can rolled over at ongoing rates on or before maturity. This restriction is not applicable to contracts covering export transactions which may be cancelled, re-booked, or rolled over at ongoing rate. Substitution of contracts for hedging trade transactions is also permissible subject to the satisfaction of the authorized dealer.

Currency Futures :
A future contract is an agreement to buy or sell a standard quantity of specific financial instrument at a future rate and at an agreed priced. These are tailors made contracts and sold organized exchanges such Chicago international money market. A corporate can take an up a future contract which is opposite to its foreign currency transaction exposure. However the future reviewed on a daily basis based on spot rates therefore the value of the future contracts varies depending upon the agreed price. Hence the resultant spot will determine the loss or gain on the transaction exposure and can be counter acted by the resultant loss or gain, on the future contracts, Now the drawback of the future contracts are :
  • Maturity rate
  • Contract size
This may not precisely meet the requirements of corporate which may result in a residual exposure either in respect of maturity dates or the amount. Also the loss in value arising out of revaluation may have to be adjusted in the margin posted in the exchange rate therefore cash flow in the corporate may be effected.
Currency Option :
Currency option gives the right but no obligation to the buyer of the option to sell (put option) or buy (call option) a specific amount of foreign currency at a pre-determined price called strike price. As stated above there are tailor made options which can be picked up over the counters of the banks. The buyer of a option to pay a price premium for conferring the above right by the option writer i.e. banks.
In an American option, option can be exercised at any time with in the period of option. In case of European option, option can be exercised on the specified expiry date. As such American option is better, as it gives flexibility to exercise strike price. If a company believes that underlying exposure will result in a gain, currency option is useful and if the company insures against loss, the company has full hedge.
As per current regulations in India, a resident is permitted to book and /or cancel freely a foreign currency option contract with an authorized dealer to hedge foreign exchange exposure arising out of his trade subject to the specified conditions. In case of contingent pre- transaction exposure, like projects abroad where the company has to bid for a large contract determined in foreign currency, the company at the bid stage will not know whether the currency exposure will arise or not. If the bid materializes, company will exercise the option if the spot rate moves adversely and will not exercise the option if spot rate is in favor.
If the bid does not materialize, the option will be abandoned and sold back to the writer. Currency options are expensive then forward contracts as premium has to pay by the buyer .If option is not exercised and permitted to expire, the premium cost will be maximum or if it has still balance time-value some portion of premium can be retrieved. In India, RBI permits the contingent foreign exchange exposure arising out of submission of a tender bid in foreign exchange for hedging.