For any business dealing beyond national borders, incorporates an inherent risk of foreign currency. This foreign currency risk can be hedged at the end of both the seller and the buyer. But optimally hedging should be done keeping in mind the inter-linked and fast evolving global foreign exchange market.
Currency risk is the risk which arises with the change in value of one currency with respect to another. This risk when left untouched, can wipe out all profits which a company starts to go international. Thus it can be a cost center for corporates when not managed or hedged. In late 1990s, the Foreign Currency Risk was identified during the Asian currency crisis in 1997 which led to the financial markets crash.
Managing foreign currency risk
Getting caught off-guard by the ever fluctuating Foreign Exchange Market, can be devastating for any corporate. The need of the hour is to mitigate the currency risk and not shy away from it. It requires to take advice from experts who assist in gaining a deep insight on possible implications of global events on the trade which has foreign currency involved in it. To manage currency risk, one is required to hedge the risk. Hedging can be done through several ways. Sometimes borrowers who take loan for the foreign currency payments are also exposed to foreign currency risk.
Tools to hedge foreign currency risk
Financial wizards developed several means and ways to manage the financial risk – specifically currency risk. These risks can be managed by using derivatives products like forward contracts, future and option contracts. Each of the tools has their own advantages which are suitable to a certain section of traders which help them to manage these risks. Hedging currency risk is an important aspect of international business and the below tools help in mitigating these risks.
Forward contracts – these are agreements which are made between two parties who agree to exchange one currency in exchange of another at a future date and at a price which is fixed today. It is an over the counter contract thus the risk of honoring the contract is there. In India, this is mostly executed between a trader (an importer or an exporter) and a bank. These banks should take the real time foreign exchange quote from the currency market (brokers who execute big volume deals on behalf of their clients) to fix the spot rate. Along with the spot rate, a premium is charged as per the contract expiry date. This premium is then added to the spot rate to arrive at the forward rate. These contracts once entered are to be honored and thus when there is not much clarity on when the money would be received or paid, a window Forward Contract serves well. Banks usually charge a margin for executing these contracts.
Future contracts – now these are quite similar to a forward contract but these are traded over the exchange so the counterparty risk is not there. These also have an expiry date which is when the contract would mature. These cannot be customized and can be executed only for major currency pairs. These are cash settled in local currency - Rupee. In this the investor agrees to buy or sell a currency in exchange of another on the expiry of the contract. An initial margin is paid which is adjusted on a daily basis to reflect the gain or loss which is dependent on the closing price of the futures. This mark to market (MTM) account has to be replenished to maintain the margin. Though the currency future has low transaction costs and offers high liquidity, the fluctuations in the currency market is high making it highly risky.
Options contract – these contracts offer to tackle the open risk associated with a futures contract. In an option contract( you can read more Currency Options & Futures ), as the name suggests, the investor has the option to execute the transaction. If the contract is favorable on expiry, then it’s executed, else not. In this the buyer of the option contract has the right but isn’t obliged to buy or sell a particular currency on or before the expiry at the specified exchange rate. Along with the strike price (rate at which the contract is executed), in an option contract the investor also has to pay an option premium which is a fixed cost like an insurance. Then depending on spot market, the investor can execute the option if the spot has moved adversely or participate in the market if spot is favorable to his position. Mostly speculators or traders use these option contracts.
These tools are used to mitigate the foreign exchange risk which if left open can harm the costing or benchmarks of corporates.
Hedging currency risk – a must
Thus in international business one is into, the foreign exchange market has an impact on them as the currency risk arising out of Foreign Currency Fluctuation can prove to be detrimental for the business. One should understand the implications of the currency market as an advice or two from a forex expert will prove fruitful in gaining deeper insight. Myforexeye has a team of forex experts who watch and understand the forex market in depth to provide forex hedging strategies to ensure the clientele’s benchmarks are protected at all times.
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