FOREIGN EXCHANGE RISK MANAGEMENT TECHNIQUES

FOREIGN EXCHANGE RISK MANAGEMENT TECHNIQUES

27 Dec 2018 05:15 PM
 

FOREIGN EXCHANGE RISK

What is Foreign Exchange Risk?

Foreign Exchange risk is the risk of incurring losses due to adverse movement in currencies. These fluctuations are caused due to many factors which are not in our control. Any depreciation or appreciation in rupee will affect the cash flows arising from that transaction. Thus businesses involved in export and import, that trade product and services in multiple countries, are majorly affected by these fluctuations and hence face this risk. This is because the proceeds of a trade, profit or loss, will be denominated in the foreign currency and will need to be converted back to the investor's base currency.

For example: Suppose an Indian exporter receives an order today to export shirts to USA. The exchange rate as of today is 74 per dollar at which he incurs the cost. The exporter is expected to receive a payment of $100,000 in 2 months. On the date of receivables the rate is 73 per dollar. When he converts the dollar receivables to INR, total loss he incurred on currency risk is of INR10,000 (100,000*(74-73)).

Timeline Rate Amount due ($) Amount due (INR)
Order received 73 100,000 73,00,000
Receivables 74 100,000 74,00,000
-10000

Predominantly there are three types of foreign exchange risk:

  • Transaction risk: A company faces this type of risk when it's buying a product from a company located in another country. An Indian manufacturing company importing raw material from a German company faces this type of risk.
  • Translation Risk: This type of exchange rate risk arises when a parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency.
  • Economic Risk: Also called forecast risk, this type of currency risk occurs when a companys market value is continuously impacted by an unavoidable exposure to currency fluctuations

Since the factors causing Exchange Rate risk are out of our control, it is better for firms to have a structured Foreign Exchange Risk Management Policy in place to protect themselves from adverse scenarios. For this a company needs to set certain objectives to stick to the purpose and stay focused.

What are the objectives of Foreign Exchange Risk Management?

  1. The main objective of good Forex Risk Management is to effectively identify, assess, monitor and manage the risk. Also, the Risk Management policy should be consistent with the overall objectives of the Company and in compliance with the legal regulations and requirements of the Central Bank.
  2. It is to be kept in mind that the aim is of cost-containment only. The focus should remain on cost reduction and prevention of losses- not to earn profit. This can be done by using a benchmark at the time a payable/receivable arises and aim to at least achieve that benchmark.
  3. To minimize the impact of Forex rate fluctuations in INR value of the committed receipts and payments in foreign currencies while minimizing the cost of such protection.
  4. To ensure FC funding, at the time of availing, does not exceed the cost of Rupee funding of a comparable nature. Companies avail Foreign Currency (FC) funding in the form of PCFC/ Buyers credit as the situation warrants. The impact of exchange rate fluctuations on the Company’s profitability and finances is considered material.
  5. To reduce uncertainties in cash flow and improve financial decision making. By booking an exchange rate for future transactions using foreign exchange risk management instruments, companies reduce cash flow uncertainties and can make financial decisions accordingly. This includes availing the correct rate while doing Foreign exchange conversions with the bank.

A good Risk Management policy can only work if it is executed using appropriate tools and techniques with timely decision making.

Foreign Exchange Risk Management Techniques

For foreign exchange risk management, there are two types of contracts in the FX market: FX Outrights and FX Options:

  • FX Outrights : : These contracts, in FX markets refer to the type of transactions where two parties agree to buy or sell a given amount of currency at a predetermined rate, on a specified date in future. In simple terms, companies that buy goods and services overseas in different currencies can use this tool to lock in favorable exchange rates. There are two types of outrights to hedge foreign exchange risk- Forward FX Outrights and Futures FX Outrights.

    A forward outright is a private agreement that can be customized. It settles at the end of the agreement and is traded over the counter (OTC). A futures outright has standardized terms and is traded on an exchange, where prices are settled on a daily basis (mark-to-market) until the end of the contract.

    Here, our main focus will be Forward Outrights because for forex risk management, it is easier to trade forwards as they are customized contracts. An Outright rate differs from the rate used in spot market, which is the price that the currency picks up today. The difference occurs because the outright rate factors in characteristics such as volatility of currencies and their mutual opinion of where they think the exchange rate will be in the future.

    If an exporter/importer is getting a favourable rate today, but the date of receivables/ payables is in some time, they can book the rate by entering into a forward outright for the maturity of the receivables/payables and on the maturity effectively make the transaction at the forward rate already booked and not on the spot rate at maturity. Thus foreign exchange risk is hedged by fixing a rate for future payment.

    The foreign exchange rates can move in the direction which would have been favorable, had the hedge not been implemented. In such a case, the hedged position is not able to gain from the favorable movement in the exchange rate because the rate has been determined and it is a binding obligation which cannot be withdrawn from.

    Thus, appropriate advice from forex experts for forex risk management has proved to be more beneficial than just speculating the currency movements and hedging based on them. Myforexeye provides a combination of many services related to foreign exchange. Currency trading with guidance from forex experts and specific forex risk advisory services are some of the services which help the trader to make suitable hedges while aiming to prevent losses through FX outrights.

  • FX Options: Unlike an FX Outright, an FX option is not binding in nature. One has the right, but not the obligation, to buy/sell the foreign currency on a future date at an exchange rate guaranteed in the option contract. The option lies with the buyer of the FX Option Contract. In this way, the option contract helps to protect from the downside foreign exchange risk while retaining the upside potential, in case of any favorable movements in the exchange rate. A disadvantage of using FX Options is that, unlike FX Outrights, an upfront premium is to be paid to buy the Option contract. However, they can be used with other strategies to minimize the premium cost.

One thing to keep in mind is that, derivatives can be complex instruments to interpret. To enjoy the benefits of using derivatives it is better to take advice from a professional- when and how to use them. Myforexeye Team provides guidance to its clients on how and when to use derivatives and thus achieve the desired outcome.

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