Companies related to international trade face the constant threat of transaction exposure risks. And this is actually not a new fact. Logically thinking, it is mundane to keep fretting over risks, isn’t it? Rather than doing so, it is better to keep an eye on the volatility of forex rates and channelize one’s energy towards coming up with some workable solutions that helps one mitigate risks and not toss profitability margins.

The risks concerning transaction exposure is closely related to foreign exchange rate and this imposes threats in cross currency transaction. Taking such in mind, derivative tools are commonly used by corporations to limit their exposure to any adverse movements occurred due to change in exchange rate. However, the use of derivative tools cannot be a random or instinctive.

It requires a lot of brainstorming and here is where Forex Managers and experienced Advisors are simply at their best. The hedging strategies they adopt are purely based on the economics of real time market situation as well as technical analysis of the market to achieve both short term and long term goals. Nothing miraculous though, but it is all a game of field expertise and experience that works the tricks here.

Standard Methods Used To Hedge Transaction Exposure

1. Forward Contracts- Say firms have an agreement to pay or receive a fixed amount of foreign currency at some date in the future. In that case, buying a forward contract today helps them hedge transaction exposure as the contract specifies the price to be paid, at what rate they can buy or sell the foreign currency at the specified date in the future. Taking this step is beneficial as it converts the uncertain future home currency value of this liability (asset) into a certain home currency value to be received on the specified date, independent of the change in the exchange rate over the remaining life of the contract.
2. Futures Contracts- This kind of contract is equivalent to forward contracts in function. However, some features do differ between the two and this distinguishes one from the other. This kind of tool is mainly exchange that is traded and therefore has standardised and limited contract sizes, maturity dates, initial collateral and several other features.

Futures contracts are available only in certain size of transaction exposure, maturities and currencies. Unlike forward contracts, this contract are traded on an exchange which has a liquid secondary market that makes them easier to unwind or close out in case the contract timing does not match the exposure timing. In addition, the exchange also requires position takers to post bond (margins) based on the value of their positions. This is what virtually eliminates any kind of the credit risk involved in trading in futures.

3. Options- Foreign currency options are contracts that charge an upfront fee and also give the owner the right but not the obligation to trade domestic currency for foreign currency or vice versa in a specified quantity at a specified price over a specified time period. This derivative tool helps in the removal of downside risk without actually impacting or cutting off the benefits of upside risks.

There are various kinds of options depending on the exercise time, the determination of the payoff price or the possibility of a payoff. A popular exotic option that corporations make use of is the basket rate option. Instead of just buying options on a bunch of currencies individually, the firms can buy an option which is based upon some weighted average of currencies that match its transaction pattern. Here again, since currencies are not perfectly correlated the average exchange rate will be less volatile and this option will therefore be less expensive. Firms can take advantage of its own natural diversification of currency risk and hedge just the remaining risk.

The key difference between Options and Futures contract was covered by us in our previous piece in detail. (Refer to the piece(Currency Options & Futures) for more details)

4. Money Market Hedging- This technique for hedging foreign exchange risk is done by using the money market and the financial market in which highly liquid and short term instruments like treasury bills, bankers’ acceptance and commercial paper are traded.

For example: If any corporation has an agreement to pay foreign currency at a specified date in the future can determine the present value of the foreign currency obligation at the foreign currency lending rate and then convert the appropriate amount of home currency based on the current spot exchange rate. Such helps the company in converting the obligation into a home currency payable and eliminates all exchange risks. Similarly, if any corporation has an agreement to receive foreign currency at a specified date in the future can determine the present value of the foreign currency receipt at the foreign currency borrowing rate and borrow this amount of foreign currency and convert it into the domestic currency at the current spot exchange rate.

Cut Time, Save Large Policy!

For Corporations, managing transaction risks becomes taxing only when they are unable to predict which way the exchange rate will move. For some companies, it is actually a complex process as well as expensive and time consuming task to manage foreign exchange risks. Although, they may have a fair knowledge on the standard derivative tools but how and when to use them becomes an unnerving thing for them. Here however taking up a step forward to getting associated with a Forex Advisory firm turns up beneficial for the corporate.

Forex Management Service Providers come up with a pool of complementary services apart from risk advisory services. The packaged services help corporate stay at ease because of the following reasons-

1. Forex Experts of Service Provider decrease the effects of exchange rate movements on profit margins of the corporate client.
2. Increase the predictability of future cash flows on behalf of corporate
3. Eliminates the need to precisely forecast the future direction of exchange rates for the Corporate
4. Assist the client on pricing of products sold on export markets
5. Protect, temporarily the corporate client’s transaction competitiveness if the value of the currency rises.

Thus, for the corporate, it is always best to outsource Forex Services to deal with Forex and risk management. This will help them manage risks at a reasonable cost and more importantly, to take wise decisions related to purchase of foreign exchange hedging instruments. Isn’t this that you wanted so long?