A

Report on
Foreign exchange risk management

By

Kavita P. Chokshi (05)

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 Index
 Introduction…………………………………………………………………………..03

 Foreign Exchange Market……………………………………………………………04

 Determinants of Foreign Exchange Rates……………………………………………06

 Risk Management…………………………………………………………………….12

 Foreign Exchange Exposure…………………………………………………………16

 Techniques of Managing Foreign Exchange Risk…………………………………...17

 Strategies for Exposure Management………………………………………………...29

 Conclusion……………………………………………………………………………31

 Illustrations…………………………………………………………………………...32

Introduction
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Coupled with globalization of business, the raising of capital from the international capital
markets has assumed significant proportion during the recent years. The volume of finance
raised from international capital market is steadily increasing over a period of years, across
the national boundaries. Every day new institutions are emerging on the international
financial scenario and introducing new derivative financial instruments (products) to cater to
the requirements of multinational organizations and the foreign investors.
To accommodate the underlying demands of investors and capital raisers, financial
institutions and instruments have also changed dramatically. Financial deregulation, first in
the United States and then in Europe and Asia, has prompted increased integration of world
financial markets. As a result of the rapidly changing scenario, the finance manager today has
to be global in his approach.
In consonance with these remarkable changes, the Government of India has also opened
Indian economy to foreign investments and has taken a number of bold and drastic measures
to globalize the Indian economy. Various fiscal, trade and industrial policy decisions have
been taken and new avenues provided to foreign investors like Foreign Institutional Investors
(FII's) and NRI's etc., for investment especially in infrastructural sectors like power and
telecommunication etc.
The basic principles of financial management i.e., efficient allocation of resources and rising
of funds on most favorable terms and conditions etc. are the same, both for domestic and
international enterprises. However the difference lies in the environment in which these
multi-national organizations function. The environment relates to political risks,
Government's tax and investment policies, foreign exchange risks and sources of finance etc.
These are some of the crucial issues which need to be considered in the effective
management of international financial transactions and investment decisions.
Under the changing circumstances as outlined above, a finance manager, naturally cannot just
be a silent spectator and wait and watch the developments. He has to search for "best price"
in a global market place (environment) through various tools and techniques. Sometimes he
uses currency and other hedges to optimize the utilization of financial resources at his
command. However, the problems to be faced by him in the perspective of financial
management of the multinational organizations are slightly more complex than those of
domestic organizations.

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 Foreign Exchange Market
The foreign exchange market (forex, FX, or currency market) is a worldwide
decentralized over-the-counter financial market for the trading of currencies. Financial
centers around the world function as anchors of trading between a wide range of different
types of buyers and sellers around the clock, with the exception of weekends. The foreign
exchange market determines the relative values of different currencies.

The primary purpose of the foreign exchange market is to assist international trade and
investment, by allowing businesses to convert one currency to another currency. For
example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S.
manufacturer sells machine tools to Japanese company for yen. Ultimately, however, the U.S.
Company will be interested in receiving dollars, whereas the Japanese exporter will want yen.
Because it would be inconvenient for the individual buyers and sellers of foreign exchange to
seek out one another, a foreign exchange market has developed to act as an intermediary.
Transfer of purchasing power is necessary because international trade and capital transactions
usually involve parties living in countries with different national currencies. Each party wants
to trade and deal in his own currency but since the trade can be invoiced only in a single
currency, the parties mutually agree on a currency beforehand. The currency agreed could
also be any convenient third country currency such as the US dollar. For, if an Indian
exporter sells machinery to a UK importer, the exporter could invoice in pound, rupees or any
other convenient currency like the US dollar.
But why do individuals, firms and banks want to exchange one national currency for another?
The demand for foreign currencies arises when tourists visit another country and need to
exchange their national currency for the currency of the country they are visiting or when a
domestic firm wants to import from other nations or when an individual wants to invest
abroad and so on. On the other hand, a nation's supply of foreign currencies arises from
foreign tourist expenditures in the nation, from export earnings, from receiving foreign
investments, and so on. For example, suppose a US firm exporting to the UK is paid in
pounds sterling (the UK currency). The US exporter will exchange the pounds for dollars at a
commercial bank. The commercial bank will then sell these pounds for dollars to a US
resident who is going to visit the UK or to a United States firm that wants to import from the
UK and pay in pounds, or to a US investor who wants to invest in the UK and needs the
pounds to make the investment. Thus, a nation's commercial banks operate as clearing houses
for the foreign exchange demanded and supplied in the course of foreign transactions by the
nation's residents.

Forex Market also supports speculation, and facilitates the carry trade, in which investors
borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it
has been claimed) may lead to loss of competitiveness in some countries.

In a typical foreign exchange transaction a party purchases a quantity of one currency by

paying a quantity of another currency. The modern foreign exchange market started forming
during the 1970s when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods system.

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The foreign exchange market is unique because of its

 huge trading volume, leading to high liquidity. According to the Bank for
International Settlements, average daily turnover in global foreign exchange markets
is estimated at $3.98 trillion, as of April 2010 a growth of approximately 20% over
the $3.21 trillion daily volume as of April 2007.
 geographical dispersion
 continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT
on Sunday until 22:00 GMT Friday
 the variety of factors that affect exchange rates
 the low margins of relative profit compared with other markets of fixed income
 the use of leverage to enhance profit margins with respect to account size

 Electronic trading is growing in the FX market, and algorithmic trading is becoming

much more common.

As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstanding market manipulation by central banks.

Market Participants

The foreign exchange market is the market in which individuals, firms and banks buy and sell
foreign currencies or foreign exchange. Four levels of participants can be identified in
foreign exchange markets:
 At the first level, are tourists, importers, exporters, investors, etc. These are the immediate
users and suppliers of foreign currencies.

 At the next, or second level are the commercial banks which act as clearing houses
between users and earners of foreign exchange.

 At the third level are foreign exchange brokers through whom the nation's commercial
banks even out their foreign exchange inflows and outflows among themselves.

 Finally, at the fourth and highest level is the nation's central bank which acts as the lender
or buyer of last resort when the nation's total foreign exchange earnings and expenditures
are unequal. The central bank then either draws down its foreign exchange reserves or
adds to them.

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 Determinants of Foreign exchange rates
The following theories explain the fluctuations in FX rates in a floating exchange rate
regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions:

Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International
Fisher effect. Though to some extent the above theories provide logical explanation for the
fluctuations in exchange rates, yet these theories falter as they are based on challengeable
assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real
world.

(b) Balance of payments model:

This model, however, focuses largely on tradable goods and services, ignoring the increasing
role of global capital flows. It failed to provide any explanation for continuous appreciation
of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model:

It views currencies as an important asset class for constructing investment portfolios. Assets
prices are influenced mostly by people’s willingness to hold the existing quantities of assets,
which in turn depends on their expectations on the future worth of these assets. The asset
market model of exchange rate determination states that “the exchange rate between two
currencies represents the price that just balances the relative supplies of, and demand for,
assets denominated in those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility in the longer
time frames. For shorter time frames (less than a few days) algorithm can be devised to predict
prices. Large and small institutions and professional individual traders have made consistent profits
from it. It is understood from above models that many macroeconomic factors affect the exchange
rates and in the end currency prices are a result of dual forces of demand and supply. The world's
currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current
events, supply and demand factors are constantly shifting, and the price of one currency in relation
to another shifts accordingly. No other market encompasses (and distills) as much of what is going
on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any
single element, but rather by several. These elements generally fall into three categories:
economic factors, political conditions and market psychology.

1. Economic factors

These include:

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(a) Economic Policy, disseminated by government agencies and central banks,

Economic policy comprises government fiscal policy (budget/spending practices) and

monetary policy (the means by which a government's central bank influences the supply and
"cost" of money, which is reflected by the level of interest rates).

(b) economic conditions, generally revealed through economic reports, and other economic
indicators.

 Government budget deficits or surpluses:

The market usually reacts negatively to widening government budget deficits, and positively
to narrowing budget deficits. The impact is reflected in the value of a country's currency.

 Balance of trade levels and trends:

The trade flow between countries illustrates the demand for goods and services, which in turn
indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of
goods and services reflect the competitiveness of a nation's economy. For example, trade
deficits may have a negative impact on a nation's currency.

 Inflation levels and trends:

Typically a currency will lose value if there is a high level of inflation in the country or if
inflation levels are perceived to be rising. This is because inflation erodes purchasing power,
thus demand, for that particular currency. However, a currency may sometimes strengthen
when inflation rises because of expectations that the central bank will raise short-term interest
rates to combat rising inflation.

 Economic growth and health:

Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail
the levels of a country's economic growth and health. Generally, the more healthy and robust
a country's economy, the better its currency will perform, and the more demand for it there
will be.

 Productivity of an economy:

Increasing productivity in an economy should positively influence the value of its currency.
Its effects are more prominent if the increase is in the traded sector.

2. Political conditions

Internal, regional, and international political conditions and events can have a profound effect
on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new
ruling party. Political upheaval and instability can have a negative impact on a nation's
economy. For example, destabilization of coalition governments in Pakistan and Thailand can

7
negatively affect the value of their currencies. Similarly, in a country experiencing financial
difficulties, the rise of a political faction that is perceived to be fiscally responsible can have
the opposite effect. Also, events in one country in a region may spur positive/negative interest
in a neighboring country and, in the process, affect its currency.

3. Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety
of ways:

 Flights to quality:

Unsettling international events can lead to a "flight to quality," with investors seeking a "safe
haven." There will be a greater demand, thus a higher price, for currencies perceived as
stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have
been traditional safe havens during times of political or economic uncertainty.

 Long-term trends:

Currency markets often move in visible long-term trends. Although currencies do not have an
annual growing season like physical commodities, business cycles do make themselves felt.
Cycle analysis looks at longer-term price trends that may rise from economic or political
trends.

 "Buy the rumor, sell the fact":

This market truism can apply to many currency situations. It is the tendency for the price of a
currency to reflect the impact of a particular action before it occurs and, when the anticipated
event comes to pass, react in exactly the opposite direction. This may also be referred to as a
market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an
example of the cognitive bias known as anchoring, when investors focus too much on the
relevance of outside events to currency prices.

 Economic numbers:

While economic numbers can certainly reflect economic policy, some reports and numbers
take on a talisman-like effect: the number itself becomes important to market psychology and
may have an immediate impact on short-term market moves. "What to watch" can change
over time. In recent years, for example, money supply, employment, trade balance figures
and inflation numbers have all taken turns in the spotlight.

 Technical trading considerations:

As in other markets, the accumulated price movements in a currency pair such as EUR/USD
can form apparent patterns that traders may attempt to use. Many traders study price charts in
order to identify such patterns.

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Thus,

Factors Effecting Rates, Factors Effecting Rates,

Short Term Long Term
 Time scale in forex  Economic fundamentals/data

 Supply/demand position  Balance of payments

 Movement of funds  Govt.’s economic policies

 Entry of a large Banks / Corporates  Interest rate changes

 Political crises, wars, oil price  Capital movements

 Central Bank intervention  Technical/psychological factors

 Purchase power parity

 Interest rate parity

Exchange Rate Determination

An exchange rate is, simply, the price of one nation’s currency in terms of another currency,
often termed the reference currency. For example, the rupee/dollar exchange rate is just the
number of rupee that one dollar will buy. If a dollar will buy 100 rupee, the exchange rate
would be expressed as Rs 100/$ and the rupee would be the reference currency.

Equivalently, the dollar/ rupee exchange rate is the number of dollars one rupee will buy.
Continuing the previous example, the exchange rate would be $0.01/Rs (1/100) and the dollar
would now be the reference currency. Exchange rates can be for spot or forward delivery.

The foreign exchange market includes both the spot and forward exchange rates. The spot
rate is the rate paid for delivery within two business days after the day the transaction takes
place. If the rate is quoted for delivery of foreign currency at some future date, it is called the
forward rate. In the forward rate, the exchange rate is established at the time of the contract,
though payment and delivery are not required until maturity. Forward rates are usually quoted
for fixed periods of 30, 60, 90 or 180 days from the day of the contract.

(a) The Spot Market

The most common way of stating a foreign exchange quotation is in terms of the number of
units of foreign currency needed to buy one unit of home currency. Thus, India quotes its
exchange rates in terms of the amount of rupees that can be exchanged for one unit of foreign
currency.

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Illustration: If the Indian rupee is the home currency and the foreign currency is the US
Dollar then what is the exchange rate between the rupee and the US dollar?

Solution
US$ 0.0217/Re. 1 reads "0.0217 US dollar per rupee." This means that for one Indian rupee
one can buy 0.0217 US dollar.

In this method, known as the European terms, the rate is quoted in terms of the number of
units of the foreign currency for one unit of the domestic currency. This is called an indirect
quote.

The alternative method, called the American terms, expresses the home currency price of one
unit of the foreign currency. This is called a direct quote.

This means the exchange rate between the US dollar and rupee can be expressed as:
Rs. 46.08/US$ reads "Rs. 46.08 per US dollar."

Hence, a relationship between US dollar and rupee can be expressed in two different ways
which have the same meaning:

• One can buy 0.0217 US dollars for one Indian rupee.

• Rs. 46.08 Indian rupees are needed to buy one US dollar.

(b) The Forward Market

A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the
currency at some future date. They agree to transact a specific amount of currency at a
specific rate at a specified future date. The forward exchange rate is set and agreed by the
parties and remains fixed for the contract period regardless of the fluctuations in the spot
exchange rates in future. The forward exchange transactions can be understood by an
example.

Illustration: A US exporter of computer peripherals might sell computer peripherals to a

German importer with immediate delivery but not require payment for 60 days. The German
importer has an obligation to pay the required dollars in 60 days, so he may enter into a
contract with a trader to deliver deutsche marks for dollars in 60 days at a forward rate – the
rate today for future delivery.

So, a forward exchange contract implies a forward delivery at specified future date of one
currency for a specified amount of another currency. The exchange rate is agreed today,
though the actual transactions of buying and selling will take place on the specified date only.
The forward rate is not the same as the spot exchange rate that will prevail in future. The
actual spot rate that may prevail on the specified date is not known today and only the
forward rate for that day is known. The actual spot rate on that day will depend upon the
supply and demand forces on that day. The actual spot rate on that day may be lower or
higher than the forward rate agreed today.

Exchange Rate Quotations

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 Direct and Indirect Quote:

A currency quotation is the price of a currency in terms of another currency. For example, $1
= Rs.44.00, means that one dollar can be exchanged for Rs.44.00. Alternatively; we may pay
Rs.44.00 to buy one dollar. A foreign exchange quotation can be either a direct quotation and
or an indirect quotation, depending upon the home currency of the person concerned.

A direct quote is the home currency price of one unit foreign currency. Thus, in the aforesaid
example, the quote $1 =Rs.44.00 is a direct-quote for an Indian.

An indirect quote is the foreign currency price of one unit of the home currency. The quote
Re.1 =$0.0227 is an indirect quote for an Indian. ($1/Rs. 44.00 =$0.0227 approximately)
Direct and indirect quotes are reciprocals of each other, which can be mathematically
expressed as follows.

Direct quote = 1/indirect quote and vice versa

 Bid, Offer and Spread:

A foreign exchange quotes are two-way quotes, expressed as a 'bid' and an offer' (or ask)
price. Bid is the price at which the dealer is willing to buy another currency. The offer is the
rate at which he is willing to sell another currency. It must be clearly understood that while a
dealer buys a currency, he at the same time is selling another currency. Thus a bid in one
currency is simultaneously an offer in another currency. For example, a dealer may quote
Indian rupees as Rs.43.80 - 43.90 vis-à-vis dollar. That means that he is willing to buy dollars
at Rs.43.80/$ (sell rupees and buy dollars), while he will sell dollar at Rs. 43.90/$ (buy rupees
and sell dollars). The difference between the bid and the offer is called the spread. The offer
is always higher than the bid as inter-bank dealers make money by buying at the bid and
selling at the offer.

% Spread= (Bid -Offer /bid) × 100

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 Risk Management
Whether it is investing, driving, or just walking down the street, everyone exposes himself or
herself to risk. A person’s personality and lifestyle play a big deal on how much risk he can
comfortably take on. If an investor invests in stocks and has trouble sleeping at nights
because of his investments, then probably he is taking on too much risk. A ‘risk’ is anything
that can lead to results that deviate from the requirements. According to Tom Gilb, risk can
be defined as “An abstract concept expressing the possibility of unwanted outcomes”.
Deciding what amount of risk an investor can take on while allowing him to get rest at night
is his most important decision.

Risk Management is, “any activity which identifies risks, and takes action to remove or
control ‘negative results’ (deviations from the requirements).” Effective risk management
strategies have become increasingly necessary due to the dynamic nature of the business
environment. Globalization is resulting in new markets, new competitors, and new products.
Technological advances are dramatically accelerating the pace of business and the volatility
of financial markets. A new relationship between the public and private sectors is
contributing to restructured markets and greater deregulation.

Volatility in financial markets was a natural outcome of changes in the flow of funds
worldwide following the first oil crisis in the 1970s, the collapse of the fixed foreign
exchange rate system, monetarist practices adopted by many central banks, the advancement
of communications and technology, and the acceptance of deregulation of financial systems
around the world during the 1980s.

Unpredictable changes in interest rates, yield curve structures, exchange rates, and
commodity prices, exacerbated by the explosion in international expansion, have made the
financial environment riskier today than it ever was in the past. For this reason, boards of
directors, shareholders, and executive and tactical management need to be seriously
concerned that corporate risk management activities be adequately assessed, prioritized,
driven by strategy, controlled, and reported.

Organizations around the globe are therefore overwhelmingly focused on the most
fundamental of financial principles: risks = returns. Executives are undertaking major
initiatives to manage the risk side of this equation, and, in doing so, are examining global
treasury alternatives and employing comprehensive and integrated risk management
strategies.

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Each organization faces a unique set of parameters with respect to, for example, industry
sector, product mix, organizational goals, business culture, and risk tolerances. Consequently,
an organization must tailor its risk management framework to meet its particular needs.

Organizations are now concerned with the problems faced by any firm whose performance is
affected by the international environment. Indeed, even companies that operate only
domestically but compete with firms producing abroad and selling in their local market are
affected by international developments. For example, Indian clothing or appliance
manufacturers with no overseas sales will find Indian sales and profit margins affected by
exchange rates, which influence the prices of imported clothing and appliances. Similarly,\
bond investors holding their own government's bonds, denominated in their own currency,
and spending all their money at home are affected by changes in exchange rates if exchange
rates prompt changes in interest rates. Specifically, if governments increase interest rates to
defend their currencies when they fall in value on the foreign exchange markets, holders of
domestic bonds will find their assets falling in value along with their currencies: bond prices
fall when interest rates increase. It is difficult to think of any firm or individual that is not
affected in some way or other by the international environment. Jobs, bond and stock prices,
food prices, government revenues and other important economic variables are all tied to
exchange rates and other developments in the global financial environment.

Risk Considerations

A multinational organization operates in more than one country. This implies that it functions
in different environments. However, the degree of risk is different in different countries. It
has been observed that international diversification is often more effective than domestic
diversification in reducing company's risk in relation to its expected return because the
economic cycles of different countries do not tend to be completely synchronized. For
example, if a company is in a particular line of business, say power and telecom facilities,
invests in another unit in the same country, both the existing and the new units are subjected
to the same environmental risks and the return from the new plant is likely to be highly co-
related with return from existing plant. This implies that there is no change in the
environmental risks and perceptions in the same country both for existing and new units.
However, had the management decided to invest the same money in the similar business but
in a different country, there would have been change in environmental risk as well as reward
perception since both the units now function in different environments. This mechanism
probably reduces the risk facing the business and improves chances of rewards.

The political instability and unfavorable Government can seriously endanger the very
existence and functioning of the multi-national organizations. It is therefore advisable that
before making investment abroad, the organization should realistically assess the political
instability and risk of that country in which investment is proposed to be made. In other
words, the company will have to forecast the political instability of the country, which is
possible by assessing the degree of stability of the existing government, its attitude towards
foreign investment, incentives offered and the quickness in processing foreign investment
proposals. If the assessment reveals that political risks is high, the company may decide not
to invest even if very high returns are expected to be made and viceversa.

There are several types of risk that an investor should consider and pay careful
attention to:

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Financial Risk:
It is the potential loss or danger due to the uncertainty in movement of foreign exchange
rates, interest rates, credit quality, liquidity position, investment price, commodity price, or
equity price, as well as the unpredictability of sales price, growth, and financing capabilities.
Balance sheet and cash flow hedges as well as derivatives tools mitigate financial risks by
reducing uncertainty faced by firms. However, these strategies and instruments themselves
are manifestations of the different types of financial uncertainty in that further risks arise
from their use.

Business Risk:
On a micro scale, business risk involves the variability in earnings due to variation in the cash
inflows and outflows of capital investment projects undertaken. This risk, also known as
investment risk, may materialize because of forecasting errors made in market acceptance of
products, future technological changes, and changes in costs related to projects.
On an aggregated basis variability in earnings may derive from the degree of efficient
diversification that the firm has achieved in its operations and its overall portfolio of assets.
The firm can reduce this risk, also referred to as portfolio risk, by seeking out capital projects
and merger candidates that have a low or negative correlation with its present operations.

Credit or Default Risk:

This is the risk that a company or individual will be unable to pay the contractual interest or
principal on its debt obligations. This type of risk is of particular concern to investors who
hold bonds within their portfolio. Government bonds have the least amount of default risk
and least amount of returns while corporate bonds tend to have the highest amount of default
risk but also the higher interest rates. Bonds with lower chances of default are considered to
be “investment grade,” and bonds with higher chances are considered to be junk bonds.

Country Risk:
This refers to the risk that a country would not be able to honour its financial commitments.
When a country defaults it can harm the performance of all other financial instruments in that
country as well as other countries it has relations with. Country risk applies to stocks, bonds,
mutual funds, options and futures that are issued within a particular country. This type of risk
is most often seen in emerging markets or countries that have a severe deficit.

Interest Rate Risk:

It refers to the charge in the interest rates. A rise in interest rates during the term of an
investor’s debt security hurts the performance of stocks and bonds.

Political Risk:
This represents the financial risk that a country's government will suddenly change its
policies.

Market Risk:
It is the day-to-day fluctuations in a stocks price. Also referred to as volatility. Market risk
applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull
market and poorly during a bear market—volatility is not so much a cause but an effect of
certain market forces. Volatility is a measure of risk because it refers to the behavior, or
“temperament,” of your investment rather than the reason for this behavior. Because market
movement is the reason why people can make money from stocks, volatility is essential for

14
returns, and the more unstable the investment the more chance it can go dramatically either
way.

Foreign Exchange Risk:

When companies conduct business across borders, they must deal in foreign currencies.
Companies must exchange foreign currencies for home currencies when dealing with
receivables, and vice versa for payables. This is done at the current exchange rate between
the two countries. All businesses trading overseas and increasingly in domestic markets will
have some exposure to exchange rate movements either directly or indirectly. Whilst
exposure to exchange rate movements may be an inevitable part of everyday activity, the risk
arising from such exposure can be controlled. Thus, Foreign exchange risk is the risk that
the exchange rate will change unfavorably before the currency is exchanged.
When investing in foreign countries, one must consider the fact that currency exchange rate
can change the price of the asset as well. Foreign exchange risk applies to all financial
instruments that are in a currency other than your domestic currency. As an example, if you
are a resident of America and invest in some Canadian stock in Canadian dollars, even if the
share value appreciates, you may lose money if the Canadian dollar depreciates in relation to
the American dollar.

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 Foreign Exchange Exposure
“An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose
magnitude is not certain at the moment. The magnitude depends on the value of variables
such as Foreign Exchange rates and Interest rates.”
In other words, exposure refers to those parts of a company’s business that would be affected
if exchange rate changes. Foreign exchange exposures arise from many different activities.

For example, travelers going to visit another country have the risk that if that country's
currency appreciates against their own their trip will be more expensive.

An exporter who sells his product in foreign currency has the risk that if the value of that
foreign currency falls then the revenues in the exporter's home currency will be lower. An
importer who buys goods priced in foreign currency has the risk that the foreign currency will
appreciate thereby making the local currency cost greater than expected.

Fund Managers and companies who own foreign assets are exposed to falls in the currencies
where they own the assets. This is because if they were to sell those assets their exchange rate
would have a negative effect on the home currency value.

Other foreign exchange exposures are less obvious and relate to the exporting and importing
in ones local currency but where exchange rate movements are affecting the negotiated price.

Types of Exposures
The foreign exchange exposure may be classified under three broad categories:

Transaction Exposure:
It measures the effect of an exchange rate change on outstanding obligations that existed
before exchange rates changed but were settled after the exchange rate changes. Thus, it deals
with cash flows that result from existing contractual obligations.

Illustration: If an Indian exporter has a receivable of $100,000 due in six months hence and
if the dollar depreciates relative, to the rupee a cash loss occurs. Conversely, if the dollar
appreciates relative to the rupee, a cash gain occurs.

The above example illustrates that whenever a firm has foreign currency denominated
receivables or payables, it is subject to transaction exposure and their settlements will affect
the firm’s cash flow position.

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Translation Exposure:
Also known as accounting exposure, it refers to gains or losses caused by the translation of
foreign currency assets and liabilities into the currency of the parent company for accounting
purposes.

Economic Exposure:
It refers to the extent to which the economic value of a company can decline due to changes
in exchange rate. It is the overall impact of exchange rate changes on the value of the firm.
The essence of economic exposure is that exchange rate changes significantly alter the cost of
a firm’s inputs and the prices of its outputs and thereby influence its competitive position
substantially.
Techniques for Managing Foreign Exchange Risk

A Foreign exchange hedge (FOREX hedge) is a method used by companies to eliminate or

hedge foreign exchange risk resulting from transactions in foreign currencies.

Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two
common hedges are forwards and options. A Forward contract will lock in an exchange rate
at which the transaction will occur in the future. An option sets a rate at which the company
may choose to exchange currencies. If the current exchange rate is more favorable, then the
company will not exercise this option.

The aim of foreign exchange risk management is to stabilize the cash flows and reduce the
uncertainty from financial forecasts. To hedge any transaction is to buy certainty to make
sure that unexpected exchange rate movements will have no impact on our operations. What
determines the price of this certainty?

• Flexibility -- Do we want to have perfect coverage?

• Opportunity – Do we want the chance to gain on the upside?
• Efficiency – How (liquid/transparent /regulated) is the market?

There are a range of hedging instruments that can be used to reduce risk. Hedging
alternatives include: Forwards, futures, options, swaps, etc.

Illustration: Swedish company has got a sales order to an American customer. Delivery time
is in three months and price is in US dollar.
• Open position
No hedging. If the Swedish Kroner (SEK) increases in value the Swedish company loses.

• Forward contract
An exchange rate quoted today for settlement at a future date.
• Futures contract
A standardized agreement for settlement at a future date.

• Money market hedge

Borrow US dollar today and exchange the proceeds to local currency.

• Options contract
17
A contract giving the Swedish company the right, but not the obligation to sell US dollar at
an agreed rate. Provides a hedge and a chance to win.

1. Derivatives

A derivatives transaction is a bilateral contract or payment exchange agreement whose value

depends on - derives from - the value of an underlying asset, reference rate or index. Today,
derivatives transactions cover a broad range of underlyings - interest rates, exchange rates,
commodities, equities and other indices.

In addition to privately negotiated, global transactions, derivatives also include standardized

futures and options on futures that are actively traded on organized exchanges and securities
such as call warrants.

The term derivative is also used to refer to a wide variety of other instruments. These have
payoff characteristics, which reflect the fact that they include derivatives products as part of
their make-up. While the range of products is diverse it is not complicated. Every derivatives
transaction is constructed from two simple building blocks that are fundamental to all
derivatives: forwards and options. They include:

• Forwards: forwards and swaps, as well as exchange-traded futures.

• Options: privately negotiated OTC options (including caps, collars, floors and options on
forward and swap contracts), exchange-traded options on futures. Diverse forms of
derivatives are created by using these building blocks in different ways and by applying them
to a wide assortment of underlying assets, rates or indices.

(A) Forwards-Based Derivatives

There are three divisions of forwards-based derivatives:

i. Forward contracts;
ii. Swaps;
iii. Futures contracts.

(i) The Forward Contract

The simplest form of derivatives is the forward contract. It obliges one party to buy, and the
other to sell, a specified quantity of a nominated underlying financial instrument at a specific
price, on a specified date in the future. There are markets for a multitude of underlying.
Among these are the traditional agricultural or physical commodities, currencies (foreign
exchange forwards) and interest rates (forward rate agreements - FRAs). The volume of trade
in forward contracts is massive.

The change in value in a forward contract is broadly equal to the change in value in the
underlying. Forwards differ from options in that options carry a different payoff profile.
Forward contracts are unique to every trade. They are customized to meet the specific
requirements of each end-user. The characteristics of each transaction include the particular
business, financial or risk-management targets of the counterparties. Forwards are not

18
standardized. The terms in relation to contract size, delivery grade, location, and delivery date
and credit period are always negotiated.

In a forward contract, the buyer of the contract draws its value at maturity from its delivery
terms or a cash settlement. On maturity, if the price of the underlying is higher than the
contract price the buyer makes a profit. If the price is lower, the buyer suffers a loss. The gain
to the buyer is a loss to the seller.

(ii) Swaps

Swaps are infinitely flexible. In technical terms they are a method of exchanging the
underlying economic basis of a debt or asset without affecting the underlying principal
obligation on the debt or asset.
A swap transaction commits the participants to exchange cash flows at specified intervals,
which are called payment or settlement dates. Cash flows are either fixed or calculated for
specific dates by multiplying the quantity of the underlying by specified reference rates or
prices.

The vast majority of swaps are classified into the following groups:

• Interest rate;
• Currency;
• Commodity;
• Equity.

The notional principal (i.e. the face value of a security) on all these, except currency swaps, is
used to calculate the payment stream but not exchanged. Interim payments are usually netted
- the difference is paid by one party to the other.

Like forwards, the main users of swaps are large multinational banks or corporations. Swaps
create credit exposures and are individually designed to meet the risk management objectives
of the participants.

 Interest Rate Swaps

In an interest rate swap, no exchange of principal takes place but interest payments are made
on the notional principal amount. Interest payments can be exchanged between two parties to
achieve changes in the calculation of interest on the principal, for example:

• Floating to fixed;
• Fixed to floating;
• LIBOR to prime - based;
• Prime to LIBOR;
• Currency A to currency B.

19
In an interest rate swap both parties raise finance as they normally would in the markets
where they have relative advantage. They then engage in the swap. The arrangement benefits
both parties since it exploits one's comparative advantage.

 Currency Swaps

These involve an exchange of liabilities between currencies.

A currency swap can consist of three stages:

• A spot exchange of principal –

this forms part of the swap agreement as a similar effect can be obtained by using the spot
foreign exchange market.
• Continuing exchange of interest payments during the term of the swap –
this represents a series of forward foreign exchange contracts during the term of the swap
contract. The contract is typically fixed at the same exchange rate as the spot rate used at the
outset of the swap.

• Re-exchange of principal on maturity.

A currency swap has the following benefits:

• Treasurers can hedge currency risk.

• It can provide considerable cost savings. So a strong borrower in the Deutschmark market
may get a better US dollar rate by raising funds in the Deutschmark market and swapping
them for US dollars.

• The swap market permits funds to be accessed in currencies, which may otherwise
command a high premium.

• It offers diversification of borrowings.

A more complex version of a currency swap is a currency coupon swap, which swaps a fixed-
or-floating rate interest payment in one currency for a floating rate payment in another. These
are also known as Circus Swaps.

In a currency swap the principal sum is usually exchanged:

• At the start;
• At the end;
• At a combination of both; or
• Neither.

Many swaps are linked to the issue of a Eurobond. An issuer offers a bond in a currency and
instrument where it has the greatest competitive advantage. It then asks the underwriter of the
bond to provide it with a swap to convert funds into the required type.

 Plain Vanilla Swaps

20
These are fixed-to-floating interest rate swaps between two parties in which each contracts to
make payments to the other on particular dates in the future till a specified termination date.

 Basis rate swaps

These are similar to plain vanilla swaps but in a basis rate swap both legs are floating rate but
measured against different benchmarks.

 Asset swaps
These can be either a plain vanilla or a basis rate swap. Instead of swapping the interest
payments on liability, one of the parties to the swap is swapping the interest receipts on an
asset.

 Mortgage swaps
A mortgage swap seeks to emulate the economic process of buying a collection of mortgage-
backed securities and financing the acquisition with short-term variable-rate debt. It is like an
interest rate swap with a long-term forward commitment. Three factors distinguish a
mortgage swap from an interest rate swap:

• A reducing principal amount;

• Periodic cash settlements for adjustments to the premium or discount resulting from
prepayment;
• Settlement with cash or delivery of securities at a prearranged date.

 Amortising swaps
These are swaps for which the notional principal falls over its term. They are particularly
useful for borrowers who have issued redeemable debt. It enables them to match interest rate
hedging with the redemption profile of the bonds.

 Forward swaps
These are swaps arranged to run from some point in the future. They are similar to FRAs but
are longer-term vehicles.

 Swaptions
Options on swaps, they give the buyer of the swaption the right but not the obligation to enter
into a swap agreement where term, notional principal and interest rates are predetermined.
They are helpful in tenders where the bidder needs to fix costs but does not know who will
win the contract.

 Callable swaps
These are similar to swaptions but here the swap counterparty has the right to end the swap.

 Canape ’swaps
These currency swaps have no initial or final exchange of principal. Interest payments in one
currency are exchanged for interest payments in another.

(iii) Futures Contracts

21
A basic futures contract is very similar to the forward contract in its obligation and payoff
profile. The volume of newer financial futures contracts in interest rates, currencies and
equity indices now far outstrips the original markets in agricultural commodities.

There are some important distinctions between futures and forwards and swaps.

• The contract terms of futures are standardized. These encompass:

o Quantity and quality of the underlying;
o Time and place of delivery;
o Method of payment.

The only variable is the price. Even the credit risk is standardized: this is greatly reduced by
marking the contract to market on a daily basis with daily checking of position.

• Futures are smaller in contract size than forwards and swaps, which means that they are
available to a wider business market.

Financial futures comprise three principal types:

• Interest Rate Futures;
• Currency Futures;
• Stock Index Futures.

Interest rate futures centre on specific types of financial instruments, whose prices are
dependent on interest rates. Currency futures are based on internationally significant
currencies. Stock index futures draw on internationally recognized stock exchange indices.

A financial futures contract is purchased or sold through a broker. It is a commitment to make

or take delivery of a specified financial instrument, or perform a particular service, at
predetermined date in the future. The price of the contract is established at the outset.

Distinction between Futures and Forward Contracts

Feature Forward Contract Futures Contract

Amount Flexible Standard amount
Maturity Any valid business date Standard date. Usually one
agreed to by the two delivery date such as the
parties second
Tuesday of every month
Furthest maturity Open 12 months forward
date
Currencies traded All currencies Majors
Cross rates Available in one Usually requires two
contract; Multiple contracts
contracts avoided
Market-place Global network Regular markets − futures
market and exchanges
Price fluctuations No daily limit in many Daily price limit set by
currencies exchange
Risk Depends on counter Minimal due to margin
party requirements

22
 Honouring of By taking and giving Mostly by a reverse
contract delivery transaction
Cash flow None until maturity date Initial margin plus ongoing
variation margin because of
market to market rate and
final
payment on maturity date
Trading hours 24 hours a day 4 − 8 hours trading sessions

(B) Options
The second of the two principal building blocks in derivatives is options. These products
offer, in exchange for a premium, the right - but not the obligation - to buy or sell the
underlying at the strike price during a period or on a specific date. So the owner of the option
can choose not to exercise the option and let it expire. A buyer can benefit from favorable
movements in the price of the underlying but is not exposed to corresponding losses. This
represents the principal difference between forwards and options.

It is summarized neatly by IP Morgan and Arthur Andersen's Guide to Corporate Exposure

Management (appearing in Risk Magazine): “The advantage of options over swaps and
forwards is that options give the buyer the desired protection while allowing him to benefit
from a favourable movement in the underlying price. ”

Privately negotiated options exist on a multitude of underlyings such as bonds, equities,

currencies and commodities, and even swaps. Options can also be structured as securities in
warrants or can be embedded in products like convertible bonds, certain commodity- or
equity-linked bonds with options.

An option is a contract which has one or other of two key attributes:

• to buy (call option);
• or to sell (put option).

The purchaser is called the buyer or holder; the seller is called the writer or grantor. The
premium may be expressed as a percentage of the price per unit of the underlying.

The holder of an American option has the right to exercise the contract at any stage during
the period of the option, whereas the holder of a European option can exercise his right only
at the end of the period.

During or at the end of the contract period (depending on the 'nationality' of the option), the
holder can do as he pleases. He can buy or sell (as the case may be) the underlying, let the
contract expire or sell the option contract itself in the market.

Call Option

23
It is a contract that gives the buyer the right, but not the obligation, to buy a specified number
of units of commodity or a foreign currency from the seller of option at a fixed price on or up
to a specific date.

Put Option
It is a contract that gives the buyer the right, but not the obligation, to sell a specified number
of units of commodity or a foreign currency to a seller of option at a fixed price on or up to a
specific date.

Distinction between Options and Futures

There are certain fundamental differences between a futures and an option contract. Let us
look at the main comparative features given below:

Options Futures
a Only the seller (writer) is obliged to Both the parties are obligated
perform to
perform.
b Premium is paid by the buyer to the No premium is paid by any
seller party.
c Loss is restricted while there is There is potential/risk for
unlimited gain potential for the unlimited
option buyer. gain/loss for the futures
buyer.
d An options contract can be exercised A futures contract has to be
any time during its period by the honoured
buyer. by both the parties only on
the date
specified.

Options Vs Futures: Gain and Losses in Different Circumstances

Call buyer Long Call Put Buyer Short Put Seller
Futures Seller Futures
Position Position
Price rises Unlimited Unlimited Unlimited Limited Unlimited limited
gain gain loss loss loss Gain*
Price falls Limited Unlimited Limited Unlimited Unlimited Unlimited
loss loss* gain Gain* Gain* loss*
Price Limited No gain Limited Limited No gain Limited
unchanged loss or loss gain loss or loss gain

Note: Transaction Costs are ignored.

*Since the price of any commodity; share are financial instrument cannot go below zero,
there is technically a ‘limit’ to the gain/loss when the price falls. For practical purposes, this
is largely irrelevant.

As regards to using derivatives as a risk management technique, it can be said that the
emergence of the market for derivatives products, forwards, futures and options, can be
traced back to the willingness of risk-averse investors to guard themselves against

24
uncertainties arising due to fluctuations in asset prices. Through the use of derivatives, it is
possible to transfer price risks by locking–in asset prices. Derivatives generally do not
influence the fluctuations in the underlying asset prices but by locking-in asset prices, they
minimize the impact of fluctuations in asset prices on the profitability and cash flow situation
of risk-averse investors.

Illustration
• Commodity Price Exposure: The purchase of a commodity futures contract will allow a
firm to make a future purchase of the input at today’s price, even if the market price on the
item has risen substantially in the interim.
• Security Price Exposure: The purchase of a financial futures contract will allow a firm to
make a future purchase of the security at today’s price, even if the market price on the asset
has risen substantially in the interim.
• Foreign Exchange Exposure: The purchase of a currency futures or options contract will
allow a firm to make a future purchase of the currency at today’s price, even if the market
price on the currency has risen substantially in the interim.

2. Money Market Hedge

A money market hedge involves simultaneous borrowing and lending activities in two
different currencies to lock in the home currency value of a future foreign currency cash flow.
The simultaneous borrowing and lending activities enable a company to create a home made
forward contract.

3. Forward Market Hedge

In a forward market hedge, a company that has a long position in a foreign currency will sell
the foreign currency forward, whereas a company that has a short position in a foreign
currency will buy the foreign currency forward. In this manner, the company can fix the
dollar value of future foreign currency cash flow.

If funds to fulfill the contract are available on hand or are due to be received by the business,
the hedge is considered to be ‘covered’. In situations where funds to fulfill the contract are
not available but have to be purchased in the spot market at some future date, then such a
hedge is known as ‘uncovered’.

4. Netting

Netting involves associated companies, which trade with each other. The technique is simple.
Group companies merely settle inter affiliate indebtedness for the net amount owing. Gross
intra-group trade, receivables and payables are netted out. The simplest scheme is known as
bilateral netting and involves pairs of companies. Each pair of associates nets out their own
individual positions with each other and cash flows are reduced by the lower of each
company's purchases from or sales to its netting partner. Bilateral netting involves no attempt
to bring in the net positions of other group companies.

25
Netting basically reduces the number of inter company payments and receipts which pass
over the foreign exchanges. Fairly straightforward to operate, the main practical problem in
bilateral netting is usually the decision about which currency to use for settlement.

Netting reduces banking costs and increases central control of inter company settlements. The
reduced number and amount of payments yield savings in terms of buy/sell spreads in the
spot and forward markets and reduced bank charges.

5. Matching
Although netting and matching are terms, which are frequently used interchangeably, there
are distinctions. Netting is a term applied to potential flows within a group of companies
whereas matching can be applied to both intra-group and to third-party balancing.

Matching is a mechanism whereby a company matches its foreign currency inflows with its
foreign currency outflows in respect of amount and approximate timing. Receipts in a
particular currency are used to make payments in that currency thereby reducing the need for
a group of companies to go through the foreign exchange markets to the unmatched portion
of foreign currency cash flows.

The prerequisite for a matching operation is a two-way cash flow in the same foreign
currency within a group of companies; this gives rise to a potential for natural matching. This
should be distinguished from parallel matching, in which the matching is achieved with
receipt and payment in different currencies but these currencies are expected to move closely
together, near enough in parallel.

6. Leading and Lagging

Leading and lagging refers to the adjustment of credit terms between companies. It is mostly
applied with respect to payments between associate companies within a group. Leading
means paying an obligation in advance of the due date. Lagging means delaying payment of
an obligation beyond its due date. Leading and lagging are foreign exchange management
tactics designed to take advantage of expected devaluations and revaluations of currencies.

7. Price Variation

Price variation involves increasing selling prices to counter the adverse effects of exchange
rate change. This tactic raises the question as to why the company has not already raised
prices if it is able to do so. In some countries, price increases are the only legally available
tactic of exposure management.

Let us now concentrate to price variation on inter company trade. Transfer pricing is the term
used to refer to the pricing of goods and services, which change hands within a group of
companies. As an exposure management technique, transfer price variation refers to the
arbitrary pricing of inter company sales of goods and services at a higher or lower price than

26
the fair price, arm’s length price. This fair price will be the market price if there is an existing
market or, if there is not, the price which would be charged to a third party customer.
Taxation authorities, customs and excise departments and exchange control regulations in
most countries require that the arm’s length pricing be used.

8. Invoicing in Foreign Currency

Companies engaged in exporting and importing, whether of goods or services, are concerned
with decisions relating to the currency in which goods and services are invoked. Trading in a
foreign currency gives rise to transaction exposure. Although trading purely in a company's
home currency has the advantage of simplicity, it fails to take account of the fact that the
currency in which goods are invoiced has become an essential aspect of the overall marketing
package given to the customer. Sellers will usually wish to sell in their own currency or the
currency in which they incur cost. This avoids foreign exchange exposure. But buyers'
preferences may be for other currencies. Many markets, such as oil or aluminum, in effect
require that sales be made in the same currency as that quoted by major competitors, which
may not be the seller's own currency. In a buyer's market, sellers tend increasingly to invoice
in the buyer's ideal currency. The closer the seller can approximate the buyer's aims, the
greater chance he or she has to make the sale.

Should the seller elect to invoice in foreign currency, perhaps because the prospective
customer prefers it that way or because sellers tend to follow market leader, then the seller
should choose only a major currency in which there is an active forward market for maturities
at least as long as the payment period. Currencies, which are of limited convertibility,
chronical1y weak or with only a limited forward market, should not be considered.

The seller’s ideal currency is either his own, or one which is stable relative to it. But often the
seller is forced to choose the market leader’s currency. Whatever the chosen currency, it
should certainly be one with a deep forward market. For the buyer, the ideal currency is
usually its own or one that is stable relative to it, or it may be a currency of which the
purchaser has reserves.

9. Asset and Liability Management

This technique can be used to manage balance sheet, income statement or cash flow
exposures. Concentration on cash flow exposure makes economic sense but emphasis on pure
translation exposure is misplaced. Hence our focus here is on asset liability management as a
cash flow exposure management technique.

In essence, asset and liability management can involve aggressive or defensive postures. In
the aggressive attitude, the firm simply increases exposed cash inflows denominated in
currencies expected to be strong or increases exposed cash outflows denominated in weak
currencies. By contrast, the defensive approach involves matching cash inflows and outflows
according to their currency of denomination, irrespective of whether they are in strong or
weak currencies.

10. Arbitrage
27
Arbitrage is not a method of hedging foreign exchange risk in a real sense. It is however a
method of making profits from foreign exchange transactions. The term arbitrage is used in
many areas of finance. It refers to the process of buying and selling of currencies. The
sale/purchase of currencies take place within an unstable market. The prices are affected by
the supply and demand of currencies and arbitrage helps in adjusting the market to
equilibrium. The process of buying in one market and selling the same in another market is
known as arbitrage.

Thus the simple notion in arbitrage is to purchase and sell a currency simultaneously in more
than one foreign exchange markets. Arbitrage profits are the result of (i) the difference in
exchange rates at two different exchange centres, (ii) the difference, due to interest yield
which can be earned at different exchanges. Thus depending upon the nature of deal,
arbitrage may be of space and time arbitrage. The space arbitrage is because of separation of
two exchange markets due to physical dispersion wherein the rates may vary while on the
other hand in the time arbitrage an investor may gain by executing a spot and forward deal to
buy and sell a currency.

28
 Strategies for Exposure Management
A company’s attitude towards risk, financial strength, nature of business, vulnerability to
adverse movements, etc. shapes its exposure management strategies. There can be no single
strategy which is appropriate to all businesses. Four separate strategy options are feasible for
exposure management.

Exposure Management Strategies

1. LOW RISK: LOW REWARD

29
This option involves automatic hedging of exposures in the forward market as soon as they
arise, irrespective of the attractiveness or otherwise of the forward rate. The merits of this
approach are that yields and costs of the transaction are known and there is little risk of cash
flow destabilization. Again, this option doesn't require any investment of management time
or effort. The negative side is that automatic hedging at whatever rates are available is hardly
likely to result into optimum costs. At least some management seems to prefer this strategy
on the grounds that an active management of exposures is not really their business. In the
floating rate era, currencies outside their home countries, in terms of their exchange rate,
have assumed the characteristics of commodities. And business whose costs depend
significantly on commodity prices can hardly afford not to take views on the price of the
commodity. Hence this does not seem to be an optimum strategy.

2. LOW RISK: REASONABLE REWARD

This strategy requires selective hedging of exposures whenever forward rates are attractive
but keeping exposures open whenever they are not. Successful pursuit of this strategy
requires quantification of expectations about the future and the rewards would depend upon
the accuracy of the prediction. This option is similar to an investment strategy of a
combination of bonds and equities with the proportion of the two components depending on
the attractiveness of prices. In foreign exchange exposure terms, hedged positions are similar
to bonds (known costs or yields) and unhedged ones to equities (uncertain returns).

3. HIGH RISK: LOW REWARD

Perhaps the worst strategy is to leave all exposures unhedged. The risk of destabilization of
cash flows is very high. The merit is zero investment of managerial time or effort.

4. HIGH RISK: HIGH REWARD

This strategy involves active trading in the currency market through continuous cancellations
and re-bookings of forward contracts. With exchange controls relaxed in India in recent
times, a few of the larger companies are adopting this strategy. In effect, this requires the
trading function to become a profit centre. This strategy, if it has to be adopted, should be
done in full consciousness of the risks.

30
 Conclusion
Thus, on account of increased globalization of financial markets, risk management has gained
more importance. The benefits of the increased flow of capital between nations include a
better international allocation of capital and greater opportunities to diversify risk. However,
globalization of investment has meant new risks from exchange rates, political actions and
increased interdependence on financial conditions of different countries.

All these factors- increase in exchange rate risk, growth in international trade, globalization
of financial markets, increase in the volatility of exchange rates and growth of multinational
and transnational corporations- combine to make it imperative for today’s financial managers
to study the factors behind the risks of international trade and investment, and the methods of
reducing these risks.

31
 Illustrations

(1)
Illustration: A company operating in a country having the dollar as its unit of currency has
today invoiced sales to an Indian company, the payment being due three months from the
date of invoice. The invoice amount is $ 7,500 and at todays spot rate of $0.025 per Re.1, is
equivalent to Rs. 3,00,000.
It is anticipated that the exchange rate will decline by 10% over the three months period and
in order to protect the dollar proceeds, the importer proposes to take appropriate action
through foreign exchange market. The three months forward rate is quoted as $0.0244 per
Re.1.
You are required to calculate the expected loss and to show, how it can be hedged by forward
contract.
Solution
Calculation of the expected loss due to foreign exchange rate fluctuation

Present Cost
US $7,500 @ today spot rate of US $0.025 per Re. 1 = Rs. 3,00,000

Cost after 3 months

US $7,500 @ expected spot rate of US $0.0225 per Re. 1 = Rs. 3,33,333
(Refer to working note)
Expected loss Rs. 33,333

Forward cover is available today at 1 Re. = US $0.0244 for 3 months

If we take forward cover now for payment after 3 months net amount to be paid is (US $
7,500/0.0244) = Rs.3,07,377

Hence, by forward contract the company can cover Rs. 25,956 (Rs.33,333 – 7,377) i.e. about
78% of the expected loss.

Working Note :

Expected spot rate after 3 months

It is anticipated by the company that the exchange rate will decline by 10% over the three
months period. The expected rate will be Present rate - 10% of the present rate.

32
= US $ 0.025 – 10% of US $ 0.025
= US $ 0.0225
Alternatively, the expected rate may also be calculated as follows:
= US $ 0.025 ×90/100 = US $0.0225

(2)
Illustration: Exporters Plc. a UK company, is due to receive 500,000 Northland dollars in
six month’s time for goods supplied. The company decides to hedge its currency exposure by
using the forward market. The short-term interest rate in the UK is 12% p.a. and the
equivalent rate in Northland is 15%. The spot rate of exchange is 2.5 Northland dollars to the
pound.
Calculate how much Exporters Plc. Actually gains or loses as a result of the hedging
transaction if, at the end of the six months, the pound, in relation to the Northland dollar, has
(i) gained 4%, (ii) lost 2% or (iii) remained stable. You may assume that the forward rate of
exchange simply reflects the interest differential in the two countries (i.e it reflects the
Interest Rate Parity analysis of forward rates).
Solution
First calculate the forward rate of exchange at which the hedging contract is made.

UK company will receive $500,000 in six months’ time.

Assuming an interest rate of 15%, this equates to $465,116.2 at today’s date ($500,000 /
1.075).

$465,116.2 at the spot rate of $2.50 equates to pound 186,046.50

Pound 186,046.50 at an interest rate of 12% would be worth pound 197,209.30 in six months’
time (pound 186,046.50 +1.06). The forward rate is therefore $2.5354 (500,000 /
197,209.30).

The effect on Exporters Plc. In the event of the pound moving in different ways over the six
months period can now be calculated.

(i) If the pound gains 4%, the exchange rate will be $2.60($2.50 × 1.04). $500,000 would
therefore buy only pound 192,307.70. Hedging has saved the company pound
4,901.60 (pound 197,209.30 – pound 192,307.70).

(ii) If the pound loses 2%, the exchange rate will be $2.45 ($2.50 × 0.98). $500,000
would therefore buy pound 204,081.60. Hedging has cost the company pound
6,872.30 (pound 204,081.60 – pound 197,307.70).

(iii) If the pound remains at $2.50, the transaction would realize pound 200,000. Hedging
has therefore cost the company pound 2,790.70 (pound 200,000 – pound 197,209.30).

33
34