CURRENCY RISK MANAGEMENT-EXPORT TRANSACTION



CURRENCY RISK MANAGEMENT-EXPORT TRANSACTION

Prof. Harkirat Singh

IIFT, New Delhi

LEARNING OBJECTIVES

• Understand Currency risk management and its implication on profits

• Understanding exposure parameters

• Factors affecting transaction exposure

• Understanding hedging instruments in currency risk management

• Use of forward Contracts in Currency Risk Management

• Inputs for developing Currency Risk Management Strategy

• Understanding Implication of Daily Scan Report, Monthly Risk Sheet, Order Sheet etc

INTRODUCTION

The Exchange rates of major currencies fluctuate in highly an unpredictable manner under the influence of demand and supply forces. Sometimes markets witness ay high percentage of change in exchange rates in short periods. Extreme movement in exchange rates have the potential to eliminate the profit factor from export transactions.

Each exporter, invoicing in foreign currency, with a condition to receive payment in the future has ‘Transaction Exposures’. This process transfers the currency risk from the foreign buyer to the exporter. Normally the exposure period starts with conversion of Rupee cost to sale price in foreign currency and terminates, when export sale proceeds are credited to the current a/c of the exporter by the bank.

Exchange rates of foreign currency during the exposure period may change in favour or against the interest of the exporter. Covering, the foreign exchange risk due to adverse change in exchange ratess, is termed as hedging the currency risk. If the exporter does not want to hedge the currency risk it means that the expectation is that the future movement of exchange rates will be in favour of the exporter. Depending on such views may lead to heavy losses.

Management of Currency risk in export-trade transaction depends on factors as appended below:

• Nature of Invoice Currency

• Amount of Currency

• Exposure Period

• Hedging Instruments

• Selection of Bank’s Branch

• Hedging System

Nature of Invoicing Currency

Selection of invoice currency not only shifts the risk to the exporter but also brings the responsibility of managing currency exposure. Exports in USD exposes to currency risk due to adverse movements of USD/INR exchange rates only, during the exposure period. Whereas invoice in non USD currency will expose to two currency risk: one changes in USD/EUR exchange rates in international Forex Markets secondly change in USD/INR exchange rates in local Forex markets. Adverse change of exchange rates in these two different markets enhance the currency risk in case of non USD and business transactions.

Exporters should note that foreign currency for its trade transaction, at any point in time, will fall in one of the following market conditions:

a. Strengthening Trend with Forward Premiums

Both the factors are in favour of the exporter. With the passage of times market, will produce better exchange rates for exporters. Hedging policy may be to wait and watch till exchange rates and forward margins move in favour of the exporter. Cover the exposure on reversal of the exchange rate trends in consultation with a banker/forex expert.

b. Weakening Trend with Forward Discounts

Both factors are against the business interest of the exporter. Hedge the exposure immediately. Delays may lead to avoidable losses. Banks provide free consultant services and share forex market information and suggestions.

c. Uncertain Trends

Selective hedging strategy in uncertain exchange rate movements has been found to be profitable. Some portion of the exposure, based on short term forecasting, is covered and balance is retained.

The portion of covered and uncovered exposures are changed by cancellation and rebooking the hedge depending upon short term exchange rate changes. Quantum and timing of hedge is based on forex market conditions and forecasting by experts.

Bank are cheap and the best source of understanding market trends and providing support for risk cover operations. Exporters should try to conduct business in a strong currency.

Amount of Exposure

Banks provide card exchange rates for small transactions. These rates are calculated by loading heavy margins and are adverse for exporters. Banks quote better exchange rates based on ongoing market rates for higher export transactions. In case of market lots transaction, the exporter gets market rate loaded by a few paisa only. Better rate creates more cash flow for exporters.

Exporters should negotiate with bankers in each export transaction, for better exchange rate based on ongoing market rate. Avoid wherever possible, the application of banks’ card rates.

Exposure Period

Normally exposure period starts with the converting of Rupee cost to foreign currency sale’s price, covering following activities/stages and ends with receipt of Rupee payment in bank’s account.

EXPOSURE PERIOD FOR EXPORT TANSACTION

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Exporters should note carefully that Exposure Period is longer than the tenor of the export bill or credit offered to the Foreign Buyer. The longer the Exposure Period the higher the uncertainty and currency risk.

In case invoiced foreign currency is on premium against Rupee, take the benefit of higher exchange rates rather than spot rates offered by banks. The longer the period of credit, the better is the exchange rate for exporter.

In a long period, export receivable in case of premium currency must be hedged to avoid uncertainties and loss due to adverse movement of exchange rate during exposure period. Some exporters hedge the exposure risks, when they get better rates than forward exchange rates available on date of conversion of costs to foreign currency sale’s price.

Monitoring the exchange rate movements during exposure period also provides an opportunity to earn extra profits by obtaining and lifting the hedge depending upon exchange rate trends.

From experience, it has been observed that exporters may cover exposure on Fridays, last weekdays of a fortnight or the month end to get better exchange rates. Usually there is heavy demand for US $ in these days causing upward trend in exchange rates and good time for exporters to cover a risk.

Hedging Instruments

Various hedging instruments traded on the counter and at the exchange houses are available for hedging the Currency Risk. Selection of hedging instrument for exports depends upon availability, flexibility and cost. The most common and exporter friendly hedging instrument in India is Forward Purchase Contract offered by banks.

Forward Purchase Contract

Banks provide on the counter derivative, Forward Purchase Contract for Exporters. Forward purchase contract is a firm agreement by the exporter to deliver a fixed amount of Foreign Currency at a future date at prior and fixed exchange rate. It is a firm and binding contract. Banks do not charge any upfront commission and book the contract, from small to large amounts. Only very small handling charges (approx. Rs. 250 per Contract) is charged irrespective of the amount.

Exporter should take uncertainties pertaining to exchange rates movements as a Threat to Profit and transfer the currency risk to a bank by booking the forward purchase contract. During the cover period exchange rates may move against the interest of the exporter but it will still get the contracted rate.

The main disadvantage of a forward contact is that the exporter is denied to gain the benefit of favourable exchange rate movements during the covered period.

Booking of Forward Contract

1. Only bank customers are eligible for booking forward contracts.

2. Forward contracts are offered by the banks for expected export proceeds already made or to be made. Where shipment is already made, forward contract shall be booked on the basis of export bills tendered to banks. In other cases, forward contacts are booked on the basis of the track record of the exporter.

3. Choice of currency and tenor of exposure period are left upto the requirement/decision of the exporter. Further, maturity of the cover period should not exceed the maturity of the export transaction. The maturity of export bills is calculated as under:

Cover Period=Period of Usance + Normal Transaction Period + Grace Period (if any)

4. Exporters are permitted to split the hedging to cover the exposure partially and balance to remain uncovered.

5. Exporters are permitted to book forward contracts with a fixed date or option period delivery of foreign exchange amount. Maximum option period of one month is given that too in the last month.

6. Exporters are free to foreclose the forward contract at any time before maturity. Any loss or gain will be passed on to the exporter. Some exporter have developed expertise in booking, cancelling and rebooking of forward contacts to generate extra cash flow.

7. Forward purchase contracts may be freely booked, cancelled any time before maturity, rolled over at the ongoing markets without any restrictions.

8. Exporters are permitted to transfer the exchange risk to third currency with the objective to achieve better exchange rates. Exporter with exposure in Euro can hedge the currency in any of the following manners:

i) Sell Euro against INR Currency risk is full covered

ii) Sell Euro against USD In this exporter is exposed to USD against

INR exchange rate

iii) Sell USD against INR In this case exporter is exposed to EURO/

USD exchange rate

In this case firstly exporter converted his Euro receivable into USD recoverable and by selling USD against INR immediately or during any time of exposure. Same approach can also be applied. This facility is applied to arrive at a better rate than covering directly against INR.

Selection of Bank’s Branch

The success of an exporter depends upon the right choice of the branch of the bank. Exporters should select a branch of the bank which is authorised to deal in foreign exchange business or is an international banking division. It should have trained experienced staff with SWIFT address and facility.

Exporters should develop professional relations with forex merchant dealer appointed in the branch or the forex dealer of the bank visiting them will make exporters more wise and professional to negotiate for better rates based on ongoing market exchange rates for each export transaction. They should bring cases of delayed export payments and better exchange rates offered by other banks to improve upon these services by the bank. Market competition will bring good results for efforts. Bankers normally take the benefit of knowledge gaps of exporters, especially in the area of quoting better exchange rates for exports.

The best branch of the bank to deal with is an “A” category branch in Metropolitan city with SWIFT facility & having the best-feedback form exporters.

Hedging Systems

Export organisation depending upon the resources, must develop some hedging system, which will help in monitoring exchange rate movements and to take timely hedge actions. It is found from the experience of exporters that even spending 15 to 20 minutes a week scanning of currency rates create more profits from export business.

For developing currency risk management strategies and skills to take timely hedging action, the following reports have been found to be useful:

Daily Scan Reports of Exchange Rates

Prepare a daily scan report with the help of the information obtained from banks or input available in daily financial newspapers. Exporters may analyse on a daily or weekly basis, this report to find the trend or factors affecting exchange rates.

Exporters have to study & understand markets and factors affecting exchange rates. Expertise has to be developed in risk management to take right hedging decisions and to secure better exchange rates to improve cash inflow. Watch trade & political news, monitor economical & fiscal policies of major countries of the world & also those countries in whose currency exporters do business.

Daily scan reports help in developing a currency view and timing of taking hedging decisions

Daily Scan Report

DATE:

|CURRENCY | | | | | |

| | | | | | |

Brief Market Comments

Mainly covering the factors influencing the exchange rate of currencies in local and foreign markets.

Monthly Risk Report

Monthly risk report should contain information currency wise covering projections of export & imports that will take place on a monthly basis. The report will provide the net figure of monthly exports & imports. Conservative exporters may take policy decisions to hedge gaps by booking or selling forward covers with banks. Aggressive exporters depending upon exchange rate forecasting information, may book export and import transactions separately on a monthly basis.

Monthly Risks Report

|MONTH |EXPORTS |IMPORTS |GAP |

| | | | |

| | | | |

|JANUARY | | | |

| | | | |

|FEBURARY | | | |

| | | | |

|MARCH | | | |

| | | | |

|APRIL | | | |

| | | | |

|MAY | | | |

| | | | |

|JUNE | | | |

| | | | |

|JULY | | | |

| | | | |

|AUGUST | | | |

| | | | |

|SEPTEMBER | | | |

| | | | |

|OCTOBER | | | |

| | | | |

|NOVEMBER | | | |

| | | | |

|DECEMBER | | | |

Order Sheet

|Order |Date of Order |Foreign Buyer |Currency |Budgeted Rate |Market Forward Rate |

|No. | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

| | | | | | |

Order sheet contains information on the basis of export orders obtained from foreign buyers. It also contains information about the budgeted rate which is the rate applied by exporters to convert costs into foreign currency sale’s price. The column ‘market forward exchange’ is provided to note down the forward hedging rate available on the date of application of the budgeted rate.

Information contained in order sheet will help in:

- Taking decisions to hedge the currency exposure

- Measure the performance of the hedging action

- Use booking, cancelling & rebooking facility to generate more cash inflows

- Budgeted Rate & Market Forward Rate will be treated as reference rates for hedging

decision

Summary

- Exchange rates of major currencies fluctuate with change in demand & supply position of concerned currencies

- Exchange rates has the capacity to translate profit from international business transactions into loss or vice versa

- Currency Risk depends upon Nature of Currency, amount, exposure period and use of internal and external hedging techniques. Forward Contract instrument offered by commercial banks is used by exporters/importers for currency risk management. It is easy to understand, cheap and latest RBI relaxation provide opportunities to create wealth from exchange rate movements.

- To cover currency risk, a company has to develop an information input system as timely decisions are essential for currency risk management and for wealth creation from exchange rate movements.

Assignments

- Why is an understanding of currency risk essential for exporter?

- Comment on main the factors which influence international trade transaction having currency risk.

- What is exposure period and mention the main stages of this period?

- What are the main features of Forward Contract offered by banks? Why is it selected by exporters/importers as protection against currency risk?

- Name the different types of inputs required for Currency Risk Management.

Key Words

• Fluctuation: Unexpected upward or downward change in exchange rates.

• Invoice Currency: Foreign Currency in which export or import transaction is conducted.

• Hedging: Action taken to stop loss created by exchange rates changes.

• Premium: When exchange rate of a foreign currency is higher for future values than spot rate.

• Discount: When exchange rate of a foreign currency is lower for future values than spot rate.

• Strengthening Trend: When foreign currency is under buying pressure.

• Weakening Trend: When foreign currency is under selling pressure.

• Hedging Instruments: Derivatives used for covering currency risk.

• Booking Forward Contract: Exporter covering exchange risk with bank for export transaction.

• Scan: Analysing daily exchange rates movements.

• GAP: Difference between exports and imports transactions in a particular month.

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