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Exchange risk management
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Exchange risk management

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It reveals the concepts of EXchange risk management and ways to hedge..

It reveals the concepts of EXchange risk management and ways to hedge..

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  • 1. EXCERPTS OF EXCHANGE RISK MANAGEMENTINTRODUCTION Today most of the nations are globalized. Every nation, in need of enlarging theireconomy in the competitive world, wants to attract the investment from the rest of the world inorder to be flourished in the each industry. In another side, the corporation which is having broad vision as to enhance their operationacross the nations would want to expand the business for the various causes such as export andimport of goods & service including ideas etc. As every nation doesn’t have all the resources thatare needed to satisfy themselves, the corporate in the nation might want to exchange the goods &services in order to earn more profit.In the process of export & import between the nations, there arises the problem of imbalancebetween the currencies of the two nations. As there is fluctuation in the value of currencies whichvarious countries adopt different currency, the problem occurs in the money value exchangingbetween the corporates. In exchanging the money, numerous factors and risks are to beconsidered.EXCHANGE EXPOSURE Exchange exposure is an extent to which transaction, assets and liabilities of an enterpriseare denominated in currencies other than the reporting currency of the enterprise itself. Theexposure relates to the absolute the value of an asset or liability, involved of the company.Specifically speaking, transaction exposure rather than translation exposure must be analyzedvery well in order to overcome variation in exchanging money. Transaction exposure is open to analyze numerous factor i.e. Both Capital and Revenue in nature All Interest Payments/ Receipts All Open hedge transactions Both Capital and Revenue in natureMARKET FORECASTS In the export/import business, many uncertainty overcurrency concerned with the nationof export and import of firm are realized when we dealing with them. The fluctuation in thecurrency market are greater dealt with. The firm must have insight in the currency market as toexchange the money. All the exporters/importers are engaged into gaining maximum value ofmoney.
  • 2. RISK APPRAISAL This word or phrase is aimed at determining where the companys exposures stand vis-à-vis market forecasts.The following Risks will be considered. 1. Value at Risk(VAR) VAR tries to determine by how much the company’s underlying cash flows are affected. Even though the value of money is worth small to larger, factor is weighted to determine the exchange. 2. Forecasting risk What is the likelihood of the rate actually moving to xx.xxxx and what is the likelihood of a forecast going wrong. It is imperative to know this before deciding on a Benchmark and devising a hedging strategy. 3. Systems risk The system risk is nothing but the risk arises through the weakness or gap in the exposuremanagement system. When there are delays/ errors in reporting exposures to the ExposureManagement cell, that is called reporting gap. When there is a gap between the decision to hedgeand the implementation of such hedge decision, that risk will be implementation risk.BENCHMARK The company will set a Benchmark for its Exposure Management practices. As in Indiathe maximum period for transaction or contract is 6 months allowed by RBI, the benchmark willbe set by 6 months. All the error & risk will be predetermined earlier. The objective of exposuremanagement is to function on whether profit basis or cost basis. Companies whose exposures are of long-term Capital nature can look to manage them ona Profit Centre basis, since the exposures are not open to day-to-day business risks. Companieswhose exposures are of short-term Revenue nature should manage them on a Cost Centre basis,since the exposures impact the P&L Account directly.HEDGING As international exchange monetary is dealt with risk factors that are concerned withinternational, the firm must take appropriate steps to safeguard their foreign exchange money. Asthe value increases, the firm must apt proper hedge as measure to overcome the exposure. Herethe hedging strategies would be formulated to attain the benchmark where the stop-loss, takeprofit is predetermined. The diversified ways are discussed below
  • 3. I. Forward contracts With the foreign exchange bank, the corporate would create the contract which enables the corporate get the foreign currency at predetermined rate at time when agreed. This is one type of instrument of hedging which most of the exporting firm uses nowadays. II. Cross currency forward contracts In order to avoid the risk between the domestic currency and foreign currency, the firm would keep the money exchanged into another currency that is riskless. This case is usually applied to the place where the firm forecasts that there will be fluctuation in the domestic the currency. III. Forward rate agreement A forward rate agreement is notionally an agreement between two parties in which one of them (the seller of FRA) contracts to lend to the other (the buyer), a specified amount of funds, in a specific currency, for a specified period starting at a specified future date, at an interest rate fixed at the time of agreement. IV. Currency swaps A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. This method is used to reduce the risk of exchange in borrowing the money abroad. So the both party’s finance cost is in the domestic currency. V. Convenient agreement with the party The party can make the foreign party to give the contract convenient in such way as to minimize the risk. The export party would force the import party to pay the money in the domestic currency. Usually as more demand for such product, the exporting party would not like to involve with the more foreign exchange risk. VI. Interest rate swap An interest rate swap (IRS) is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to anotherVII. Foreign exchange option Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.VIII. Foreign debt Foreign debt can be used to hedge foreign exchange exposure by taking advantage of foreign loan. Suppose the domestic firm is yet to convert the money from the foreign. As the forecasted domestic currency appreciates, instead of converting them, they borrow the money from foreign by now. When they realize the money, they pay it to the concerned
  • 4. lending party. But here the interest payment (in foreign currency) must be equalized to the gains realized by investing proceeds from the loan.STOP LOSS In exchange risk management, the stop-loss function should be activated. Stop loss orderis an important tool of forex risk management in currency trading. A stop-loss order containsinstructions to exit your position if the price reaches a certain point.You need to set up strict stop-loss limits for your losing trades, so that you dont lose more thanyou can handle. If the market starts going in the wrong direction, dont close that position andcancel the order. Know more about stop loss risk management in forex and maximize your profitwhile trading forex. Stop loss in currency trading is one good option to reduce your risk whiletrading in forex.REPORTING AND REVIEW The report must be recorded, summarized, analyzed in the periodical manner. It must be acontinuous process to analyze the currency value. It must be ensured that exposure are headedwhere they are intended to reach. The reports like MTM report, exposure NAV report, VARreport are prepared to analyze the trend value of currency. Market situation, benchmarking,hedging strategy, operational issues are considered here.CONCLUSION In every export/import company, the exchange risk must be analyzed very well in order toavoid the loss. In India, the maximum duration is 6 months for currency trading fixed by the RBI.So within the period, they could use the above tool to overcome the exchange risk. ExposureManagement is an essential part of business and should be viewed with Objectivity.