exchange rate risk hedging

8/8/2019 Exchange Rate Risk Hedging

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INTERNAL HEDGING STRATEGIES

BY: MEHUL DUBEY&

SHRIRAM KESHRI


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Exchange rate risk hedging

The variability of exchange rates gives rise to

the foreign exchange risk.

This is the risk which affect the businessoperation or the value of an investment assets

and liabilities.

Also called currency risk.


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Hedging

Hedging refers to covering of transaction risk.

It provides a mechanism to exporter and

importer .To guard them selves against losses

arising from fluctuation in exchange rates.


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The situations when hedging may beused

Hedgingtransactionexposure.

Hedgingbalancesheetexposure.

Hedgingeconomicexposure.


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Hedging techniques

Broadlyclassifiedintointernalandexternal

hedgingtechniques,thevariousinternal

hedgingtechniquesare :

Exposurenetting

Cross Hedging

Denominationinlocalcurrency

Foreigncurrencyaccounts

Leadsandlags


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Exposure Netting

Offsetting exposure in one currency with

exposure in the same or another currency.

When exchange rates are expected to move insuch a way that losses or gains on the first

expose position should be offset by gains or

losses on the second currency exposure.


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For instance:

US dollar and Swiss Franc are expected to

appreciate.

The company has receivables ofUSD 5 million.

It can manage its exposure by havingequivalent amount as payable in Franc.


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Cross Hedging

Crosshedgingisusedtomanageexposurein

minorcurrencies.

Takingpositionindifferent (proxy)currency.

Currenciesarehighlycorrelatedandmove

similarly.

Effectivenessdependsonpositivecorrelationof

theproxycurrencyandoriginalcurrency.


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For instance:

An Indianfirmhasexpectstoreceive 5 million

pesosin 180 days.

Forwardrateforbothcurrencyisnotavailable.

Thefirmwillhedgebysellingforwardtheequivalenthighlycorrelatedcurrencyforsame

timeperiod.


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Denomination in local currency

Effectively transfers all foreign exchange risk to

the other party in the business transaction.

The other party may charge a higher price to

compensate for the extra risk.

Invoicing in local currency depends upon the

relatives bargaining capacity of the importer and

exporter and the status of the currency

concerned in the international market.


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For instance:

Ifexportsfrom Indiaareinvoicedin Indian

rupees,theobligationoftheimporterisfixed

sumofrupees.

Theexporterisnotaffectedbyanymovement

inexchangerate.

Theimporteronotherhand,willbebearing

exchangeriskentirely.

Hemayhavetopaymoreintermsofthe

currencyofhiscountryifthatcurrency

depreciates.


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Foreign Currency Accounts

A traderwhoengagesinbothexportandimports,theexchangeriskcanbeminimizedifanaccountismaintainedabroad,inthecurrencyoftrade,throughwhichalltransactionscanberouted.

a) Exportscanpayfor Imports.

b)Theywillapplybuyingrateforexportsandsellingrateforimports,withtheusualspreadbetweentheratestowardsmargin.


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In Indiaunderthe Exchange EarnerForeign

Currency (EEFC)accountscheme:

Inwardremittanceisentitledtoretainupto100% forremittancereceived.

A firmlocatedin Special Economic Zone

(SEZ) isallowedtomaintainforeigncurrency

accountwithabankin India.Thebenefitis

similartothatunder EEFCaccount.


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Leads and Lags

Leadingandlaggingforeignexchange

transactions

Leading

Changingthetimingofacashflowsothatittakesplacepriortotheoriginallyagreed

date.

e.g.paya USD payablebeforean

expected AUD depreciation.


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Lagging

DelayingthetimingofanexistingFXcash

flow.

e.g.delaya USD payabletocoincidewith

a USD receivable.

Needtoassesscosts/impactofstrategies,

e.g.unpredictablepaymentbehavior


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Conclusion

Hedgingatransactionexposurecanbedoneto

managetransactionexposureistominimizethe

possibilityoflossandretaintotheextent

possible theopportunitytogainfromexchange

ratechanges.

exchange rate risk hedging

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