Currency Risk Management
HOW IMPORTER CAN MANAGE CURRENCY RISK
Any individual or business that deals with foreign currency is exposed to forex risk. An importer or a foreign borrower has payables in foreign currency. An importer or a foreign currency borrower will have to hedge his business against a weakening of the rupee.
An importer will have a dollar payable at a future date. Therefore, they need to ensure that the INR does not depreciate too much as it will mean that they will require more rupees to get the equivalent amount of dollars.
Usually, Importer needs to make payment in 3-4 months. But during that month USD/INR can go up or down which is unpredictable so it can hedge their risk by buying the USD-INR. No one knows about the future so ,it is better to hedge (Like when you buy car you take car insurance before even thinking of future loss)
FX Risk Involve while importing are as follows:
- Transaction Exposure: Concerned with the risk of loss due to adverse foreign exchange rate movement that affects the domestic currency value of imports and exports contracts that are denominated in the foreign currency. (Payment in future period)
- Translation exposure:It is pure accounting issue involving risks that may arise due to adverse currency movements that are likely to affect the value of assets, liabilities and other income statement transactions when preparing the consolidated financial statements.
- Economic(operating) exposure: relates to ongoing risks that a firm’s cash flows, foreign investments, and earnings may be negatively impacted as a result of fluctuating foreign currency exchange rates.
- Margin: Importer has to give margin to bank for doing transactions of currency conversion.
- Costing: Due to currency fluctuation costing is affected if not hedged.
- Premium: Interest rate differential. Any change in interest rates may result in increase in premium thus increasing the forward rates if left unhedged.
CASE STUDY
M/s Anuj Timbers imports wood from Africa and supplies to Indian Companies for Making Furniture. He has got an order to import teakwood. He enquires from his supplier and finds that the cost of wood is total $ 1,000,000. His Payment terms are payment on receiving shipment which is normally 1 month.
Current Spot rate is 78.60 and 1 Month Forward is at 78.80, He assumes a cost of Rs.78.90 per dollar as his cost and quotes a rate of 79.00 keeping a profit margin of 20 paise The Risk he carries is if Dollar rupee goes above 78.90 in 1 month then his profit will start getting reduced and if it crosses 79.00, he incurs a loss in his deal.
Hedging Process
Using Forward Contract
He buys USD 1 Million Dollar in forward date at 78.80 and locks a profit of 20 paise
Using Currency Futures
Amount USD 1,000,000 1 lot = $ 1,000 No of lots = 1,000
He Buys 1,000 lots of one month Expiry at 78.80 thus locking a profit of 0.20 paise in this deal
SCENARIO ANALYSIS
|
HEDGED |
UNHEDGED |
|||
| Rate | Exchange or Bank | Cash Flow | EXCHANGE | BANK |
| 78.75 |
78.80 |
20 paise Profit |
0 |
78.80 – 78.75 = 5 paise Profit |
| 79.00 |
78.80 |
20 paise Profit |
0 |
78.80 – 79.00 = 20 paise Loss |
| 79.50 |
78.80 |
20 paise Profit |
0 |
78.80 – 79.50 = 70 paise loss |
| 80.00 |
78.80 |
20 paise Profit |
0 |
78.80 – 80.00 = 1.20 paise loss |
As we can see that by hedging, the company is able to protect the 20 paise profit in the trade. We recommend importers having import exposures to use Bank Forwards / future contract for Managing Risk More efficiently.
