Management of the Foreign Currency Exposoure

Exposure management

Once the importer or exporter has a fixed contract for the import or
export of goods or services, foreign currency exposure of the local
currency versus the foreign currency commences and becomes an
issue. The issues are:

· denomination of the foreign currency payable or receivable, i.e.
euro, US dollar, yen, etc.,
· amount,
· due date.

Consideration of whether to eliminate (hedge) the exposure now
becomes necessary. Taking action at this stage of the import/export
process enables the business to:

· eliminate possible losses due to exchange rate fluctuation,
· price the goods or commodity in advance, and
· avoid speculation.

In order to eliminate all foreign exchange risk, hedging is
recommended. The simplest and most usual form of forex hedge is the
“forward exchange contract”. A forward exchange contract is an
agreement between a bank and a counterpart:

· to exchange a fixed amount of one currency for another,
· at an agreed rate,
· for value at a fixed date in the future.

This gives business the opportunity to hedge against possible losses
due to future fluctuations in foreign exchange rates. This will enable:

· the importer to fix costs of imports, materials or capital goods at
agreed rates on due date and determine pricing strategy in
advance,
· the exporter to fix local currency proceeds of export sales and
possibly to obtain exchange rates better than spot if interest
differentials permit.


In practice, this requires some familiarity, but the rule is actually quite
simple. Where the interest rate of the local currency is higher than the
interest rate of the foreign currency, the foreign currency will sell at a
premium to the local currency in the forward market versus the spot
market. That is, the importer who has to buy foreign currency forward will, in
this case, have to pay more local currency for the foreign currency in
the forward market (a premium) than in the spot market.
For the exporter who wishes to sell this foreign currency forward, the
case is the opposite. He will receive more local currency in the
forward market than by selling it spot. The difference will of course be
equal to the interest rate differential between the two currencies.
Taking the above example, the importer will have to pay $1.0421 per
euro forward, compared to $1.0350 spot, a premium of $0.0071.
Similarly, the exporter to Eurozone, who will be receiving euro, will
be able to enter a forward sale of euro at a rate of $1.0421, a premium
of $0.0071 over spot.
The opposite of the above is, of course, also true; that is, where the
interest rate of the local currency is lower than the interest rate of the
foreign currency, the foreign currency will sell at a discount to the
local currency in the forward market versus the spot market.
By remembering this simple relationship, businessmen will be able to
determine fairly easily whether forward cover of foreign currency
exposures will be available at a premium or discount versus spot
cover.
Other hedging alternatives
As mentioned above, the simplest and most usual form of forex hedge
is the forward contract. This of course fixes the exchange rate between
the parties and is a commitment to exchange currencies at a future
date at an agreed rate.

Other forms of hedging are possible where more flexibility is required,
but this usually involves the use of “currency options” which give the
buyer the right rather than the obligation to exchange currencies at an
agreed rate. For this flexibility and privilege there is usually a fee.
Furthermore, there is usually the need for a fairly sophisticated
banking system to deliver such products, so the availability and
suitability is best discussed with the company’s bankers.