Question

8.What are the risk management tools in exchange risk management. Explain

Answer 1

Answer:-

The risk management tools in exchange risk management are

1) Forward contracts :-

The forward contract in the commitment that a buyer and the seller make to buy or sell the currency at a later date. This removes the risk of change in exchange rates.These are not standardized and bear a risk of default in case one party does not performs the action.

2) Future contracts:-

The future contracts are contracts that are standardized and trade on organized future exchanges on a specific date and do not have any risk. The future contract cost is based on bid/offer spread of currency.

3) Swap:-

The swaps are used to hedge the currency fluctuations which might adversely effect the profitability of companies. In currency swaps there is an agreement to exchange one currency for another at a specified rate and date. Currency swaps are carried out and intermediated by investment firms or big banks.

4) Currency Options:-

This currency options gives the holder to buy or sell a fixed amount of currency at an agreed price within the given time. An option is an agreement made by buyer and a seller that entitles the holder the right but not the obligation to buy or sell financial instruments at a time through a specified date, however the seller should fulfill the obligation.

Answer 2

Four main risk management technique tools to manage foreign exchange risk. The techniques are: 1. Forward contracts 2. Future contracts 3. Options 4. Swap.

Foreign Exchange Risk: Technique # 1.

Forward contracts:

A forward contract is a commitment to buy or sell a specific amount of foreign currency at a later date or within a specific time period and at an exchange rate stipulated when the transaction is struck. The delivery or receipt of the currency takes place on the agreed forward value date.

A forward transaction cannot be cancelled but can be closed out at any time by the repurchase or sale of the foreign currency amount on the value date originally agreed upon. Any resultant gains or losses are realized on this date.

Generally, there is variation in the forward price and spot price of a currency. In case the forward price is higher than the spot price, a forward premium is used whereas if the forward price is lower, a forward discount is used.

To compute annual percentage premium or discount, the following formula may be used:

Forward premium or discount = (Forward rate – Spot rate)/Spot rate x 360/Number of days under the forward contract

In this formula, the exchange rate is expressed in terms of domestic currency units per unit of foreign currency. To illustrate, if the spot price of 1 US dollar is Indian rupees 39.3750 on a given date and its 180-day forward price quoted is Rs 39.8350, the annualized forward premium works out to 0.92, as under:

Forward premium or discount = (39.8350 – 39.3750) * 360/180 = 0.92

The forward differential is known as swap rate. By adding the premium (in points) to or subtracting the discounts (in points) from the spot rate, the swap rate can be converted into an outright rate. These forward premiums and discounts reflect the interest rate differentials between the respective currencies in the inter-bank market.

If a currency with higher interest rates is sold forward, sellers enjoy the advantage of holding on to the higher earning currency during the period between agreeing upon the transaction and its maturity.

Buyers are at a disadvantage since they must wait until they can obtain the higher earning currency. The interest rate disadvantage is offset by the forward discount. In the forward market, currencies are bought and sold for future delivery, usually a month, three months, six months, or even more from the date of transaction.

Foreign Exchange Risk: Technique # 2.

Future contracts:

Commonly used by MNEs as hedging instruments, future contracts are standardized contracts that trade on organized futures markets for a specific delivery date only.

The major difference in forward and future markets is summarized as follows:

i. The forward contract does not have lot size and is tailored to the need of the exporter, whereas the futures have standardized round lots.

ii. The date of delivery in forward contracts is negotiable, whereas future contracts are for particular delivery dates only.

iii. The contract cost in future contracts is based on the bid/offer spread, whereas brokerage fee is charged for futures trading.

iv. The settlement of forward contracts is carried out only on expiration date, whereas profits or losses are paid daily in case of futures at the close of trading.

v. Forward contracts are issued by commercial banks, whereas international monetary markets (for example, the Chicago Mercantile Exchange) or foreign exchanges issue futures contracts.

Foreign Exchange Risk: Technique # 3.

Options:

Foreign currency options provide the holder the right to buy or sell a fixed amount of foreign currency at a pre-arranged price, within a given time. An option is an agreement between a holder (buyer) and a writer (seller) that gives the holder the right, but not the obligation, to buy or sell financial instruments at a time through a specified date.

Thus, under an option, although the buyer is under no obligation to buy or sell the currency, the seller is obliged to fulfill the obligation.

This provides the flexibility to the holder of a foreign currency option not to buy or sell the foreign currency at the pre-determined price, unlike in a forward contract, if it is not profitable. Price at which the option is exercised, i.e., at which a foreign currency is bought or sold, is known as strike price. Both currency call and put options can be purchased on an exchange.

There are two types of foreign currency options:

Call option gives the holder the right to buy foreign currency at a pre-determined price. It is used to hedge future payables. Put option gives the holder the right to sell foreign currency at a pre-determined price. It is used to hedge future receivables.

Foreign currency options are used as effective hedging instruments against exchange- rate risks as they offer more flexibility than forward or future contracts because no obligation is required on the part of the buyer under the currency options.

Foreign Exchange Risk: Technique # 4.

Swap:

In order to hedge long-term transactions to currency rate fluctuations, currency swaps are used. Agreement to exchange one currency for another at a specified exchange rate and date is termed as currency swap. Currency swaps between two parties are often intermediated by banks or large investment firms. .

Foreign exchange swap accounts for about 55.6 per cent of the average daily foreign exchange turnover of the world, whereas spot deals account for 32.6 per cent and outright forward for 11.7 per cent.

Buying a currency at a lower rate in one market for immediate resale at higher rate in another with an objective to make profit from divergence in exchange rates in different money markets is known as ‘currency arbitrage’. To capitalize on discrepancy in quoted prices, arbitrage is often used to make risk less profits.