Foreign Exchange: Risk-reward Tightrope

As emerging markets became the manufacturing hub for the world, their economies are always vulnerable to foreign exchange volatility. Currency depreciation is double-edged sword. When the rate for US dollar goes up, on one hand it brings in more for the exports, while on the other hand the outlay for import rises simultaneously.

Countries with a favorable balance of trade do not suffer due to foreign exchange (FX) rate fluctuation as much as their counterparts which are net importers. Among the major emerging economies, China, India, and Brazil have sufficient reserves to ride out the storm. Many central banks are defending their currencies to cover high food and fuel imports.

What is Foreign Exchange Risk?

Foreign exchange risk is the risk that becomes a concern with changes in the exchange rate between currencies. Every entity that earns FX shall convert it in its home currency for accounting and transacting purposes.

For example, an exporter based in India that does business with an Australian customer. The financial transactions must be converted to Indian rupee for exporter’s financial statements. Changes in the exchange rate would be the risk, hence the term foreign exchange risk.

Importance of Managing Foreign Exchange Risk

The outbreak of the coronavirus pandemic and the subsequent lockdown in March 2020 marked the start of a period of dramatic change in the economic landscape. Many companies had to completely change how they work, not only in day-to-day business but also in terms of currency hedging. 

The volatility in the currency market is a great leveler, and it is does not give special concessions to first time exporters and importers. Even the experienced entities suffer losses, if they rely entirely on guesswork, when it comes to FX rate fluctuation. If an entity does not proactively manage its FX transactions, the benefits of international trade will eventually get washed away.

Foreign Exchange Management Techniques

Several techniques are available for reducing short-term FX risk exposure, which are suitable for new-to-export SMEs or exporters who are exploring accepting payment in foreign currency. The FX instruments outlined below are available in all major currencies and are offered by numerous commercial banks and FX service providers.

However, some techniques may be impractical or cost prohibitive for certain SME exporters. 

1.  Cash-in-Advance in Foreign Currency

One-way exporters could avoid FX exposure is to demand cash-in-advance payment for foreign currency denominated sales. The exporters can then immediately calculate the expected net proceeds in home currency using the spot exchange rate, which is the current exchange rate of two currencies. 

2.  Natural Hedges

Another way to minimize FX risk exposure is to find natural hedges, that is, matching foreign currency receipts with foreign currency expenditures. For example, an Indian exporter who receives payment in euro from a French buyer may use euro for other purposes such as paying agents’ commissions or paying another French trading partner for supplies. If the euro receipts and payments are comparable in value, FX risk is minimized as the exporter will rarely need to convert euro into Indian rupee. The risk is further reduced if those euro denominated transactions are conducted on a regular basis.

3.  FX Forward Hedge

The most popular way of hedging FX risk is using a forward contract, which enables the exporter to sell a set amount of foreign currency at a pre-determined exchange rate at a pre-specified time in the future with a delivery date from three days to one year into the future. 

For example, an Indian exporter agrees to accept payment in dollar for 10,000 dollars’ worth of goods sold to an American company on a 60-day term. In fear of dollar exchange rate falling in the next 60 days, the Indian exporter engages in a forward contract today at the forward exchange rate of one dollar to 80 Indian rupees. 

This forward contract helps the Indian exporter minimize FX risk exposure by ensuring the conversion of 10,000 dollars to 8,00,000 Indian rupees, regardless of what happens to the dollar-rupee exchange rate in 60 days.

4.  FX Options Hedge

If an exporter has a large transaction quoted in foreign currency and/or there exists a significant time between quote and acceptance of the offer, an FX option may be worth considering. For an exporter, using FX option to hedge currency risk is like buying insurance against foreign currency depreciation. 

Under an FX option, the exporter acquires the right, but not the obligation, to exchange the foreign currency into home currency at a specified rate on or before the expiration date of the option. As opposed to a forward contract, the exporter who purchases an FX option must pay a premium, which is like an insurance premium. If the value of the foreign currency goes down, the exporter is protected from the loss. 

On the other hand, if the value of the foreign currency goes up, the exporter simply walks away from the option contract and sells the foreign currency at a more favorable rate in the spot market. While FX options provide flexibility, they are more costly than FX forward contracts.

Better Safe Than Sorry

Geo-political developments, monetary policy action, extreme weather events, default risk, etc. are some of the factors that bring wild swings in the currency market. If history is an accurate guide, such events will never cease to exist. To safeguard financial interests, entities involved in international trade should follow time-tested techniques.