International Finance – II April 19, 2010Posted by Chetan Chitre in International Business Management, International Finance.
Tags: Forex Risks
Foreign Exchange Market – Introduction
In India the Forex Market Functions at 3 Levels –
Level 1 – Deals between RBI and Authorized Dealers
Level 2 – Deals between Authorized Dealers
Level 3 – Authorized Dealers and Corporates (or Merchant Establishments)
The Authorized Dealers are further classified in 3 categories by the RBI –
Category I – includes all Scheduled Commercial Banks, State Co-operative Banks, Urban Co-operative Banks – These are allowed to conduct forex related transaction pertaining to all permissible current a/c and capital a/c purposes.
Category II – includes all co-operative banks other than State Co-operative and Urban C-operative Banks, Regional Rural Banks, Full Fledged Money Changers – These are allowed to exchange currency for permissible Non-trade related current a/c transactions eg. travel, hospitalization, education, etc. This forms the Retail segment of the forex market.
Category III – Select Financial Institutions such as EXIM Bank, etc.
Growth in Indian Forex Market –
|Average Daily Turnover||USD 4 bn.||USD 25 bn.|
|Of which Merchant Requirements||USD 1 bn||USD 7 bn|
|Spot||50% of total turnover|
The annual turnover of the Indian forex market is 30 times the forex assets of the RBI and 6 times the country’s BoP. This is an indicator of the degree of speculative traders in the forex market.
Forex Quotes and Terminology –
Forex Quotes are normally given as 2-way quotes i.e. the trader gives quotations for buying as well as selling foreign currency.
Eg. USD / INR : 45.50 / 45.55
USD – Base Currency
INR – Quoted Currency
45.50 – Rate at which the trader is ready to BUY / BID
45.55 – Rate at which the trader is ready to SELL / OFFER
European Terms – Base Currency is USD
American Terms – Base currency is EUR / GBP / AUD / NZD and the quoted currency is the USD
Direct Quote – Price of 1 unit of foreign currency
Indirect Quote – Price of 1 unit of domestic currency
The codes use to indicate currencies eg. USD, INR, EUR, etc. are called SWIFT codes.
SWIFT (Society for Worldwide International Financial Telecommunications) is an agency for electronically transmitting financial messages across various market participants across the world.
Spot Transaction – Immediate settlement of transaction (usually T + 2 i.e. Transaction to be settled within 2 working days from the date of entering into contract)
Forward Transaction – Transaction to be settled after a certain lapse of time from the date of entering into contract – usually 30, 60 or 90 days i.e. Buyer and seller enter into a contract today to exchange fixed amounts of currencies at an agreed future date at a value which is to be fixed today.
Futures Transaction – A standardized forward contract
Currency Risk Exposure –
All businesses are exposed to various types of risks. In addition to these risks, International Business are specifically exposed to various types of risks that arise because of unpredictable changes in currency values.
The Currency related risk exposure of International Businesses can be summarized by the following chart –
Long Term Risks –
(a) Operating Risk – A business takes a lot of decisions related to its operations based on certain assumptions regarding currency values eg. decision to export its products to particular markets, decision to import raw material from certain suppliers located in different countries, etc. A change in the value of foreign currency may radically change the profitability outcomes of these decisions. Eg. Indian Software Industry has been traditionally targeting exports to markets in USA and EU. However, a depreciation of USD vis-à-vis INR may lend Indian exporters uncompetitive in the USA markets compared to Chinese exporters (if the Yuan – USD exchange rate is fixed)
Some other factors that would also have to be considered while analyzing Operating Risk –
(i) Nominal Exchange Rates
(ii) Price elasticity of products
(iii) Transportation Costs and extent of market (whether the market for a particular commodity is global or local)
(iv) Competition – their strength and location
(v) Impact on raw material costs
(b) Strategic Risk – A Firm may also take long-term strategic decisions based on certain assumptions regarding the exchange rate scenario. Eg. locating its global production facilities in a particular country, etc. A long-term and radical change in the exchange rate situation may force the firm to reverse such a strategy.
It should be noted that it may take a longer period – say 1 to 5 year time – for a firm to correct the adverse impact of the exchange rate on operational or strategic matters. Hence these are considered as long-term risks.
Short Term Risks
Short Term Risks can be classified as –
Accounting Risk –
Also called Translation Risk. The accounts of a business are closed on a particular date at the close of the accounting year. The rate of exchange on that particular date is taken as a valuation rate for valuation of assets and liabilities for various accounting purposes. However, this rate may not reflect the true long-term exchange rate between the two currencies and thus the valuation shown in the books of account on the basis of this rate may not reflect the true and fair value of the asset / liability. Such a loss /gain in value is called an Accounting loss or Translation Loss.
An important point to be noted here is that the loss / gain of this nature is not a cash loss or gain but merely a loss in reporting or Translation.
Cash-flow Risk –
On the other hand certain short-term risks will have a direct impact on the cash flows of the business. These can be further classified as – (a) Anticipated (b) Contractual
(a) Anticipated Risk – This is a risk that arises prior to entering into a contract. So some contracts may not be signed as the exchange rate fluctuations have made the proposed contract a loss-making proposition for the other party.
(b) Contractual Risks – These risks are also called as Transaction Risks. They directly affect the cash-flow of the firm. These risk arise due to an unexpected change in the exchange rates at the time of liquidation of an asset. Eg. A bill is made to the customer for USD 100 and the customer has been given a 30 days credit period. Suppose at the time of making the bill the USD / INR rate was Rs. 45. If at the time of settlement of the transaction, the USD / INR value goes down to Rs. 42, the seller suffers a loss of Rs. 300. This is a net loss of cash-flow to the seller.
An unexpected change in forex rates can change the value of foreign currency receivables / payables that are expected to arise at some future date. A number of instruments are available to help businesses remove this uncertainty –
(1) Forward Transaction –
A foreign currency receiver may choose to eliminate the uncertainty by selling his receivables in the forward market –
Eg – A firm is expecting a payment of USD 100 after 30 days. It knows the USD/INR rate for today is Rs. 45.50. However, it is not sure what the rate will be after 30 days when the USD inflow will actually be received. It may choose to eliminate the uncertainty by entering into a contract with a buyer to sell USD 100 after 30 days at a rate to be fixed today.
Say – the seller contracts to sell USD 100 after 30 days @ 45.25. i.e. F30 = 45.25
Now if the actual Spot rate after 30 days is 45.00 i.e. S30 < 45.25, the seller has earned a profit of 0.25 by entering into a forward transaction.
However, if S30 > 45.25 and is say 45.50, the seller would have made a loss of 0.25.
However, in the process what he has achieved is elimination of the uncertainty and ensured that he would get a certain value of Rs. 45.25 for his USD.
(2) Option Forward –
This is similar to the forward contract, except the fact that the delivery date is flexible i.e. The party can enter into a delivery at any point before the date of expiry of the contract. Here the Bank would generally assume that the customer would settle the contract on a date which is favorable to the customer. The bank, therefore quotes the lowest of buy rate and highest of sale rates.
Eg. If Spot USD / INR is 45.50/46.00
And – F90 is 46.50 / 47.00
In this case, if the merchant wants an option forward, the Bank will quote the lowest buy rate i.e. 45.50 and the highest of sale rate i.e. 47.00
Thus the Bank quote for Option Forward in the above situation would be – 45.50/47.00
(3) Broken Date Deals –
While the normal contracts are for 30, 60 or 90 days, a broken date deal can also be found for 45 or 50 days, etc. depending on the time of expected cash flows.
(4) Currency Swap –
A Swap is replacing one for the other. A currency swap may thus have various dimensions.
A simple swap is a time swap. Eg. If a cash-flow of USD 100 is expected in 30 days. The firm may thus enter into a forward sale for 30 days.
However, if for some reason the receivable is delayed by another 10 days, the firm can enter into a time swap. i.e. buy USD 100 from the spot market on 30th day and use the money to settle the forward deal. Then at the same time sell another USD 100 forward for 10 days to match with the revised schedule of receivable.
More often, however, swaps are used for hedging debts.
Eg. A firm in US has all its cash-flows in USD. However, for some reason it is in need of a 5-year INR loan. This results in inherent forex risk for he firm over a 5 year period.
On the other hand if there is an Indian firm with all cash-flows in INR but needs a 5-year USD loan.
The exchange rate risk of both these firms can be eliminated in 2 ways –
(a) The two firms may choose to designate their cash-flows to each other to the extent of the value of the loan. i.e. The US firm may designate a part of its cash-flows which are in USD to the Indian firm to enable the Indian firm to repay its USD loan and vice versa.
(b) Another way would be the exchange loans i.e. Indian firm borrow in INR and US firm borrows in USD. Then the two firms exchange the loans funds.
While this is an effective way to eliminate currency risk, the following factors need to be considered –
# The swap can be either only for principal amount only or for both principal and interest.
# The tenure and quantum of the two loans should be exactly the same.
# The swap could be either be with or without recourse
(5) Futures and Options –
This is one of the important hedging mechanisms. A Futures contract is similar to a forward contract except that the terms and size of a single contract is standardized. Futures contracts are of two types –
Call – Right to Buy
Put – Right to Sell
If the firm is expecting to receive foreign currency –
It may buy a Put i.e. – This will give the firm the right but not an obligation to sell
If the firm buys Put of 1 USD = INR 45 @ premium of 50 p.
If price at any time before expiry is more than 45 => say INR 47 => The firm will not exercise the right to sell i.e. it will not sell @ INR 45 as per the Put contract – but will sell in the spot market @ INR 47
Apart from these there could be number of other hedging strategies to eliminate transaction related exchange rate risks involving netting and off-setting strategies. A rule of thumb principle in such transactions would be to advance payables and postpone receivables in the stronger currency.
Methods of Payment –
Payment in International transaction is done using any of the following methods –
(a) Open Account – This method is followed if there is a long-standing relationship between exporter and the importer. This essentially means that there is no one-to-one correspondence between export dispatches and payments. The exporter keeps dispatching as per the agreed schedule of dispatches while the importer keeps paying as per agreed schedule of payments. The relationship is long-term and continuous. There are no third parties involved.
(b) Consignment – Here the ownership of the goods is not transferred on export. The ownership gets transferred at the time of final sale. This method is usually followed if a firm is dispatching goods to its own branch overseas. The payment becomes due when the branch books a sale to the final consumer.
(c) Advance Payment – Advance Payment or Cash Before Delivery (CBD) method is followed if the importer is not trustworthy. This method is usually followed in transaction of retail nature eg. online purchases.
(d) Documentary Drafts – These can be of 2 types – (i) Documents against payment – where the shipping documents are handed over to the buyer against payment (ii) Documents against acceptance – where the buyer accepts his obligation to pay, usually by signing a draft after which the shipping documents are handed over to the buyer. A third-party mediator, usually a Bank is involved in these transactions
(e) Letter of Credit – L/C is the most popular mode of payment in International Transactions. Here the Importer’s bank issues a Letter of Credit for payment on behalf of the importer. This substantially increases the confidence of the exporter. After shipment, the exporter sends the shipping documents to the importer’s bank. The Bank upon inspecting the document releases the payment to the exporter. Types of L/Cs – (i) Sight (ii) Time (iii) Usance (iv) Red Clause
(f) Cross Border Leasing – Usually followed in civil aviation sector
(g) Counter-trade – This includes buying some goods from the from the buyer (or from any other party located in the buyer’s country) for an equivalent amount. This can also serve as an effective currency risk hedging mechanism. Barter Trade, Off-setting are various forms of counter-trade.
Other Methods of Financing International Business Transactions –
(i) Buyer’s Credit – Usually given by exim bank of the exporter’s country to the buyer in order to encourage exports
(ii) Supplier’s Credit – Usually given by exim bank of the country to exporters
(iii) Line of Credit to exporters
(iv) Forfaiting – Non-recourse purchase of receivables prior to delivery. Eg. A agrees to commission a certain plant for B over a 12 month period. The contract involves certain interim payments from B to A prior to completion of the plant to which B has agreed. A can get immediate cash from a financial institution by discounting these expected receivables.
(v) Factoring and Bill Discounting.
(For Further Reading – International Financial Management – by P. G. Apte – Mc-Graw Hill – parts of this note are also taken from this book)