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    Managing Foreign Exchange

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    Vasant Kothari
    - Garment exporters face risks from fluctuating foreign exchange rates when importing fabrics and exporting finished garments. Hedging is an important tool for managing this foreign exchange risk. - There are various hedging instruments available including forwards, futures, options, swaps, and foreign debt. While hedging provides certainty, some exporters are unaware of hedging techniques or are not qualified to use them, leaving them exposed to exchange rate risks. - Hedging is a way to reduce risk rather than make profits. The best strategy is to hedge at least 50% of foreign exchange receivables to limit losses from unfavorable exchange rate movements.

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    Download as PDF, TXT or read online from Scribd

    Managing Foreign Exchange

    Uploaded by

    Vasant Kothari
    168 views5 pages
    - Garment exporters face risks from fluctuating foreign exchange rates when importing fabrics and exporting finished garments. Hedging is an important tool for managing this foreign exchange risk. - There are various hedging instruments available including forwards, futures, options, swaps, and foreign debt. While hedging provides certainty, some exporters are unaware of hedging techniques or are not qualified to use them, leaving them exposed to exchange rate risks. - Hedging is a way to reduce risk rather than make profits. The best strategy is to hedge at least 50% of foreign exchange receivables to limit losses from unfavorable exchange rate movements.

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    - Garment exporters face risks from fluctuating foreign exchange rates when importing fabrics and exporting finished garments. Hedging is an important tool for managing this foreign exchange risk. - There are various hedging instruments available including forwards, futures, options, swaps, and foreign debt. While hedging provides certainty, some exporters are unaware of hedging techniques or are not qualified to use them, leaving them exposed to exchange rate risks. - Hedging is a way to reduce risk rather than make profits. The best strategy is to hedge at least 50% of foreign exchange receivables to limit losses from unfavorable exchange rate movements.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    168 views5 pages

    Managing Foreign Exchange

    Uploaded by

    Vasant Kothari
    - Garment exporters face risks from fluctuating foreign exchange rates when importing fabrics and exporting finished garments. Hedging is an important tool for managing this foreign exchange risk. - There are various hedging instruments available including forwards, futures, options, swaps, and foreign debt. While hedging provides certainty, some exporters are unaware of hedging techniques or are not qualified to use them, leaving them exposed to exchange rate risks. - Hedging is a way to reduce risk rather than make profits. The best strategy is to hedge at least 50% of foreign exchange receivables to limit losses from unfavorable exchange rate movements.

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    of 5

    Money Matters

    Managing Foreign Exchange


    Garment exporters have to deal with fluctuating foreign exchange on a daily basis. Vasant R. Kothari talks about the various ways in which exporters can guard their businesses against heavy losses.
    In 1971, the system of administering fixed foreign exchange rates, called Bretton Woods, was abolished in favour of market-determination of foreign exchange rates. This brought about the concept of fluctuating exchange rates. It is very difficult for the market to determine fluctuations. Exporters and importers struggle to cope with the uncertainty in profits, cash flows and future costs. An exporter dealing in multiple currencies faces a risk (an unanticipated gain/loss) on account of sudden/ unanticipated changes in exchange rates. These are quantified in terms of exposures. One can define exposure as a contracted, projected or contingent cash flow whose magnitude is not fixed at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by a firm and protecting the firm from these risks by implementing financial or operational hedging is defined as foreign exchange risk management.

    Necessity of maNagiNg foreigN exchaNge risk


    A key assumption in the concept of foreign exchange risk is that it is not possible to predict when exchange rates change and that this is determined by how efficient the markets for foreign exchange are. Further, foreign exchange

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    APPAREL November 2011

    Hedge is an investment position taken in order to protect exporter/ importer from tHe risk of an unfavorable price move in a currency.

    michael Zysman| dreamstime.com

    risks cannot be controlled by employing resources to predict exchange rate changes.

    hedgiNg as a tool to maNage foreigN exchaNge risk


    Hedge is an investment position taken in order to protect exporters/importers from the risk of an unfavourable price move in a currency. Hedging is the most important tool to manage exchange rate risk. Fluctuations in the exchange rate of currencies give rise to exchange rate risk to the exporter as well as importer. Garment factories are exposed to fluctuations in exchange rates as they need to import fabrics/trims and export finished garments. Normally, there is a time gap of six to twelve months between finalising an export/import order and receiving/making payment against it, which increases the possibility

    of fluctuation of exchange rate. It is very necessary for an exporter and importer to think of this as a question of core competence. A garment exporter should cultivate a special expertise in garments. Exporters make speculative choices about what to produce, how to produce it, distribution strategies, etc. A garment exporter needs to do all this but without diffusing his efforts by focussing too much on currency movements. Adverse movements can mitigate export profits, while positive changes can increase the profit. Adopting currency risk, i.e. speculating on currency movements, is obviously not the core competence for a garment exporter. In this sense, the garment exporters are better off hedging away their currency exposure. A hedge helps exporters and importers in protecting businesses from unfavourable fluctuations in foreign exchange rate.

    APPAREL November 2011

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    Forwards: A forward is a made-tomeasure agreement (tailor-made agreement) between two parties. Normally, a bank is involved as one party and the exporter/importer as the other, to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. If an exporter thinks that the receivable currency is going to depreciate, then the same can be hedged against by selling a currency forward. On the other hand, if the exporter thinks that the risk favours currency appreciation, he can hedge by buying the currency forward. The main advantage of a forward contract to exporters and importers is that it can be tailored to specific needs and an exact hedge can be obtained as per the actual invoice value. On the downside, these contracts are bonded

    Following are the benefits of hedging: Hedging brings certainty in business A garment exporter and a fabric importer would know the precise exchange rate at which their receivables/payables will be converted. Hedging helps in estimating receipts and payments Once exporters and importers are aware of one side of the profit/loss, they can plan the other things in a better way. Opinions regarding foreign exchange hedging in the garment industry vary. Some garment exporters do not venture into hedging practices either because they feel hedging techniques are speculative or theyre not qualified in that area of expertise. Few exporters are totally unaware, exposed as they are to foreign exchange risks on a daily basis. Some exporters and importers only

    robert paul van beets | dreamstime.com

    some exporters and importers only Hedge some of tHeir risks, wHile otHers ...are unaware of tHe metHods to protect tHeir firm against tHe risk.

    suriyaphoto | dreamstime.com

    hedge some of their risks, while others (although aware of the various risks they face) are unaware of the methods to protect their firm against the risk.

    and not marketable. This means they cant be sold to another party when they are not required. Futures: A futures contract is similar to the forward contract but the advantage of futures contract is liquidity, as it can be traded in an organised exchange i.e. the futures market. In this type of contract, depreciation of a receivable currency can be hedged by selling futures and appreciation can be hedged by buying futures. The main advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence. Further, futures provides a sort of leverage as it requires a small initial outlay, for example, 10% of the total value, with

    fiNaNcial iNstrumeNts for hedgiNg


    There are various financial instruments available for the exporters as well as importers in the garment industry to choose from for hedging their Forex receivables/payables: Forwards Futures Options Swaps and Issue of foreign debt

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    which significant amount of money can be gained or lost with the actual forwards price fluctuations. The limitation of futures is the tailorability, i.e. only standard denominations of money can be bought instead of the exact amount of invoice that is bought as in case of forward contracts. Options: Option is another hedging instrument for exporters and importers. It is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price, called the Exercise Price or Strike Price. The fixed nature of the exercise price compensates for the uncertainty of exchange rate changes and limits the losses of open currency positions for the
    suriyaphoto | dreamstime.com

    radoslaw drewek | dreamstime.com

    exporter who expects a fixed amount of USD, for example, in a few months from now. The exporter stands to lose if the INR appreciates against USD in the meanwhile; so, to hedge this, the exporter could take a loan in the USD for the same time period and convert the same into INR at the current exchange rate. The theory assures that the gain realised by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.

    hedgiNg is iNsuraNce
    Exporters and importers need to understand one thing very clearly that hedging is not a recipe to make money. Hedging is a recipe to reduce risk; its just like an insurance policy. Every hedging activity can look smart or look foolish, depending on the direction that prices take. After the earlier debacle in 2007, when the currency appreciated by nearly 11 per cent, garment exporters do not want to go uncovered even if it means taking some risks against an uncertain rupee. Garment exporters are caught in a volatile market where it is hard to point out which way the rupee will sway. In 2007, exporters had not hedged their receivables, so they lost money. In 2008, exporters hedged the currency, but the rupee depreciated. So again, they got hammered. So, the best strategy is to hedge at least 50% of receivables.
    APPAREL November 2011

    exporter and importer. Exporters can use Call Options if the risk is an upward trend in price (of the currency), while Put Options can be used if the risk is a downward trend. Swaps: As the name suggests, a swap is a contract whereby the buyer (importer) and seller (exporter) exchange equal initial principal amounts of two different currencies at the spot rate i.e. current rate of exchange. The buyer and seller exchange either fixed or floating rate interest payments over the term of the contract using their respective swapped currencies. At maturity of the contract, the principal amount

    is effectively re-swapped at a predetermined exchange rate so that both the parties end up with their original currencies. The advantages of swaps are that exporters and importers with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of foreign currency swaps, while leaving the underlying borrowing intact. Foreign Debt: Foreign debt can be used to hedge foreign exchange exposure by either exporters or importers by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an

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