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Exchange Rate Fluctuation

Exchange Rate Fluctuation

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Published by: asifanis on Feb 26, 2010
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05/11/2014

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EXCHANGE RATE FLUCTUATION RISK

INTRODUCTION
Both importers and exporters run the risk of loss due to fluctuations in the foreign exchange rates in international business transactions. An exporter who agrees to a certain price in a foreign currency today may find himself at a loss after a few months when the actually receives the payment owing to a fall in the exchange rate of the contracted currency. Likewise, an importer’s fortunes may also swing up or down with exchange rate movements. For example, let us take an exporter in India who ships 5,000 shirts at US $ 4.00 each to an exporter in the US, and expects to receive the payment after 60 days. In today’s date at $1.00 = Rs. 46.00, he expects a payment of Rs. 9,20,000.00. After the months, on actual receipt of payment, the US $ is equal to Rs. 45.30 and he, therefore, receives Rs. 9,06,000.00, incurring a loss of Rs. 14,000.00. This loss is actually due to weakening of the US $ against the Indian rupee.

Exporters in India can avail of forward exchange covers provided by most commercial banks. Foreign exchange rates are usually quoted as Spot Rates or Forward Rates. Spot Rates : For immediate requirement of foreign currency, the purchaser has no choice but to buy foreign exchange on the spot (current) market. Spot rates are meant for immediate delivery. It is simply the current market rate decided by demand and supply. Spot contracts are the most basic and widely used foreign exchange contracts. This is an agreement to buy or sell one currency in exchange for another. Spot transaction requires the receipt of the bought currency in two days and the payment of the sold currency in two days.

Forward Rates : A forward contract allows the exporter to buy or sell one currency against another, for settlement on some future date. A forward contract eliminates the risk of fluctuating exchange rates by locking in a price today for a transaction that will take place in the future. It does not eliminate losses occurring in future but it makes the outcome of the future transaction certain. This is called hedging for expected foreign currency transactions. A forward foreign exchange contract protects the exporter from adverse currency movements.

HEDGING ALTERNATIVES
The following hedging alternatives are available to exporters in India to deal with foreign exchange fluctuations risks : • Option Dated Forward Contract : Forward transactions that offer one of the parties to the transaction an option to set any value date within a prescribed period. • Such options benefit the party as he may not know in advance the precise date on which he would be able to deliver the currency. • An option forward contract helps a company overcome market risk by deciding today, a price for a foreign exchange transaction at a future date.

• Foreign Currency Options : • A currency option gives the buyer the right, not the obligation, to exchange two currencies at a fixed rate at a future point of time. • Under this type of option, the buyer’s downside risk is eliminated while retaining the unlimited upside potential. It is akin to an insurance policy.

• It is an effective ‘hedging mechanism’ that permits exchange rate (strike price), without an obligation to do so. The option may not be used, if the spot rate is more favorable than the option’s strike price. • With such instruments the buyer is protected against an adverse exchange rate movement while retaining the ability to benefit from a favorable movement. As the name indicates, the party has the option to deal or not.

• Currency Swaps : • A currency swap is defined as an exchange of principal and/or interest payments on a loan or asset in one currency for principal and/or interest payments on equivalent loan or asset in another currency at pre-fixed spot/forward rate agreed on the trade date.

• For example, a customer in India having a loan in USD may enter into a currency swap in order to hedge its USD interest rate risk as well as the USD/INR exchange risk. • Under this type of swap, the client may cover either only interest payment or principal repayment or both.

In India ECGC also offers a special scheme called Exchange Fluctuations Risk Cover to provide protection from exchange rate fluctuations to exporters of capital equipments, civil engineering contractors, and consultants who have to receive payments over a period of years for their exports, construction works, or services.

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