FOREX Management

What is Foreign Exchange (FOREX)?
Foreign exchange involves exchanging money to facilitate the transfer of goods and/or services in one currency for another traded on foreign exchange markets.

What are the risks involved in FOREX?
Foreign currency transactions are sensitive towards fluctuations in the exchange rates. A price agreed with a customer or supplier on one day could rise or fall if the exchange rate changes. Changes in the value of currencies worldwide will affect organisations engaged in international transactions and businesses.

Some of the foreign exchange risks faced by organisations worldwide can be summarised in the following broad categories:

i) Accounting/Translation Exposure
Occurs on consolidation of financial statements of business units/subsidiaries in foreign countries as a result of the change in the value of currency of the business units/subsidiaries when translated to the domestic currency of the parent company.

ii) Transaction Exposure
Represented by the impact of exchange rate fluctuations on present cash flows as a result of importing and exporting, borrowing and lending in foreign currencies, inter-firm fund transfers, etc. This will affect the organisation’s revenues, costs, cash flows and profits.

iii) Real Operating Exposure
Changes in exchange rates alters future operating revenues and costs streams of an organisation. The changes in future cash flows as a result of the changes in exchange rates represents the real operating exposure of an organisation. Ultimately, this will affect the overall competitiveness of an organisation against its competitors.

Factors affecting risks
• Economic - Domestic & International
• Political / Country Risk
• Regulatory
• Spillover
• Other untoward events

Identifying Risks
• Strong information system for Currency exposure
• Continuous flow of information, review of factors affecting risk
• Continuous process involving reading, interaction, experience etc.
• Prediction extremely difficult

Objectives of FOREX Management
• To reduce costs involved in foreign exchange
• To contain and minimise losses in foreign exchange transactions
• To optimise potential foreign exchange gains
• To protect the operating profit of the Company/Group
• To achieve Company’s budgets and targets



How to achieve the objectives of FOREX Management
i) Determine the nature of exposure
ii) Evaluate the risk and rewards
iii) Decide on targets and appropriate strategies
iv) Formulate policies for day-to-day operations
v) Strong MIS Reporting System
vi) Periodical review of performance and strategy
vii) Single treasury concept for FOREX & money market

Key factors for an effective FOREX Management Strategy
• Management’s attitude towards risk
• Type of exposure – Tenure & Cost
• Firm’s willingness to devote the amount and quality of resource to exposure management function
• Access to various markets & instruments such as forwards, options, futures etc and there implications
• Choice of currency - Dollar / Non- Dollar
• Gross or Net Exposure to be managed

Management’s approaches towards FOREX Management

1) Conservative Approach
• Hedge the exposure as it arises
• Yields and costs of transactions are known
• Less risk of cash flow destabilization
• Less of management time and effort required
• Unlikely to yield optimum results
• Any opportunity arising in the market cannot be encashed

2) Moderate Approach
• Partial/Selective hedging
• Scope for taking advantage of opportunity gains
• Helps in averaging out total cost
• Management time and effort required

3) Aggressive Approach
• Active trading in currency
• Continuous cancellation and rebooking
• Aim is to treat treasury as a separate profit center
• Active treasury and management efforts
• High Risk :High Reward scenario
• Proper evaluation of risk extremely important bearing in mind risk-taking appetite of the company.

4) Indifferent Approach
• No conscious decision to manage exposure
• No hedging - everything left to chance
• Risk of destabilization of cash flows very high
• Merit – ZERO investment of time and effort
• Worst approach – Highly speculative

Tools for Hedging FOREX Exposure
• Financial Engineering Products:

i) Forwards - contract to sell/buy specific amount of currency at a future date against expected receivables/payables at a pre-determined rate.

ii) Futures - simultaneous right and obligation to buy/sell a standard quantity of a specific financial instrument at a specified future date and at a price agreed between parties at the time of contract.

iii) Forward Rate Agreement - This is interest rate agreement for future dates between two parties on London Interbank Offer Rate (LIBOR)/London Interbank Bid Rate (LIBID)

iv) Options - A contract between two parties which gives them the right but not the obligation to buy/sell at an agreed price at a future date.

v) Swaps - is an agreement between two parties to exchange their liability. Primarily can be categorised as Interest rate swap (exchange of periodic interest payments - no exchange of principal. E.g. from fixed rate of interest to floating rate and vice versa) and Currency Swap (exchange of interest and principal in two different currencies.)

vi) Others

• Internal Hedging Strategies:

i) Netting – receivables/payables can be netted out by matching amount. It reduces the amount of exposure to be covered hence reducing the banking costs.

ii) Leading and lagging – shift the timing of exposures by leading or lagging payables or receivables.

iii) Invoicing – choice of currency for invoicing

iv) Asset and Liability Management - e.g. increase exposed cash inflows in stronger currencies and vice-versa

v) Price Variation