Economy Transdisciplinarity Cognition

www.ugb.ro/etc
Vol. XIV,
Issue 1/2011
296-302

Ways to protect against currency risk in international economic relations

LUCIAN OCNEANU
George Bacovia University
Bacau, Romania
lucian.ocneanu@ugb.ro
RADU CRISTIAN BUC
George Bacovia University
Bacau, Romania
radu.bucsa@ugb.ro
MARIAN FOTACHE
George Bacovia University
GABRIELA FOTACHE
George Bacovia University



Abstract:
Effective legal drafting can minimize significant international transaction risk. However, the risk of currency exposure
can be mitigated or even eliminated in its entirety by the techniques and instruments described in this article. How much
currency risk exposure remains depends on the instrument selected. Many instruments do not hedge transaction
exposure perfectly, but are more accessible to the individual and small to medium size companies. Instruments used to
more completely hedge currency exposure, such as put and call options, may contain sizeable transaction costs.
Nevertheless, most international businesses prefer the certainty of minimizing exposure, despite the increased
transaction costs involved, in lieu of unquantifiable and potentially disastrous foreign exchange risk.

Keywords:
Currency risk, forward transaction, futures contracts


Introduction

This paper aims to present situations in which companies are subject to currency risk. I also tried to
present the types of measures that can be used to prevent or mitigate the currency risk.
Currency risk refers to the probability of loss of international trade agreements and other economic
relations because of currency exchange rates during the signing of the contract until maturity.
Exporters are subject to currency risk if the currency depreciates during the time elapsed since
signing the contract until the collection. In turn, importers bear the effects of currency risk if the currency
appreciates in the period between signing the contract until maturity.
Exchange position refers to the difference between the estimates received and receivable and
surrendered currency to cover payment obligations in international economic relations. Exchange position
may be long, if currency received and receivable are greater than estimates due to be delivered, short if the
currency received are lower than estimates that will be taught and firm if the two sizes are equal.


Contractual measures

Effects of currency risk may be prevented or mitigated by contract measures including: the choice of
currency of contract, subscription contract a currency clause or revision of prices clause. Extracontractual
measures refers to the use of parallel loans, the use of forward transactions.
When negotiating the contract, the parties analyze the currency legislation of countries of origin,
evolution and foreseeable impact of the currency market currency rate contract.
At the end the international trade contract, the parties may act to link payments for imports by the
time of export revenues, to include clauses in contracts to strengthen the currency and prices of safety
margins.
During the performance of international commercial contract, the negative effects of currency risk
attenuates by contracting parallel loans, running of forward currency market operations and hedging
transactions on derivatives markets.
Contractual measures to mitigate the negative effects of exchange rate risk have different forms
depending on the period and the specificity of the contracts. In international commercial contracts signed
until 1971, gold clause was applied, which means specifying the gold content of the coin at the contract
signing and the fact that, depending on changes in the gold content of the coin, payment is made at the new
exchange ratio resulting modify the content of gold.
Currency clause is to correlate the contract value with a currency more stable and agreed by the
parties to the contract. International trade agreement set the exchange rate between two currencies at the date
of signature and provides that in case of currency exchange ratio changes over certain limits on maturity,
payment is made according to a new report by the exchange of currencies.
Currency basket clausediffers in that currency in international trade contracts are expressed relates
to more currency (currency basket). Based on this clause, deviation rates of a basket is moderate because
some negative effects in some currencies is offset by positive effects in other currencies.
Special Drawing Rights clause requires reporting currency of international commercial contract to
SDRs - and recalculate contractual rights and obligations depending on the evolution of the exchange rate
against foreign exchange contract settling the date of signing the contract.
Price revision clauseis included in the international trade agreements to mitigate the effects arising
from price changes during the contract signing until the value of goods contracted collection.


Extracontractual measures

If the international trade contract protection clause does not register the negative effects of currency
risk can mitigate by extracontractual measures.
Credit parallel method can be used if the creditor should receive a payment in a currency with a
tendency to depression. Thus he will borrow an amount equal and in the same currency to be used at that
moment. At the commercial maturity, he collects the amount in currency and refund the loan.
For example, suppose that a Romanian exporter has signed a commercial contract with a European
partner in trade worth 100.00 euros at a rate of 4.20 RON / EUR. Collection will be made within 30 days. If
at maturity due to depreciation of EUR rate would be 4.05 RON / EUR, the exporter would record a loss:

(4,20 4,05)*100.000 = 15.000 RON

To protect against currency risk, exporters can borrow from the banking institution with an amount
of 100,000 euros for a period of 30 days at an interest rate of 5% per year. Thus, he will be able to use the
amount in euros at a rate of 4.20 RON / EUR in the current activity and maturity of the commercial contract
will pay the sum of bank credit in euros received from trading partners. Interest that will have to pay the
bank for the amount borrowed is (100.000 EUR * 5%)/12 = 417 EUR = 1.750 RON.
Using this method of reducing currency risk, the exporter eliminate loss due to exchange rate
amounted to 15.000 RON, supporting only an additional expense of approximately 1.750 RON, representing
banking interests.
Term cover implies that the operator, who is at risk of loss due to fluctuation of currency exchange
rate expressing commercial transaction, to initiate a sale or purchase operation on forward currency market.
Term operations (forward market) refers to transactions of buying or selling of currency to be based
on teaching values at a future time and at a rate determined. Generally, forward rate should be higher than
the spot rate, because it includes interest for a certain period. Forward rate of a currency is better than the
spot rate if it provides an appreciation of the currency. The difference between the forward and spot rate plus
the interest on a currency is known as "agio.

Purchase forward rate
360
1
360
1
S F
purchase
RON
EUR
purchase
RON
EUR
d
i
d
i
ask
EUR
bid
RON

Sale forward rate
360
1
360
1
S F
sale
RON
EUR
sale
RON
EUR
d
i
d
i
bid
EUR
ask
RON

where:
S
EUR/RON
spot rate EUR/RON (purchase, sale);
i
bid
deposits interest (EUR, RON);
i
ask
loans interest (EUR, RON);
d period (days / months).


On forward currency market, currency quotes to within 1 month, 3 months, 6 months and 1 year.
Forward quotes are reflected through the points they recorded over a certain period. Forward rate is
mentioned directly or through forward points.
Importers, who is to pay amounts in foreign currency, have profits if the forward will be lower than
the spot rate, and loss, if forward rate is higher than the spot rate. Exporters, which will collect the amount in
currency of international trade agreements, obtain favorable difference if the forward is better than the spot
rate and losses in case the foward is weaker than the spot rate.

For example, suppose the following situation related to the quotation EUR / RON:

BID ASK
EUR/RON spot 4,2200 4,3100
Interest rate EUR at 6 months 1,7 2,5
Interest rate RON at 6 months 6,5 8,5

Based on this information can be determined forward rate between EUR and RON within six
months, as follows:
3034 , 4
360 / 180 * 025 , 0 1
360 / 180 * 065 , 0 1
* 2200 , 4 F
purchase
RON
EUR

4553 , 4
180/360 * 0,017 1
180/360 * 0,085 1
* 3100 , 4 F
sale
RON
EUR

Another way to hedge against currency risk is the development of futures market operations. Futures
markets are known as derivative markets because the interventions and rates depending on the operation of
spot and forward markets.
Development of trade, exchange rates volatility, currency needs, improving negotiation techniques
on currency markets, currency risk amplification led to the appearance and evolution of derivative markets
operations.
Futures and options markets have diversified access to funding sources, have provided mechanisms
for protection against currency risk and obtain gains from the interventions made.
Futures currency were launched in 1972 in the department International Money Market (IMM) in the
Chicago Mercantile Exchange (CME).
On the futures currency markets participate: banks and institutions that use futures contracts in their
operations, brokerage firms acting on behalf of clients, brokers who participate in their own name or for
clients, buyers and sellers of futures contracts and speculators who operate with short deadlines.
Futures contracts express written agreement between two parties, to give or receive a certain amount
in a currency at one time mentioned and an agreed price (futures price) at the time of signing, which are
distinguished by:
futures contracts have a standardized size (62.500 pounds, canadian dollars 100.000 etc.).
currency futures contracts are negotiated and signed with fixed maturities: March, June,
September and December, for periods of two years, which means eight-time quotes;
currencies which is traded on futures markets are the U.S. dollar, euro, yen, British pound, Swiss
franc, Canadian dollar and Australian dollar;
minimum fluctuation of the futures contract value is between 10 to 12.5 U.S. dollars per
contract;
effective delivery of the currency futures contracts are reduced because the positions held by
buyers / sellers are close to maturity through a reverse position in order to avoid currency risk
and to get a win.
Currency futures contracts prices are formed in conjunction with the exchange ratio on the spot
currency market. The difference between the futures and spot rate is known as the "base".
Base = Spot rate Futures rate
If the spot rate is higher than the futures base has a positive value. The difference between the
futures and spot rate tends to zero as the contract approaches maturity.

Forward Contract Futures Contracts
contracts negotiated by the parties related to the
size and delivery date monetary assets
standardized contracts on maturity and size of
monetary assets
private contract between two parties: buyer and
seller
standard contract for each transaction and
compensation chamber
difficulty in taking a reverse position to close the
account and low liquidity
possibility of negotiating a reverse position to
maturity and better liquidity
profit or loss of position is made on delivery of
monetary assets
contracts are valued at the price of each day,
reflecting a gain or loss
margin is determined on the first day of the
transaction
margin can be maintained to reflect the price
movement of monetary assets
Tabel 1: Differences between forward and futures contracts

The participants of currency futures markets addressed orders to buy or sell currency at some time
through brokers agree the stock market supervisory institutions. Brokers negotiate the purchase or sale
transactions of futures contracts on currencies on behalf of customers according to orders received. At
maturity, are determining the effects of purchase or sale transactions of futures contracts on the market and
adjust differences through chambers of compensation.
Purchase or sale orders on currency futures markets can be formulated in two versions:
order at limited rate, according to which the customer mentions to broker a rate which will run
the operation, if there is a degree of market;
order at market price.
Quotes on currency futures markets is done through auctions that result: open rates, rates the highest,
lowest rates and closing rates. The difference of reselling the futures contract at maturity at a particular rate
(c) can be determined as follows:
based on the number of contracts (n), considering the rates at maturity (CVS), the contracts
traded (FVC) and the standardized value of the contract of that month (Vs);
Vs CVf CVs n c

if one takes into account the number of contracts (n) of points which reflect rate differences (p),
the minimum limit of turnover in that month contract value (fm)
fm p n c


Every day the futures market provides a market valuation of futures contracts based on price
recorded at the end of day trading, which ensures obtaining a gain or loss by sellers or buyers of contracts of
this nature.
Importers who buy futures contracts on currencies may be obtained differences to offset any losses
on the spot market or forward.
To participate in the futures market operators shall submit an initial guarantee that depends on the
contract, currency volatility and further guarantees depending on the evolution of market rates.
Chamber of compensation have mission to regulate relations between the participants in this market
contracts, and to calculate the differences resulting from the interventions.
Futures market participants close their initial positions until maturity contract in reverse position. At
the time, contract buyer in this market resell and contract vendors redeem their value.
To highlight how to mitigate currency risk through futures contracts present the following example:
On October 1, 2009, a company contracted exports worth EUR 100,000 in Belgium, with the
obligation to deliver up to 15 December and pay before December 30, 2009.
The company decided to protect the amount in euros that is receivable against a possible
depreciation of the EUR, choosing the technique of hedging foreign exchange futures contracts. So he sold
through a brokerage agency 100 contracts EUR / RON with maturity in December at a price of 4.1263
(contract value is 1.000 EUR). The margin required to submit to a contract is 120 RON. Commission paid to
broker a contract is 0.5 ron and deposits interest rate is 16.75% per year.

Changes in futures contract quotation EUR / RON by the end of its validity is:

Date BNR
rate
Futures
quotation
01.10.2009 4,1127 4,1263
14.10.2009 4,1301 4,1275
09.11.2009 4,0546 4,0630
26.11.2009 3,9401 3,9399
03.12.2009 3,7560 3,7500
23.12.2009 3,8046 3,8000
30.12.2009 3,9410

Starting from this hypothetical situation can be outlined two approaches which may have the
exporter during the period to maturity futures contracts:
liquidation of contracts at maturity;
obtaining maximum profit depending on the evolution of futures quotes
In the first approach evolution as follows:
01.10.2009
exporter sells 100 contracts in December 2009, at the rate of 4.1263 RON / EUR. Account opened at
the Agency related initial margin deposit of 100 contracts sold:
120 RON x 100 contracts = 12.000 RON
Amount in account: 12.000 RON
14.10.2009
futures quotation EUR / RON is 4.1275, higher than the rate at which 100 futures contracts were
sold, so the account will register a virtual loss of 4.1275 - 4.1263 = 0.0012 RON/EUR, 0.0012 RON / EUR
x 1,000 EUR / contract = 1.2 EUR / contract, so the virtual total loss of 1.2 EUR / contract x 100 contracts =
120 RON
Amount in account: 12.000 120 = 11.880 RON
09.11.2009
futures quotation is 4.0630 RON / EUR, lower than the exporter has sold the contracts, for which the
account recorded a profit virtually from 4.1263 - 4.0630 EUR = 0.0633 RON/EUR, 0.0633 RON / EUR x
1,000 EUR / contract = 63.3 EUR / contract
63,3 RON/contract x 100 contracts = 6.330 RON
Amount in account: 12.000 +6.330 = 18.330 RON


26.11.2009
futures quotation is 3.9399 RON / EUR < 4.1263 RON / EUR, so the account will register a virtual
profit 0.1864 RON / EUR, 186.4 EUR / contract respectively 18.640 RON for the 100 contracts sold.
Amount in account: 12.000 + 18.640 = 30.640 RON
03.12.2009
in that day, futures quotation EUR / RON is 3.7500 RON / EUR.
Profit per EUR: 4,1263 3,7500 = 0,3763 RON/EUR
Profit per contract: 0,3763 RON/EUR x 1.000 EUR/contract = 376,3 RON/contract
Profit/100 contracts: 376,3 RON/contract x 100 contracts = 37.630 RON
Amount in account: 12.000 + 37.630 = 49.630 RON
23.12.2009
Futures quatation: 3,8000 RON/EUR.
Profit per euro: 4,1263 3,8000 = 0,3263 RON/EUR
Profit per contract: 0,3263 RON/EUR x 1.000 EUR/contract = 326,3 RON/contract
Profit/100 contracts: 326,3 RON/contract x 100 contracts = 32.630 RON
Amount in account: 12.000 + 32.630 = 44.630 RON


30.12.2009
BNR rate: 3,9410 RON/EUR
Since the exporter has not liquidated its position before maturity, that has not made a purchase of
futures contracts, he has an open short position. At maturity, Chamber of compensation close position
opened with cash at BNR rate in last day of trading, 3.9410 RON / EUR, while the exporter had sold the
contracts of 4.1263 RON / EUR.

Profit per euro: 4,1263 3,9410 = 0,1853 RON/EUR
Profit per contract: 0,1853 RON/EUR x 1.000 EUR/contract = 185,3 RON/contract
Total profit: 185,3 RON/contract x 100 contracts = 18.530 RON
Amount in account: 12.000 + 18.530 = 30.530 RON

This operation involved the following costs:
broker commission: 0,5 RON/contract x 100 contracte = 50 RON;
three months interest on the margin of account
5 , 502
100 * 360
90
* 75 , 16 * 000 . 12


Total expenditure: 502,5 + 50 = 552,5 RON
Operation Result: 18.530 552,5 = 17.977,5 RON
If the exporter did not initiate a futures transaction in late December, when collecting 100.000 EUR,
and it could change the rate of 3.9410 RON RON / EUR, achieving 394.100 RON.
Equivalent in lei of the 100.000 EUR when signing the contract was:
4,1127 RON/EUR x 100.000 EUR = 411.270 RON
So his loss would have amounted to:
411.270 RON - 394.100 RON = 17.170 RON
The coverage achieved with futures contracts, the exporter has not only avoided the loss of 17.170
RON, but won 17977.5 RON.
From the perspective of a speculator, the optimal time to liquidate the contract is the day when the
difference between the futures quotation and the sale contracts rate is maximum. So liquidation would be
made on 3/12/2009, when the virtual profit amounted to 37.630 RON. Profit diminishes with the broker's
commission income and interest on deposits for the period 10/01 - 12/03 (64 days).

Conclusions

In Romania, increased exchange rate volatility and uncertainty about the future value of national
currency against major international currencies has become a problem of increasingly large majority of
Romanian companies. Whether importing or exporting, or that they have debts in foreign currency
depreciation or appreciation of national currency has caused unexpected losses. Active management of
currency risk may be the solution for reducing damage caused by currency fluctuations.



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