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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.