Three main types of currency risks are:
The academic books will tell you that foreign exchange risk can be broken down into the three categories:
- Transaction risk
- Translation risk
- Economic risk
According to us, all the risks are important. However not all risks are easy to manage. Transaction risk and translation risk could be hedged using available financial instruments. However there are no financial instruments to hedge economic risks. In the market, all the financial instruments like forwards, futures, options, swaps etc. are suited to hedge transaction risk and to some extent translation risk.
The details of these risks and practical issues involved in hedging the same are given below.
1. Transaction risk:
When companies are involved either in trade transaction (export and import), financial transaction (borrowing and lending in foreign currency) dividend payment/receipts, they are exposed to transaction risk. Such companies face Transaction risk, which could be defined as the risk that exists because of possible changes in currency rates between transaction date and its settlement date. For example, an exporter ships goods to Australia and has extended a credit period of 90 days from Bill of Lading date. Exporter accepted the order on say 2 Feb 2019 (transaction date) and takes some weeks to manufacture the goods and finally ship it. He receives the payment in AUD on 18th June 2019 (settlement date). On 2nd Feb 2019, AUDINR exchange rate was 52 and on 18th June it had dropped to 48. The difference between 52 and 48 is the transaction risk that exporter is carrying. Similar risk is seen in imports; in dividend (difference in dividend declaration date and dividend payment date); foreign currency loans etc. You would notice that transaction risk increases with increase in the gap of transaction date and its settlement date.
Managing transaction risk requires companies to first understand the importance of it, collect data to quantify exchange risk, get buy-in of senior members of the organization for FX risk management, make a policy for it and then strategize on ways to hedge the risk. Many companies outsource the job of managing currency risk (hedging strategies and execution) to external experts like Edugains.
With respect to managing transaction risks, our experience suggests that businesses have to first mitigate foreign currency risk by adjusting business models; changing terms of payments with international business partners and changing currency of loans and assets to minimize risks. Only after such actions are done and then the left over risk could be hedged using financial instruments.
Some real-life examples of managing foreign currency risk, without using any financial instruments:
Exporter shipping to Europe and taking packing credit in EUR – A textile exporter was selling to a European subsidiary of a US MNC. The subsidiary was paying the money in USD because exporter had signed the original contract in USD with the parent company of the subsidiary. To save interest, exporter was drawing packing credit (PCFC) in EUR and not USD (EUR Libor being negative interest rate as compared to USD Libor of about 2%). This mismatch in currency of packing credit (EUR) and currency of revenue (USD) resulted in foreign exchange risk. For exporter, one way to manage this risk was by using financial instruments like forward and hedge EURUSD risk. But each financial instrument has its own costs and brings its own risks. Therefore, the suggested approach is to convince the buyer in Europe and start receiving export payments in EUR and this way the currency of loan and currency of revenue can be matched and currency risk is mitigated, without the use of any forward contract.
An importer of engineering parts buys the goods from various countries and pays for imports in multiple currencies- Out of total import payment, USD constitutes about 50% of payment, EUR about 15%; GBP about 10% and balance 25% across many currencies like SGD, SEK, CHF, AUD etc. Importer is able to hedge USD because it is large in value. However, he finds it operationally difficult to hedge other currencies because the amount of each import payment is small (ranging between 2000-20000 of respective currencies). Such practical difficulty in hedging foreign currency risk could adversely affect business. On realizing the importance of such risk, the importer convinced most of his suppliers to start billing in USD. This helped importer concentrate his currency risk to only USD and which are easy to hedge using forwards and options.
Create liability in a currency in which you have assets/ revenues- A pharma manufacturer had 30% of sales in exports and balance in the domestic market. Large value invoices of exports were hedged and small value invoices were left unhedged. Aggregate value of such small invoices for the whole year was about USD 1 million. For expansion purpose, the company availed term loan in INR.
In the given case, company was exposed to currency risk on small value export invoices since they were left unhedged. One choice to mitigate the risk is to hedge such invoices using forwards or futures or options. Another choice is to take term loan in USD and structure the repayment such that annual repayment on term loan is almost equal to the amount of unhedged export invoices. This way company could mitigate currency risk on small value invoices and that too without using any financial instrument.
Even after adjusting the business model, commercials etc., the left-over transaction risk could be managed by using instruments like forwards, futures, options and swaps. The company has to carefully choose which instrument to use, study its pros and cons, study which instrument can provide most effective hedge in the business context, study the cost of exiting the instrument before maturity (this is one of the biggest costs and is very less understood).
Some common reservations that we encounter from corporates to hedge currency risks and ways to address those reservations:
The date and period of payment is unsure –
In most non-LC backed exports or imports, the date of payment is not sure. The delay could vary from few days to few months. In such circumstances, the company could use PP method (past performance) to hedge. Under this method, the hedging could be done for a period of 12 months and the forward contract could be early utilized. Alternatively, exchange traded currency futures or options could be used which does not require underlying exposure.
The amount of total import or export is not clear –
There are business situations where company has contracted into a fixed price contract with an overseas buyer or supplier and approximate value of order for the whole year is also fixed. However it is not clear in which month what would be the value of order. This uncertainty exposes company to a risk of changing currency prices during the year while company’s buying (for an importer)/ selling (for an exporter) price in foreign currency is fixed. In such a scenario, the company could again use PP based forward contracts and hedge an indicative amount and keep early utilizing the forward as and when foreign currency import/ export payment materializes.
2. Translation Risk:**
Commonly known as accounting exposure or consolidation risk. Translation risk arises from the revaluation of foreign currency balances (cash flows, receivables, payables, etc.) in accordance with accounting rules. Managing this risk is important in scenario where the company is accountable to external stakeholders like bankers and investors. However hedging this risk could itself add to risk and therefore needs to be clearly thought of.
For example, An Indian company opens a subsidiary in South Africa for manufacturing goods and catering to African market. The Indian company took a loan from a bank and one of the financial covenants stipulated to maintain a consolidated net worth of say Rs 10 cr. While computing consolidated net worth, valuation of South African subsidiary would be added. South African subsidiary value in INR would be a function of South African Rand (ZAR) vs INR exchange rate. If ZAR witnesses significant weakness, value of South African subsidiary would also fall and the Indian company may not be able to comply with bank’s financial covenant. This may be despite good functioning of South African subsidiary. Such risk arising from accounting/ valuation norms is called translation risk.
To manage the risk, Indian company may hedge ZARINR. Unlike transaction risks, the uncertainty of how much to hedge and for what period to hedge is far higher for translation risks. In this example, Indian company would ideally hedge against ZAR weakness for period during which African subsidiary would be sold and money received. However, there may not be any plans to sell African subsidiary and Indian company would be not sure for what period to hedge.
Another issue in managing translation risk is that hedge contract itself would bring a new and a real risk. In the above example, Indian company would be forced to hedge for a period of 12 months (one financial year) to comply with bank’s condition of maintaining net worth at the end of each year. Once hedge is booked, at the year end, hedge contract would get settled at prevailing ZARINR exchange rate. Suppose at the time of settlement of hedge contract, ZAR gains against INR, the hedge contract will be in loss and Indian unit would have a cash outlay. Therefore, hedge results in actual loss while helping keep accounting conditions satisfied.
Economic risk arises when there is a change in your product market dynamics, changes in competitive intensity and currency risk and country risks arising because of location of factory/offices. As economic risk materializes over a very long period of time, it requires a long term perspective and is difficult to measure and difficult to hedge
Edugains can help identify various risks, help quantify them, help prepare policy and finally help strategize and execute various hedging instruments. We have helped many companies manage transaction risk by avoiding financial instruments and wherever financial instruments were used, we minimized the risk and helped choose the most cost effective one.