Foreign Exchange Risk Management

Exposure Management: Operating, Transaction and Translation

Risk
Risk refers to uncertainty. In foreign currency transactions, risk arises due
to fluctuation in the exchange rates. Fluctuation in exchange rates are not
always adverse but the risk arises due to the uncertainty about the fluctuation.
Risk cannot be eliminated but it has to be managed to an acceptable level.
“Acceptable level” of risk will differ from person to person. It depends upon each
person’s ability & willingness to take risk. The different types of exchange risks
are:
(1) Transaction risk: An enterprise having foreign currency transactions like
imports payables, exports receivables, foreign currency loans & interest
payment thereon, etc. are exposed to the risk of adverse fluctuation in
exchange rates.
(2) Translation risk: This is the risk associated with loss in translation
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(conversion) of foreign currency assets, liabilities, incomes & expenses to
domestic currency for reporting purpose; i.e. financial statements. This
arises due to adverse movement or depreciation in currency in which they
are denominated.
(3) Economic risk: The long term adverse fluctuations in the exchange rates
may affect the cash flows of the firm which in turn affect the value of the
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firm. For example, a manufacturing facility set up in a foreign country which

was highly profitable becomes totally unviable due to devaluation of the
currency of that country. These risks are difficult to foresee or manage.
Hedging & Speculation
Hedging is a technique which involves taking action to minimize the effect of
fluctuation in exchange rate risk. Whereas, speculation involves trying to make a
profit/gain from fluctuation in exchange rate; e.g. covered interest rate arbitrage.
Managing Exposure to Exchange Rate Fluctuation
Hedging is effective in managing exchange rate fluctuations. For international
trade the following hedging techniques are suitable:
(1) Home Currency Invoicing
(2) Leading & lagging.
(3) Forward exchange contracts.

Foreign Exchange Risk Management 1

(4) Money market hedge.
(5) Currency futures & options.
(6) Netting
(1) Home Currency Invoicing: The risk of foreign currency rate fluctuation can be
avoided by invoicing in the home currency. As no foreign currency is involved
the risk of fluctuation is totally avoided. This method effectively transfers
the risk to the counter-party. This method will be particularly effective for
imports from a country with a strong currency and exports to a country with
a weak currency. However, most of the international transactions are done
in the major currencies of the world which may not be the home currency
of either the buyer or the seller — US dollar, British pound, Japanese Yen or
Euro. Recently (2023), the Indian Government decided to sign agreements
with more than 80 countries for rupee trade agreements.
(2) Leading & lagging: Leading means advancing the date of payments or
receipts and lagging means delaying.
In case of imports, a simple way to hedge the risk of exchange rate
fluctuations is to make foreign exchange payments immediately (leading),
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even if credit period is available, if it is expected that the foreign currency is
likely to appreciate. If the foreign currency is expected to depreciate, then
the payment may be delayed (lagging), even if it involves paying interest for
the delay, as it may be beneficial to do so. Whether it is beneficial to lead or
lag can be decided only after computing the cash outflow of each alternative
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in the local currency.
In case of exports, conversion of foreign currency can be delayed if
the home currency is likely to depreciate. If home currency is likely to
appreciate, then it may be beneficial to convert the foreign into home
currency at an early date. In either case, the opportunity cost of interest on
investment should be taken into consideration.
(3) Forward exchange contracts: An importer or exporter may enter into a
forward contract with a bank to buy or sell foreign exchange. These contracts
are of two types:
(i) Fixed Forward Contracts: In these contracts the date of buying or selling
foreign currency is fixed and the contract must be performed on or
before such date. However, international transactions are often delayed
and therefore it may not be possible for the customer to honour the
contract by the fixed date in case of delays. These contracts will not
provide a hedge in case there is a long delay in the transaction.

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 (ii) Option Forward Contracts: These contracts are more flexible than the
fixed forward contracts. The customer is allowed to buy or sell the
foreign currency during a certain period specified in the contract. Such
period could be a week or more and as much as one month. This allows
greater flexibility to the customer who need not worry about normal
delays that may arise in international transaction.
55 Forward contracts are not derivatives.
(4) Money market hedge: The market for short-term instruments is called
money market. Borrowing or lending for short-term can be undertaken in
the money market. Period of borrowing or lending can be as short as 1 day
(24 hours) up to one year.
In case of imports, if it is expected that foreign currency is likely to
appreciate then the following steps are carried out:
(i) The foreign currency is purchased immediately. The amount purchased
is the present value (PV) of the foreign currency liability discounted at
the deposit rate applicable to the maturity period.
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(ii) Investment is made in the money market in the foreign currency for a
period which matures around the date on which the foreign currency
liability is to be paid.
(iii) The investment maturity date coincides with the liability due date.
(a) The investment & interest thereon will be equal to the liability; and
(b) the proceeds are used to settle the liability.
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(iii) Deposit grows to

(ii) Invest the PV of amount Step (iii)(a) amount payable
payable to earn deposit rate. which is used to
pay the liability.
Step (ii)
Step (iii)(b)
(i) buy spot the PV of amount
Step (i)
payable discounted at Amount payable
deposit rate.

Today Payable date

To find out the efficacy of this hedge, compute the cash outflow in the local
currency and compare with other alternatives.
In case of exports, if the foreign currency is likely to depreciate then the
following steps are carried out:

Foreign Exchange Risk Management 3

 (i) A loan is taken in such foreign currency. The amount of borrowing will
be the present value (PV) of the expected amount in foreign currency
discounted at the rate of borrowing applicable for the period from the
date of borrowing to the date when the foreign currency dues are to be
received.
(ii) The foreign currency loan is immediately converted to the home
currency. The home currency is then invested in the local money market
till the due date as the proceeds were not due till that date anyway.
(iii) When the foreign currency proceeds are received on due date the
foreign currency loan together with the interest will be equal to the
proceeds and the proceeds are used to settle the loan.
Step (i)
(i) borrow FC spot equal to the PV Amount receivable
of receivable discounted at
FC loan rate. (iii) Loan + Interest equals
Step (iii) (b) receivable. The
receivables are used Step (iii) (b)
Step (ii) to repay the loan.
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(ii) convert FC at spot rate and Step (iii) (a) (iii) Deposit grows till
invest at home deposit rate. original receipt date.

Today Receivable date

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To find out the efficacy of this hedge, compute the cash inflow in the local
currency on the due date and compare with other alternatives.
(5) Currency futures & options: Futures and options are available for different
currencies. These may be used to lock in a favourable rate of foreign
exchange. However, as the futures and options are of standard size, it may
result in under- or over-hedging. It is better to over-hedge than to under-
hedge. In case of imports, long futures or call option in foreign currency
needs to be bought. In case of exports, short futures or put option in foreign
currency needs to be bought.
(6) Netting: If a firm has both receivables & payables in the same foreign
currency then the simpled way of avoiding exchange rate fluctuation risk
is to net the two and convert only the remaining amount. This not only
eliminates the exchange rate fluctuation risk for the netted amount but
also saves the conversion cost for the same. Only the net receivable or net
payable is exposed to risk. The cost of hedging is also reduced. Netting has

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 the following variation –
(i) Bilateral Netting: This involves netting between two entities. This can
happen only where amount is payable to and receivable from the same
party for different transactions. The net amount, after set-off, is paid or
received as the case may be.
(ii) Multilateral Netting: This involves a group of entities which may be
subsidiaries or group companies. The procedure is more elaborate
than bilateral netting as the amounts may be owed to one another and
that too involving different currencies. This is usually handled by the
central treasury department. Where multiple currencies are involved, a
common currency as well as the method of establishing the exchange
rate has to be decided for netting.
(iii) EEFC Account for Netting: Reserve Bank of India has the Exchange
Earners’ Foreign Currency (EEFC) Account Scheme whereby export
proceeds and certain other inwards remittances in foreign currency can
be retained and used for meeting commitments under current account
transactions.

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Thus, foreign currency earnings can be used to pay foreign currency
obligations.
Problems
General Exchange Rate Risk Management Decisions
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1.1 [C.S.] Honey Ltd. is supplying goods worth CA $1,00,000 to a Canadian
importer and the amount is payable after 4 months. The current spot rate of CA
$1 is `57.68. It is expected that the rupee will appreciate in the next 4 months
and CA$ would be quoted at `56.84. The importer accepts to pay immediately if
2% cash discount is offered by Honey Ltd. The current borrowing rate is 8% per
annum. Advise.
[Accept immediate payment. Gain ₹1,19,377]
1.2 [C.S.] Madhur Ltd., an Indian company, has an export exposure of 100 lakh
Yen value at end of March, 2022. Yen is not directly quoted against Rupee. The
current spot rates are:
INR/USD = 63.60 & JPY/USD = 124.75 Yen.
It is estimated that Yen will be depreciate to 144 and INR to 65 against a dollar.
You are required to calculate the expected loss if hedging is not done.
[Loss ₹5.84 lakhs]
1.3 [C.S.] Management of an Indian company is contemplating to import a
Foreign Exchange Risk Management 5
machine from at a cost of €15,000 at today’s spot rate of €0.0113636 per Rupee.
Finance manager opines that in the present foreign exchange market scenario,
the exchange rate may shoot up by 10% after two months and accordingly he
proposes to defer import of machine. Management thinks that deferring import
of machine will cause a loss of `50,000 to the company in the coming two
months.
You are asked to express your views, giving reasons, as to whether the company
should go in for purchase of machine right now or defer purchase for two
months.
[It will be beneficial to defer the purchase.]
Forward Contract
2.1 [C.A., C.S.] A company operating in a country having the $ as its unit of
currency has today invoiced sales to an Indian company, the payment being due
3 months from the date of invoice. The invoice amount is $13,750. At today’s
spot rate of $0.0275 per `1, is equivalent to `5,00,000.
It is anticipated that the exchange rate will decline by 5% over the 3-month
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period and in order to protect the $ payments, the importer proposes to take
appropriate action in the foreign exchange market. The 3-month forward rate is
presently quoted as $0.0273.
Calculate the expected loss and show how it can be hedged by a forward
contract.
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[Expected exchange loss under present condition ₹26,316; under forward contract ₹3,663]
2.2 [C.A.] JKL Ltd., an Indian company has an export exposure of JPY 1,00,00,000
payable April 30, 2022. Japanese Yen (JPY) is not directly quoted against Indian
Rupee.
The current spot rates are:
INR/US$ = `62.22
JPY/US$ = JPY 102.34
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to
depreciate against US $ to `65.
Forward rates for April 30, 2022 are
INR/US $ = `66.50
JPY/US$ = JPY 110.35
Required:
(i) Calculate the expected loss, if the hedging is not done. How will the position

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 change if the firm takes forward cover?
(ii) If the spot rates on April 30, 2022 are:
INR/US$ = `66.25
JPY/US$ = JPY 110.85
Is the decision to take forward cover justified?
[(i) Expected loss ₹8,38,000, loss after hedging ₹54,000 (ii) Yes. Loss without hedge ₹1,08,000]
2.3 [C.S.] Queen Ltd., an Indian company, has an export exposure of ¥100 lakh
value due on 30th April, 2022. Yen is not directly quoted against rupee. The
current spot rates are:
INR/USD = 62.685 and JPY/USD = 194.625
It is estimated that Yen will depreciate to 216 level and rupee to depreciate
against dollar to 64.50. Forward rate for 30th April, 2022 was JPY/USD = 206.025
and INR/USD = 64.335. If the spot rate on 30th April, 2022 was eventually INR/
USD = 64.17 and JPY/USD = 206.775, is the decision to take forward cover
justified?
[Yes. Loss with forward cover ₹9.76 lakhs; loss without forward cover ₹11.75 lakhs.]
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2.4 [C.S.] Zed Ltd., an Indian company, has an export exposure of 10 million (100
lakh) Yen, payable on April 30, 2022. Yen is not directly quoted against Rupee.
The current spot rates are:
INR/USD = 60.50 and JPY/USD = 145.60
It is estimated that Yen will depreciate to 159 level and Rupee to depreciate
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against $ to 61. Forward rates for April 30, 2022 are INR/USD = 61.81 and JPY/
USD = 155.25.
You are required to —
(i) Calculate the expected loss if hedging is not done. How the position will
change if the firm takes forward cover?
(ii) If the spot rate on April 30, 2022 was eventually INR/USD = 61.71 and JPY/
USD = 155.75, is the decision to take forward cover justified?
[(i) Loss without hedging ₹3,19,000; loss with forward cover ₹1,74,000 (ii) Without forward cover
loss would have been ₹1,93,000]
Leading & Lagging
3.1 [C.M.A. modified] An import house in India has bought goods from
Switzerland for SF 1,00,000. The exporter has given the Indian company two
options:
(i) Pay immediately the bill for SF 10,00,000.
(ii) Pay after 3 months with interest @ 5% p.a.
Foreign Exchange Risk Management 7
The importer’s bank charges 14% on overdraft. If the exchange rates are as
follows, what should the company do?
Spot (`/SF) 86.00/86.50
3-month (`/SF) 86.10/86.70
[Pay after three months and save ₹1,74,375]
3.2 [C.A., C.S.] An Indian importer has to settle a bill for CAD 1,30,000. The
exporter has given the Indian importer two options:
(i) Pay immediately.
(ii) Pay after 3 months with interest 5% p.a.
The importer’s bank charges 15% on overdraft. If the exchange rates are as
follows, what should the company do?
Spot (`/$) 78.35/78.36
3-month (`/$) 78.81/78.83
[Pay after 3 months]
3.3 [C.A., C.M.A.] Electronics Ltd., your customer, has imported 5,000 cartridges
at a landed cost, in Mumbai, of US $20 each. The company has the choice of
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paying for the goods immediately or in 3 months time. It has a clean overdraft
limit with you where 14% pa. rate of interest is charged.
Calculate which of the following methods would be cheaper to your customer.
(i) Pay in 3 months time with interest @ 10% and cover risk forward for 3
months.
(ii) Settle now at current spot rate and pay interest on the overdraft for 3
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months.
The rates are as follows:
Mumbai `/$ spot 80.25 - 80.55
3 months swap 35/25
[Outflow: Option (i) ₹82,30,750; Option (ii) ₹83,36,925. Pay after three months.]
Forward Contract & Money Market Hedge
4.1 [C.A. twice, C.S.] An exporter is a UK based company. Invoice amount is
$3,50,000. Credit period is three months. Exchange rates in London are:
Spot rate ($/£) 1.2565 – 1.2595
3-month forward rate 1.2610 – 1.2645
Rates of interest in money market:
Deposit Loan
$ 7% 9%
£ 5% 8%

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Compute and show how a money-market hedge can be put in place. Compare
and contrast the outcome with a forward contract.
[Forward contract gives gain of £1,619]
4.2 [C.A.] An Indian exporting firm, Rohit and Bros., would like to cover itself
against a likely depreciation of pound sterling. The following data is given:
Receivables of Rohit and Bros £5,00,000
Spot rate `100.50/£
Payment date 3-months
3 months interest rate India: 12% p.a.
UK: 5% p.a.
What should the exporter do?
[Gain from money market hedge ₹8,68,502]
4.3 [C.A. modified] A Ltd. of U.K. has imported some chemical worth of USD
3,64,897 from one of the U.S. suppliers. The amount is payable in six months
time. The relevant spot and forward rates are:
Spot rate USD 1.2517 - 1.2573
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6 months’ forward rate USD 1.2415 - 1.2489
The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit
rates are 5.5% and 4.5% respectively.
The company has two choices:
(i) Forward cover, and
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(ii) Money market cover

Which of the alternatives is preferable to the company?
[Outflow: (i) £2,93,925 (ii) £2,95,080]
4.4 [C.A.] H Ltd. is an Indian firm exporting handicrafts to North America. All the
exports are invoiced in US$. The firm is considering the use of money market or
forward market to cover the receivable of $50,000 expected to be realized in 3
months time and has the following information from its banker:
Exchange Rates
Spot `/$ 72.65/73.00
3-month forward `/$ 72.95/73.40
The borrowing rates in US and India are 6% and 12% p.a. and the deposit rates
are 4% and 9% p.a. respectively.
(i) Which option is better for H Ltd.?
(ii) Assume that H Ltd. anticipates the spot exchange rate in 3-months time

Foreign Exchange Risk Management 9

 to be equal to the current 3-months forward rate. After 3-months the
spot exchange rate turned out to be `/$: 73.00/73.42. What is the foreign
exchange exposure and risk of H Ltd.?
[(i) Cash inflow: MMH - `36,59,340.85, FC - `36,47,500 (ii) Gain `17,500]
4.5 [C.A. modified] H Ltd. is an Indian firm exporting handicrafts to North
America. All the exports are invoiced in US$. The firm is considering the use of
money market or forward market to cover the receivable of $50,000 expected to
be realized in 3 months time and has the following information from its banker:
Exchange Rates
Spot `/$ 72.65/73
3-m forward `/$ 72.95/73.40
The borrowing rates in US and India are 6 % and 12% p.a. and the deposit rates
are 4% and 9% p.a. respectively.
Which option is better for H Ltd.?
[MMH `36,59,340.85; FC `36,47,500]
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 BF
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