INTERNAL HEDGING STRATEGIES

BY: MEHUL DUBEY&

SHRIRAM KESHRI
Exchange rate risk hedging
• The variability of exchange rates gives rise to
the foreign exchange risk.

• This is the risk which affect the business

operation or the value of an investment assets
and liabilities.

• Also called currency risk.

Hedging

• Hedging refers to covering of transaction risk.

• It provides a mechanism to exporter and

importer .To guard them selves against losses
arising from fluctuation in exchange rates.
The situations when hedging may be used

• Hedging transaction exposure.

• Hedging balance sheet exposure.

• Hedging economic exposure.

Hedging techniques
• Broadly classified into internal and external
hedging techniques, the various internal
hedging techniques are :
• Exposure netting
• Cross Hedging
• Denomination in local currency
• Foreign currency accounts
• Leads and lags
Exposure Netting
• Offsetting exposure in one currency with
exposure in the same or another currency.

• When exchange rates are expected to move in

such a way that losses or gains on the first
expose position should be offset by gains or
losses on the second currency exposure.
• For instance:
• US dollar and Swiss Franc are expected to
appreciate.

• The company has receivables of USD 5 million.

• It can manage its exposure by having

equivalent amount as payable in Franc.
Cross Hedging
• Cross hedging is used to manage exposure in
minor currencies.

• Taking position in different (proxy)currency.

• Currencies are highly correlated and move

similarly.

• Effectiveness depends on positive correlation of

the proxy currency and original currency.
• For instance:
• An Indian firm has expects to receive 5 million
pesos in 180 days.

• Forward rate for both currency is not available.

• The firm will hedge by selling forward the

equivalent highly correlated currency for same
time period.
Denomination in local currency

• Effectively transfers all foreign exchange risk to

the other party in the business transaction.

• The other party may charge a higher price to

compensate for the extra risk.

• Invoicing in local currency depends upon the

relatives bargaining capacity of the importer and
exporter and the status of the currency
concerned in the international market.
• For instance:
• If exports from India are invoiced in Indian
rupees, the obligation of the importer is fixed
sum of rupees.
• The exporter is not affected by any movement
in exchange rate.
• The importer on other hand, will be bearing
exchange risk entirely.
• He may have to pay more in terms of the
currency of his country if that currency
depreciates.
Foreign Currency Accounts
• A trader who engages in both export and imports,
the exchange risk can be minimized if an account
is maintained abroad, in the currency of trade,
through which all transactions can be routed.

a) Exports can pay for Imports.

b) They will apply buying rate for exports

and selling rate for imports, with the
usual spread between the rates towards margin.
• In India under the Exchange Earner Foreign
Currency (EEFC) account scheme:

• Inward remittance is entitled to retain up to

100% for remittance received.

• A firm located in Special Economic Zone

(SEZ) is allowed to maintain foreign currency
account with a bank in India. The benefit is
similar to that under EEFC account.
Leads and Lags

• Leading and lagging foreign exchange

transactions
• Leading
• Changing the timing of a cash flow so that
it takes place prior to the originally agreed
date.

• e.g. pay a USD payable before an

expected AUD depreciation.
• Lagging
• Delaying the timing of an existing FX cash
flow.

• e.g. delay a USD payable to coincide with

a USD receivable.

• Need to assess costs/impact of strategies,

e.g. unpredictable payment behavior
Conclusion
• Hedging a transaction exposure can be done to
manage transaction exposure is to minimize the
possibility of loss and retain to the extent
possible the opportunity to gain from exchange
rate changes.