Foreign Exchange Risk Management Tools - CA Final SFM

The Foreign Exchange Risk can be managed by using Following Tools: -

1. Forward Contract

2. Money Market Operation (MNO)

3. Currency Swap (Exchange)

4. Option Contract

5. Future Contract

Forward Contract

Risk of Foreign Exchange Price Fluctuation can be reduction by making a forward contract to sell or buy at pre-determined rate.

Money Market Operation

If one have to receive foreign Currency than Borrow such amount of foreign currency at Interest Rate Prevails to it which becomes equal to foreign currency Receivable and convert in home currency and invest in Home Currency.

If one have to pay foreign currency then invest such amount of foreign currency at Interest Rate Prevails to it which becomes equal to foreign currency payable and take loan in home currency to buy foreign currency.

In Simple Words,

Exporter = Borrow in Foreign Currency & Invest in Home Currency

Importer = Invest in Foreign Currency & Borrow in Home Currency

Or, Create Liability if we have assets and create assets we have liability.

Steps for Exporter

Step I: - Borrow in foreign currency.

Step II: - Convert in to Home Currency.  

Step III: - Invest into Home Currency & Receive Foreign currency.

Step IV: - Realize investment after tenure.

Step V: - Repay Loan along with Interest.

Steps for Importer

Step I: - Invest in FC such amount so that at Investment plus interest becomes equal to amount to be paid after tenure.

Step II: - Buy Foreign Currency by taking loan in Home Currency.

Step III: - Realize investment along with interest and pay to party.

Step IV: - Repay loan (in Home Currency) along with Interest.

Option Contract

Foreign Exchange Risk can be managed by either by buy Call or Put.

Exporter	Importer
He will Sell FC, So to Hedge P+ in FC He will buy HC, So to Hedge C+ in HC	He will Buy FC, So to Hedge C+ in FC He will Sell HC, So to Hedge P+ in HC

Foreign Currency will be converted at actual price on that date but any loss due to price fluctuation will be recovered from option contract.

Either Exporter or Importer will always go for long position either in Call or Put. Premium paid will be cost to both Importer and Exporter.

Future Contract

Foreign Exchange Risk can be managed by taking position in future.

Exporter	Importer
He will Sell FC, So to Hedge F- in FC He will buy HC, So to Hedge F+ in HC	He will Buy FC, So to Hedge F+ in FC He will Sell HC, So to Hedge F- in HC

Foreign Currency will be converted at actual price on that date but any loss r gain due to price fluctuation will be recovered or paid by settlement of future position.

Interest on Initial Margin will be cost to the Importer and exporter. Initial Margin will not be considered as cost because it is refundable on settlement of future.

Currency Swaps

In Currency Swap, two parties to pay each other’s debts obligation in different currencies.

A Currency Swap involves: -

An Exchange of Principal amount today

An Exchange of Interest payment during the tenure of currency loan

An Exchange of Principal amounts at the time of maturity.

In simple words,

A company whose subsidiary in an another country and in that country a company is operating whose subsidiary in country of first company. Both companies wants to grant loan to their subsidiaries, to overcome the boundaries of countries they agrees to grant loan to each other’s subsidiary, this process is called currency swaps.

  

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