Foreign currency:
SPOT
RATE
It is the rate at which a foreign exchange
trade can be immediately transacted. The reason for spot market is
i.
Settle a
commercial transaction through buying and selling local currency.
ii.
Settle a
financial operation(e.g. buying FC for repayment of loan or interest)
iii.
Balance or
hedge an unwanted position in FC
iv.
Increase/decrease
a currency position as a speculative move owing to expected future currency
movements.
While some major
currency are traded directly (Rs/SR, Rs/JPY) while smaller currencies are
traded indirectly. The banks normally quote as SR 23.1212_23.1532. This is
buying and selling rate of the bank while the difference is termed as spread.
The spread in interbank is expressed as points or pips i.e. 1/10,000th
share of unit of currency. The smaller currencies are not expressed directly
but expressed in terms of USD or EUR e.g.
90.1254_90.8934Rs=1$
34.3452_34.8765N=1$
Cross
rate=34.3453/90.1254-34.8765/90.8934=0.3412_0.3576
The rates are published daily by bank for
commonly traded currencies but it fluctuates on real time basis therefore,
customer must get current currency information before committing any trade
deal. However, information can also be obtained through other means e.g.
Reuters
The bid-ask spread increase with rate
volatility and decreases with dealers’ competition. The news of economic
adjustments like unemployment, trade deficit, inflation, GDP and interest rates
play a role in fluctuation in foreign exchange rates.
FORWARD
MARKET
The forward contract creates an obligation
between two parties to exchange a fixed amount of currency for another currency
at an agreed rate and date.
Forward
rate are usually available in those currencies for which spot market exists.
However, rates are not quoted as real currency rates but as differences from
the spot rates (forward points). Theses points are mainly dependent on the
length of time and respective interest rates. Forward rates are contracts in
the form of contracts for currency swaps.
The obvious
example is that the forward rates do not change automatically. These are not
constantly changing like spot rates.
CALCULATION
OF FORWARD RATE:
The interest
rates, economic performance are the basis for calculation of forward rate. The
forward rates is obtained by adding/subtracting the difference between the
lending and borrowing rates for two currencies up until due date.
TRIANGULAR ARBITRAGE
The process of
making profit by converting currency A into Currency B which is then used to
buy Currency C and then C is converted back to A.
CURRENCY EXPOSURE
The currency
exposure OR the translation exposure is divided into two separate parts:
i.
Economic
exposure
ii.
Balance/translation
exposure
iii.
Payment/transaction
exposure
Economic Exposure
The change in
the value of an entity by change in the foreign exchange rates.
BALANCE EXPOSURE
It is in fact
the accounting risk. It appears in the company’s books of account while
consolidating foreign assets. The foreign assets are when translated for
consolidation in the parent’s company give a distorted picture which may not be
representative of the real value of assets.
For example the
assets in foreign currency which are finance by a foreign currency loan are
consolidated in the parent company’s account by using the rate at acquisition
date, whereas the corresponding loan is translated using the account closing
date. Therefore, floating exchange rates always affect account whether positive
or negative. This adjustment would be inaccurate if they do not reflect the
true value of assets.
PAYMENT /TRANSACTION EXPOSURE
This relates to
flow of payments in foreign currency for trading, interest and dividend payment
between a parent and its subsidiary companies or any trading partner. The
exchange rates instantly affect the cash flow and resulting gain/loss is
recognized in the income statement.
STRATEGIES FOR CURRENCY EXPOSURE
i.
Try to
keep the exposure as low as possible at all times and cover the risk
systematically as they occur.
ii.
Selective
coverage for one or more currencies or amounts exceeding a certain limit or
exposure over certain periods.
iii.
Not to
cover the exposure at all, normally when exposure is small
However, a
combination of above is most suitable.
CURRENCY POSITION SCHEDULE
HEDGING CURRENCY RISK
The most
commonly used methods are
i.
Choice of
currency
ii.
Currency
steering
iii.
Payments
brought forward
iv.
Forward
currency contracts
v.
Currency
options
vi.
Short-term
currency loans
vii.
Invoice
discounting
viii.
Currency
clauses
ix.
Tender
exchange rate insurance
CHOICE OF CURRENCY
Invoicing in own
currency can eliminate the FC exposure for the exporter similarly importer can
get rid of the foreign currency risk by accepting the invoice in own currency.
If both currency are not easily convertible then in the currency of any third
country whose currency is stable and readily convertible in the market or
dealings in third country’s currency are common in country (USD in Afghanistan). However, the following are worth to consider
a)
Invoicing
currency is freely convertible and actively traded.
b)
Does it
have the trading volumes needed to give it market stability?
c)
The
forward market working properly for the volumes and time periods that may be
applicable to transaction.
CURRENCY STEERING
It is the
management of currency positions. If an entity has the inflow/outflows in the
same currency it may be possible to match parts of payment flows through the
choice of currency.
PAYMENTS BROUGHT FORWARD (LEAD/LAG STRATEGY)
To request the
buyer to make payments in advance or before maturity date not only to ease the
liquidity position but to avoid the currency exposure as well. But importer, on
the other hand, would consider these early payments as disadvantage unless they
get any incentive for early payment. However, an exporter can make it possible
by making quick deliveries of goods, delivering documents in short period of
time and having payment against documents mode of payment and enforcing tight
credit control.
FORWARD CURRENCY CONTRACTS/FORWARD MARKET HEDGE
The most
commonly used method of hedging the risk is through a forward contract with a
bank whereby the company can fix the value in local currency at an early stage
but with delivery of the foreign currency at a later date. It is useful when
payment/receipt can be predicted with accuracy.
CURRENCY OPTIONS
An alternative
to the forward currency contract where the holder of an option has the option
but not the obligation to buy or sell the currency at an agreed rate and date.
The holder is required to pay an upfront premium to the bank but not the
commission or other charges.
The types are:
Put (vanilla) option: (the
right but not obligation to sell currency)
Call option (the right but
not obligation to buy the currency)
Basket option: where the
holder sells a basket of currencies against a single currency or vice versa
Caller option: it consists
of simultaneous purchase of put and call options for the same principal amount
and maturity period but with different strike prices.
Cap and floor contract:
the seller (or buyer) can take advantage of favourable price movement to the
upper end of contract range while remain protected against move below the lower
end. The contract settle at spot rate and customer pays a net premium based on
the structure of the set limits.
The
agreed rate at which the exchange of currency takes place is called the strike
or exercise price.
SHORT-TERM CURRENCY LOANS (MONEY MARKET HEDGE)
This is although
a type of finance but the seller can use these loans as hedge for the future
incoming foreign currency payments. The hedging cost will then be interest rate
less profit on the deposit of local currency. It will normally result in cost
similar to that of forward contract.
INVOICE DISCOUNTING
This is also a
form of short term financing where proceed from export are used to repay the
loan.
CURRENCY CLAUSES
When counter
parties agree to avoid the currency risk, it can be tempting to use some sort
of currency clause with the intent of sharing or dividing the risk between
them. e.g. if an importer buys goods from Pakistan with a fixed exchange rate
floor against Pak Rs. If rupee weakens against $ during the contract period the
seller would then automatically be compensated through receiving a
corresponding higher amount. The parties could also agree on similar cap to
buyer’s advantage.
TENDER EXCHANGE RATE INSURANCE
It is also
called as the tender exchange risk
indemnity. If one quote for a tender in fixed foreign currency, he may lose
the money if the local currency depreciates against the foreign currency;
therefore, this indemnity is obtained from an insurer to avoid the risk. These
are provided for shorter periods. They buyer of this insurance policy pays a
fraction of insurance premium upfront and the balance is paid if tender is
successful.
OPERATING/TRANSACTION EXPOSURE
The extent to
which the operating cash flows would be affected by random changes in foreign
exchange rates.
Unlike the
exposure to assets and liabilities that are listed in the Balance Sheet the
exchange rate fluctuations can affect the operating cash flows of an entity
which may force it out of competition.
For example if there are two persons competing
in the Pakistan’s market for sale of Urea. One is buying locally and other one
is importing from Saudi Arabia. If SR’s appreciate as compare to Rupee the
import will be costly than buying locally which has not been affected due to
appreciation in SR. the effect could be vice versa.
MANAGING OPERATING EXPOSURE
1-
Selecting
low-cost production sites
2-
Flexible
sourcing policy
3-
Diversification
of the market
4-
Product
differentiation
5-
Financial
hedging
TRANSLATION EXPOSURE (ACCOUNTING EXPOSURE)
Before
discussing the method of translation of foreign subsidiary, associate’s
financial statement. The following rates are used for translation before
consolidating into parent’s financial statements.
|
Description
|
Rate
|
|
Non-monetary assets (land,
building, depreciation equity,)
|
Historical rate at which they
were first recorded
|
|
Monetary assets (cash, bank,
payable)
|
Current rate of exchange
|
|
Income statement
|
Average exchange rate for the
period
|
Comments