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Unit 5: Methods of Financing Exporters and Business Risk Management

Foreign exchange rates are usually quoted as Spot Rates or Forward Rates. Notes
1. Spot Rates: For immediate requirement of foreign currency, the purchaser has no choice
but to buy foreign exchange on the spot (current) market. Spot rates are meant for immediate
delivery. It is simply the current market rate decided by demand and supply. Spot contracts
are the most basic and widely used foreign exchange contracts. This is an agreement to
buy or sell one currency in exchange for another.

Notes Spot transaction requires the receipt of the bought currency in two days and the
payment of the sold currency in two days.
2. Forward Rates: A forward contract allows the exporter to buy or sell one currency against
another, for settlement on some future date. A forward contract eliminates the risk of
fluctuating exchange rates by locking in a price today for a transaction that will take place
in the future. It does not eliminate losses occurring in future but it makes the outcome of
the future transaction certain. This is called hedging for expected foreign currency
transactions. A forward foreign exchange contract protects the exporter from adverse
currency movements. The forward rate adjustment is a complicated calculation that involves
the interest rates of the currencies involved.
The following hedging alternatives are available to exporters in India to deal with foreign
exchange fluctuations risks:
Option Dated Forward Contract: Forward transactions that offer one of the parties to
the transaction an option to set any value date within a prescribed period. Such
options benefit the party as he may not know in advance the precise date on which
he would be able to deliver the currency. An option forward contract helps a company
overcome market risk by deciding today, a price for a foreign exchange transaction
at a future date.
Foreign Currency Options: A currency option gives the buyer the right, not the
obligation, to exchange two currencies at a fixed rate at a future point of time.
Under this type of option, the buyer’s downside risk is eliminated while retaining
the unlimited upside potential. It is akin to an insurance policy. It is an effective
‘hedging mechanism’ that permits exchange of one currency for another on a
given date, at a pre-arranged exchange rate (strike price), without an obligation to
do so. The option may not be used, if the spot rate is more favorable than the
option’s strike price. With such instruments the buyer is protected against an
adverse exchange rate movement while retaining the ability to benefit from a
favourable movement. As the name indicates, the party has the option to deal or
not. European options allow the exercise of an option on the expiry date only.
American options permit the exercise of an option at any time from the date of
purchase until expiry.
Currency Swaps: A currency swap is defined as an exchange of principal and/or
interest payments on a loan or asset in one currency for principal and/or interest
payments on equivalent loan or asset in another currency at pre-fixed spot/forward
rate agreed on the trade date.

Example: Customer in India having a loan in USD may enter into a currency swap in
order to hedge its USD interest rate risk as well as the USD/INR exchange risk. Under this type
of swap, the client may cover either only interest payment or principal repayment or both.

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