Page 100 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 6: Economic Fundamentals and Foreign Exchange Risk Exposure

6.4 Tools and Techniques of Foreign Exchange Risk Management Notes

The most frequently used financial instruments by companies in India and abroad for hedging
the exchange risk are discussed below. These instruments are available at varying costs to the
company. Two criterions have been used to contrast the different tools. First, there are different
tools that serve practically the same purpose differing only in details like default risk or
transaction cost or some fundamental market imperfection. Second, different tools hedge different
kinds of risk.

1. Forward Contracts: A forward contract is one where a counterparty agrees to exchange a
specified currency at an agreed price for delivery on a fixed maturity date. Forward
contracts are one of the most common means of hedging transactions in foreign currencies.
In a forward contract, while the amount of the transaction, the value data, the payments
procedure and the exchange rate are all determined in advance, no exchange of money
takes place until the actual settlement date. For example, an Indian company having a
liability in US dollars due in December end may buy US dollars today for the maturity
date (December end). By doing so, the company has effectively locked itself into a rate. A
forward contract for a customer involves a spot and a swap transaction, as the customer
cannot cover the transaction outright for the forward data. This is because the market
quotes only spot transactions on an outright basis. In the example given above, the customer
(or the company) will have to first buy US dollars in the spot market and then enter into
a swap where he sells spot and buys forward (December end).
The problem with forward contracts however, is that since they require future performance,
sometimes one party may be unable to perform the contract. Also, many times forward
rate contracts are inaccessible for many small businesses. Banks often tend to quote
unfavorable rates for smaller business because the bank bears the risk of the company
defaulting in the payments. In such situations, futures may be more suitable.
2. Futures Contracts: Futures is the same as a forward contract except that it is standardized
in terms of contract size is traded on future exchanges and is settled daily. In practice,
futures differ from forwards in three important ways.
First, forwards could be for any amount while futures are for standard amount with each
contract being much smaller than the average forward transaction. Also, futures are also
standardized in terms of delivery dates while forwards are agreements that can specify
any delivery date that the parties choose. Second, forwards are traded by phone and letters
while futures are traded in organized exchanges, such as SIMEX in Singapore, IMM in
Chicago. Third, in a forward contract, transfer of funds takes place only once – i.e. at
maturity while in a futures contract, cash transactions take place practically every day
during the life of the contract. Thus, the default risk is largely avoided in a futures contract.
Despite the above mentioned advantages, futures contract also entails some limitations.
Since the futures trade only in standardized amounts, flexibility is missing and thus the
hedges are not always perfect. Also, many big companies tend to prefer futures because of
their adaptability.

3. Option Contract: An option contract is one where the customer has the right but not the
obligation to contract on maturity date. Options have an advantage as compared to forward
contracts as the customer has no obligation to exercise the option in case it is not in his
favour.

An option can be a call or a put option. A call option is the right to buy the underlying asset
whereas a put is the right to sell the underlying asset at the agreed strike price. For the
purchase of an option, a customer will have to pay a premium. Likewise, the seller of the

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