8. (c) Elucidate the concept of Foreign Exchange Risks and Exposure. Discuss the techniques included in Managing Foreign Exchange Risks with suitable examples.

Understanding Foreign Exchange Risks and Exposure

Foreign exchange risk is the financial risk posed by unexpected changes in exchange rates between currencies. It exposes firms to risks related to contractual cash flows denominated in foreign currencies, as well as risks to their competitiveness, market value, and financial reporting. Foreign exchange exposure, on the other hand, is the sensitivity of a company's assets, liabilities, or operating income to changes in exchange rates.

Types of Foreign Exchange Exposure:

There are three primary types of foreign exchange exposure:

• Transaction Exposure: This arises from the effect of currency fluctuations on a company's future cash transactions, typically from contractual obligations like receivables and payables denominated in foreign currency. It is the risk that the domestic currency value of foreign currency cash flows will change between the time a transaction is initiated and when it is settled.
• Translation Exposure (Accounting Exposure): This occurs when a company's financial statements, which may include foreign assets and liabilities of subsidiaries, need to be converted to the home currency for consolidation purposes. Fluctuations in exchange rates can alter the reported value of these foreign-denominated assets and liabilities, impacting the consolidated financial statements, particularly the balance sheet.
• Economic Exposure (Operating Exposure): This reflects how long-term exchange rate movements can affect a company's future cash flows and competitive position. Unlike transaction exposure, which involves specific payments, economic exposure considers the broader impact of currency shifts on a company's market value, pricing, costs, and revenues over the long term.

Techniques for Managing Foreign Exchange Risks

Managing foreign exchange risks involves a combination of internal and external strategies aimed at mitigating potential losses due to currency fluctuations. The Reserve Bank of India (RBI) regularly updates its guidelines to streamline foreign exchange risk management practices, with the latest Revised Master Direction on Risk Management and Inter-Bank Dealings effective April 5, 2024, providing enhanced hedging options and user classifications (retail and non-retail).

1. Internal Hedging Techniques (Operational or Natural Hedges):

These techniques leverage a company's internal operations and financial structure to reduce exposure without involving external financial instruments.

• Netting: This involves offsetting payables and receivables in the same foreign currency. For multinational corporations with numerous inter-company transactions, netting can significantly reduce the volume of foreign currency conversions needed.
  • Example: An Indian subsidiary owes €1 million to its German parent, while the German parent owes €0.5 million to the Indian subsidiary. Instead of two separate transactions, the Indian subsidiary pays €0.5 million, netting off the difference.
• Matching: This technique involves matching foreign currency inflows with outflows in the same currency, either by timing them or by structuring operations.
  • Example: An Indian exporter receiving USD revenue can strategically source raw materials or components from the US, thereby using its USD receipts to pay for USD expenses, naturally hedging the exposure.
• Leading and Lagging: This involves accelerating (leading) or delaying (lagging) the timing of foreign currency payments or receipts in anticipation of favorable exchange rate movements.
  • Example: If an Indian importer anticipates that the USD will appreciate against the INR, they might choose to 'lead' their USD payments by paying earlier to lock in a more favorable exchange rate. Conversely, an exporter expecting USD depreciation might 'lag' their receipts.
• Invoicing in Home Currency: By invoicing exports in the home currency, firms shift the FX risk to their buyers.
  • Example: An Indian exporter invoicing a European customer in INR instead of EUR. This transfers the risk of EUR/INR fluctuations to the European importer.
• Diversification: Diversifying export markets or sourcing locations across a range of countries can reduce reliance on any single currency and spread risk.
  • Example: An Indian company selling products in both the US (USD) and Europe (EUR) instead of exclusively to one market.

2. External Hedging Techniques (Financial Hedges):

These techniques involve using financial instruments, typically derivatives, to hedge against foreign exchange risks.

• Forward Contracts: A customized agreement between two parties to exchange a specified amount of one currency for another at a predetermined exchange rate on a future date. This locks in the exchange rate, providing certainty.
  • Example: An Indian company expects to receive USD 100,000 in three months. To hedge this transaction risk, it enters into a forward contract with a bank to sell USD 100,000 for INR at a fixed rate (e.g., INR 83/USD) in three months, regardless of the spot rate at that time.
• Currency Futures Contracts: Similar to forward contracts, but standardized, exchange-traded agreements to buy or sell a specific currency at a predetermined price on a future date. They are typically more liquid than forwards.
  • Example: A small Indian business expecting EUR receivables might use EUR-INR futures contracts traded on an exchange (e.g., NSE or BSE) to hedge their exposure.
• Currency Options: These give the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of foreign currency at a predetermined exchange rate (strike price) on or before a specified date, by paying a premium. Options offer flexibility as they protect against unfavorable movements while allowing participation in favorable ones.
  • Example: An Indian importer expecting to pay USD 50,000 in two months buys a USD call option. If the INR depreciates against the USD, they can exercise the option at the favorable strike price. If INR appreciates, they can let the option expire and buy USD at the cheaper spot rate.
• Currency Swaps: An agreement between two parties to exchange principal and/or interest payments in different currencies over a specified period. This is often used for long-term hedging of economic exposure or foreign currency debt.
  • Example: An Indian company has USD-denominated debt and a US company has INR-denominated debt. They could enter into a currency swap to exchange their principal and interest payment obligations, effectively converting their debt into their respective home currencies.
• Money Market Hedge: This involves borrowing in one currency, converting it to another, and investing it to cover a future payment or receipt. It utilizes the money market to create a synthetic forward rate.
  • Example: An Indian exporter expecting USD receivables in three months can borrow INR today, convert it to USD, invest the USD for three months, and use the maturity proceeds to fulfill the expected USD inflow, effectively locking in an exchange rate.

RBI's Role in Foreign Exchange Risk Management

The RBI plays a crucial role in regulating and facilitating foreign exchange risk management in India. The recent Revised Master Direction on Risk Management and Inter-Bank Dealings (effective April 5, 2024) consolidates existing regulations, expands hedging facilities to include Non-Deliverable Foreign Exchange Derivative Contracts (NDDCs), and classifies users into retail and non-retail categories based on financial exposure and net worth. These measures aim to enhance the effectiveness and accessibility of risk management tools for various market participants.