Risk management

Risk Management:-

In forex management  we can just  manage the risk but can’t eliminate the risk.  Let’s find out the approaches of risk management :-

1. Do nothing :-  This strategy is followed when risk amount is low or otherwise chances of moving the forex  in the favour of the party is very high.
2. Home currency invoicing :-  Means trade in your currency. Being an Indian, we will prefer to sale/buy in INR. Like an American will do the same for doller. In That case, exchange rates risk won’t occur.
3. Leading and legging :-  Leading means receiving payments early and paying off at early stage. But legging means  delaying the export and import payments later. Suppose , you are an importer and you are expecting the market to decline , so you RS. Value will be declining... so what would you prefer .... 

Obviously you wanna payment early so that you have to pay less RS.To compensate the payment and vice-versa will happen in case of export. You want to receive the payments late so that you can receive more INR.

Let’s take an example:-

Paper Products ltd.  Has already received the invoices for HKD 2,10,000. Spot rate RS/HKD = 6.50 and 60 day fwd rate is 6.60 . Determine whether  PPL should avail the credit of 60 days or lead the payment if interest rates in india is  (a)11% p.a  (b) 6.5 % p.a. 

Answer :- if we just settle the transaction today we will pay :-

=2,10,000* 6.50 =RS.13,65,000

But if we have to pay after 60 days :-

= 2,10,000* 6.60 = RS.13,86,000

Means we will pay Rs21, 000 extra for 60 days as which will amount to the interest rate of

= 21,000/13,65,000 * 360/60 *100 = 9.24 % (approx.)

In the first case interest rate in India is 11 %which is higher than the rate derived from forward rate. And in the secondcase, we can take the loan and settle the amount today at spot price.

So the company will

1.  Case no 1 . = Lagging the payment  :- pay later at forward price.
2.  Case no 2 =  Leading the payment :- pay early at spot price

3. Netting 

Bilateral Netting:- “Bi” as the name is suggesting , it’s between two entities. For example, you have bought 1 pen froma shopkeeper at the rate of Rs.10. AndGave him Rs.20. In return, if the shopkeeper gives youmini packet of maggy (costRs. 10). So ,all transactions are settled.Well, it doesn’t mean that transactionwould always settle to nil amount. Sometimes, you have to receive or pay (for net off) as well.But the real point is, it’s just between two entities.

Multi-lateral netting :-This process is adopted when more than 2 entities are involved.The arrangement is coordinated by the parties.

Example :-USA has 3 subsidiary companies in UK , Europe and Japan. Compute and show net payments to be made by subsidiaries, after netting off N exchange rates are1 $ = euro .90

1$ = Sterling .70

1$ = 120 Yen

Methods of solving :-

1. Convert each amount in Base currency( US $) and you will get the creditor’s amount and then net off. ( Like method used in the book)
2. Otherwise , I use country wise method ( as I found it more easy) .  Just count where the same country is debtor and creditor and change the money into base rate and you’ll know the exact amount like :-

Details of UK :-

Payment in Euro =                   240 EL    = (266.67) $

Payment in Yen =                     120 yen                =(100.00) $

Receipt from Europe=           75 pound= 107.14 $

So UK need to pay  259.53 to the USA company to net off. The same method can be followed by other companies as well.

You can read other parts of forex at these links

Forex basics

Forex part 2

Regards

Renu