Though there are a range of hedging instruments that can be used to reduce risk but often Exporters use Natural Hedging Strategy to mitigate transaction exposure risk by availing different Short Term Foreign currency loans i.e. Pre-Shipment Credit in Foreign Currency (PCFC)/ Foreign Currency Non- Resident Account (FCNR B) Loans because of following two major benefits:
PCFC is available to exporters for exporting their goods in Foreign Currencies. This product is available at cheaper rate compared to other Domestic Currency rates.
Secondly by availing PCFC, one can hedge foreign currency transaction risk against exports receivables by settling exports collection against PCFC loans outstanding.
Broadly other techniques can be divided into:
Internal Techniques: These techniques explicitly do not involve transaction costs and can be used to completely or partially offset the exposure. These techniques can be further classified as follows:
Invoicing in Domestic Currency: Companies engaged in exporting and importing, whether of goods or services, are concerned with decisions relating to the currency in which goods and services are invoiced. Trading in a foreign currency gives rise to transaction exposure. Although trading purely in a company’s home currency has the advantage of simplicity, it fails to take account of the fact that the currency in which goods are invoiced has become an essential aspect of the overall marketing package given to the customer. Sellers will usually wish to sell in their own currency or the currency in which they incur cost. This avoids foreign exchange exposure but buyers’ preferences may be for other currencies. Many markets, such as oil or aluminum, in effect require that sales be made in the same currency as that quoted by major competitors, which may not be the seller’s own currency. In a buyer’s market, sellers tend increasingly to invoice in the buyer’s ideal currency. The closer the seller can approximate the buyer’s aims, the greater chance he or she has to make the sale. Should the seller elect to invoice in foreign currency, perhaps because the prospective customer prefers it that way or because sellers tend to follow market leader, then the seller should choose only a major currency in which there is an active forward market for maturities at least as long as the payment period. Currencies, which are of limited convertibility, chronically weak, or with only a limited forward market, should not be considered. The seller’s ideal currency is either his own, or one which is stable relative to it but often the seller is forced to choose the market leader’s currency. Whatever the chosen currency, it should certainly be one with a deep forward market. For the buyer, the ideal currency is usually its own or one that is stable relative to it, or it may be a currency of which the purchaser has reserves.
Leading and Lagging: Leading and Lagging refer to adjustments at the time of payments in foreign currencies. Leading is the payment before due date while lagging is delaying payment post the due date. These techniques are aimed at taking advantage of expected devaluation and/or revaluation of relevant currencies. Lead and lag payments are of special importance in the event that forward contracts remain inconclusive.
Netting: Netting involves associated companies, which trade with each other. The technique is simple. Group companies merely settle inter affiliate indebtedness for the net amount owing. Gross intra-group trade, receivables and payables are netted out. The simplest scheme is known as bilateral netting and involves pairs of companies. Each pair of associates nets out their own individual positions with each other and cash flows are reduced by the lower of each company’s purchases from or sales to its netting partner. Bilateral netting involves no attempt to bring in the net positions of other group companies. Netting basically reduces the number of inter-company payments and receipts which pass over the foreign exchanges. Fairly straightforward to operate, the main practical problem in bilateral netting is usually the decision about which currency to use for settlement. Netting reduces banking costs and increases central control of inter-company settlements. The reduced number and amount of payments yield savings in terms of buy/sell spreads in the spot and forward markets and reduced bank charges.
Matching: Although netting and matching are terms which are frequently used interchangeably, there are distinctions. Netting is a term applied to potential flows within a group of companies whereas matching can be applied to both intra-group and to third-party balancing. Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing. Receipts in a particular currency are used to make payments in that currency thereby reducing the need for a group of companies to go through the foreign exchange markets to the unmatched portion of foreign currency cash flows. The prerequisite for a matching operation is a two-way cash flow in the same foreign currency within a group of companies; this gives rise to a potential for natural matching. This should be distinguished from parallel matching, in which the matching is achieved with receipt and payment in different currencies but these currencies are expected to move closely together, near enough in parallel.
Both Netting and Matching presuppose that there are enabling Exchange Control regulations. For example, an MNC subsidiary in India cannot net its receivable(s) and payable(s) from/to its associated entities. Receivables have to be received separately and payables have to be paid separately.
Price Variation: Price variation involves increasing selling prices to counter the adverse effects of exchange rate change. This tactic raises the question as to why the company has not already raised prices if it is able to do so. In some countries, price increases are the only legally available tactic of exposure management.
Let us now concentrate on price variation in inter-company trade. Transfer pricing is the term used to refer to the pricing of goods and services, which changes hands within a group of companies. As an exposure management technique, transfer price variation refers to the arbitrary pricing of inter – company sales of goods and services at a higher or lower price than the fair price, arm’s length price. This fair price will be the market price if there is an existing market or, if there is not, the price which would be charged to a third-party customer. Taxation authorities, customs and excise departments and exchange control regulations in most countries require that the arm’s length pricing should be used.
Asset and Liability Management: This technique can be used to manage balance sheet, income statement or cash flow exposures. Concentration on cash flow exposure makes economic sense but emphasis on pure translation exposure is misplaced. Hence, our focus here is on asset liability management as a cash flow exposure management technique.
In essence, asset and liability management can involve aggressive or defensive postures. In the aggressive attitude, the firm simply increases exposed cash inflows denominated in currencies expected to be strong or increases exposed cash outflows denominated in weak currencies. In contrast, the defensive approach involves matching cash inflows and outflows according to their currency of denomination, irrespective of whether they are in strong or weak currencies.
External Techniques: Under this category range of various financial products are used which can be categorized as follows:
Money Market Hedging: At its simplest, a money market hedge is an agreement to exchange a certain amount of one currency for a fixed amount of another currency, at a particular date. For example, suppose a business owner in India expects to receive 1 Million USD in six months. This Owner could create an agreement now (today) to exchange 1 Million USD for INR at roughly the current exchange rate. Thus, if the USD dropped in value by the time the business owner got the payment, he would still be able to exchange the payment for the original quantity of U.S. dollars specified.
Derivative Instruments: A derivatives transaction is a bilateral contract or payment exchange agreement whose value depends on – derives from – the value of an underlying asset, reference rate or index. Today, derivatives transactions cover a broad range of underlying – interest rates, exchange rates, commodities, equities and other indices. In addition to privately negotiated, global transactions, derivatives also include standardized futures and options on futures that are actively traded on organized exchanges and securities such as call warrants. The term derivative is also used to refer to a wide variety of other instruments. These have payoff characteristics, which reflect the fact that they include derivatives products as part of their make-up. Transaction risk can also be hedged using a range of financial derivatives products which include: Forwards, futures, options, swaps, etc.