Post-liberalisation, volatility has become the buzzword in the brave new world of finance. While financial deregulation translates into added opportunities for the CFO, the uncertainty implies more risk. What tools does the CFO have at his disposal to hedge foreign exchange and interest rate risks? BT draws up the CFO's handbook of hedging strategies for 2000.

By A BT-Greenback Forex Services Research Project

CURRENCY RISKS FORWARD CONTRACTS

THE DEFINITION. A forward contract is simply an agreement to buy or sell foreign exchange at a stipulated rate at a specified time in the future. It is a contract calling for settlement beyond the spot date. The time-frame can vary from a few days to many years.

THE INSTRUMENT. A forward contract locks you to a particular exchange rate, thereby insulating the CFO from exchange rate fluctuations. In India, the forward contract has been the most popular instrument employed by corporates to cover their exposures, and, thereby, offset a known future cash outflow. Forward contracts are usually available only for periods upto 12 months. Forward premiums are governed purely by demand and supply, which provide corporates with arbitrage opportunities. The premiums in this market are quoted till the last working day of the month.

Internationally, the forward premiums, or discounts, reflect the prevailing interest rate differentials. Arbitrage opportunities are, therefore, limited. As a rule, a currency with a higher interest rate trades at a discount to a currency with a lower interest rate. Since there is a forward market available for longer periods, the forward cover for foreign exchange exposures can stretch upto five years. The premiums, or discounts, are quoted on a month-to-month basis. That is, from the spot date to exactly one month, or two months, or even a year.

THE EXAMPLE. A corporate has to make a payment of US $1 million on March 31, 1998. The CFO can book a forward contract today, and fix the exchange rate at which he will make the payment. Assuming that the dollar-rupee spot rate is Rs 36.40, and the forward premium on the dollar for delivery on March 31, 1998, is Rs 0.30, the effective exchange rate for the remittance becomes Rs 36.70 (36.40 + 0.30).

THE REGULATIONS. In March, 1992, in order to provide operational freedom to corporates, the unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade-related or not, was permitted.

In February, 1992, corporates with cross-currency exposures were permitted to split their cover through the dollar. For instance, if an importer with a DM 1-million payment to make on March 31, 1998, is of the view that the rupee will depreciate against the dollar, but that the dollar will appreciate against the deutsche mark, he can split his exposure into a $-DM leg and a $-Re leg--and hedge the latter. The Reserve Bank of India (RBI) has also permitted corporates to take cover in a currency of their choice irrespective of the currency receivable or payable.

In January, 1997, the RBI allowed the banks to quote rupee forward premiums for more than six months. This has resulted in the development of a local forward market for upto one year. However, as the link between the local money market and the foreign exchange markets is not strong, and as prices are determined by demand and supply, activity in the long-term forward market has been limited.

FORWARD-TO-FORWARD CONTRACTS

THE DEFINITION. A forward-to-forward contract is a swap transaction that involves the simultaneous sale and purchase of one currency for another, where both transactions are forward contracts. It allows the company to take advantage of the forward premium without locking on to the spot rate. The spot rate has to be locked onto before the starting date of the forward-to-forward contract.

THE INSTRUMENT. A forward-to-forward contract is a perfect tool for corporates that want to take advantage of the opposite movements in the spot and the forward markets. By locking in the forward premium at a high or low level now, CFOs can defer locking on to the spot rate to the future when they consider the spot rate to be moving in their favour.

However, a forward-to-forward contract can have serious cash-flow implications for a corporate. Before booking a forward-to-forward contract, a CFO should carefully examine his cash-flow position bearing in mind the immediate loss that he would make if the spot rate did not move in his favour.

THE EXAMPLE. An exporter believes that forward premiums are high, and will move down before the end of December, 1997. Also, he expects the spot rate to depreciate in the next few months. Then, the optimal strategy would be to lock in the high forward premium now, and defer the spot rate to a future date. So, he opts for a forward-to-forward contract for end-December, 1997, to end-March, 1998, paying a premium of, say, Rs 0.64. By entering into such a contract, the exporter has the opportunity to lock on to the spot rate any time till December 31, 1997. Alternatively, if the three-month premium between end-December and end-March moves below the Rs 0.64-level, he can cancel the contract and book his profits.

OPTIONS

THE DEFINITION. An option is a contract that gives the holder the right, but not the obligation, to buy (call) or sell (put) a specified underlying instrument at a fixed price--called the strike--or exercise price before, or at, a future date. The option-holder has to compensate the writer (the issuer of the instrument) for this right, and the cost borne is called the premium, or the option price.

The premium should be adequate for the risk borne by the writer and yet, from the holder's point of view, must be worth paying. If the option contains a provision to the effect that it can be exercised any time before the expiry of the contract, it is termed an American contract. If it can be exercised only on the expiry date, it is termed a European contract.

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