Foreign currency finance always looks lucrative when companies compare the interest rate offered with rates prevailing in INR funding. But one needs to understand the fact that repayment is also required to be done in foreign currency. So till maturity, if INR depreciates against foreign currency importer’s effective liability in INR will increase.
Importer takes buyer’s credit of USD 100,000 on 1stJanuary for 90 days at 2% p.a. Let’s take on 1st January USD/INR was trading at 60.00. So his total import liability as of this date was Rs. 60,00,000.
Now on maturity 31st March with interest amount is USD 100,493.20. If exchange rate remains the same importer’s total liability would be Rs. 60,29,592. So effective interest rate is 2%p.a.
But if rupee depreciates against USD and trading at 63.00 on maturity date of buyer’s credit the effective liability of importer becomes Rs.63,31,071.6. Given its loan for 90 days the annualized effective interest rate becomes 22% p.a. Instead of assumed 2% p.a.
Do you believe history repeats itself?
Historical evidence suggests the INR is more prone to depreciation against foreign currency, which increases the Risk of keeping Foreing currency exposure open.
Even though there is equal probability of INR appreciating against the foreign currency keeping the foreign currency loan fully open to market movement can lead to significant profit erosion at times. If we look at long term chart at beginning of FY 2010-11 USD/INR RBI reference ratewas 44.73. After 5 year on March end 2015 USDINR RBI reference rate was 62.59. Even if we do not consider the in between highs and lows and go as per RBI reference rate mentioned, there is average annually compounded depreciation of 7% (3.57 rupee) per annum. So if we were to believe history gives some evidence of probable future the possibility of loss on open exposure increases even more.
How to Mitigate this Risk
The simplest and most suggested way of mitigating this risk is to book forward contract or buy future against the open exposure. This hedging will fix his total liability in Indian rupees by which company can avoid any risk of adverse movement in the currency pair. But the fact is generally USD trades at premium so the hedging will happen on the rate higher than current market rate, this will increase effective costing of the foreign currency finance.
In example given above if importer decides to hedge his buyer’s credit on 1st January itself through forward contract and premium for 3 month is trading at 90 paisa. The effective repayment rate becomes Rs. 60.90 in this case.
So for 31st March if USD repayment amount was 100,493.20, the total INR liability will become Rs.61,20,036. This makes his effective cost of funds as 8.00% p.a
Need for Active Risk Management
Given forward premiums are ranging between 6-8% per annum hedging fully with forwards will eliminate the the benefit of lower interest rates. Same is the case with keeping exposure fully unhedged given historical depreciation of 7% per annum.
Scenario augurs need for active risk management strategies which involved tracking the markets and open exposure closely along with stop-loss and target levels. There are instruments beyond simple forward contracts which require much more involvement. Given the main business of the companies is to trade in to goods and services beyond financial management. Setting up treasury will mean hiring the professionals with thorough experience and understanding for forex risk management and cost buying costly software like Reuters or Bloomberg. FinByz Consulting offers Forex advisory service which solves this issue and enables customers actively monitor the fx exposures along with daily MTMs. We also provide our inputs based on market analysis for timing and right mix of available instruments to hedge.
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About the Author: Mukesh Variyani
A result oriented professional with of experience in Forex Risk Management and Debt Syndication. Having insights of both Corporate and Banking side of Treasury management I help corporates to optimise the strategies of financial risk management and debt syndication through FinByz Consulting.