Top 6 Internal Strategies to Reduce Currency Exposure

A firm may be able to reduce or eliminate currency exposure by means of internal strategies such as: 1. Currency Invoicing 2. Netting and Offsetting 3. Leading and Lagging 4. Indexation Clauses in Contracts 5. Switching the Base of Manufacture 6. Re-Invoicing Center.

Internal Strategy # 1. Currency Invoicing:

The foreign exchange risk can be transferred to other party by a firm, by invoicing its exports in its home currency, when they are of the opinion that home currency will appreciate.

Many firms try to invoice their exports and pay their suppliers in the local currency, so as to minimize the exchange risk, by not approaching to the Forex market for settlement. By following this practice, a firm can know exact amount which it has to pay for imports and to receive for exports.

If the firm is following such practice, it has to suffer sometimes when the local currency appreciates and firm has to pay in domestic currency and not in foreign currency. This might result into loss of market for the products of the firm, if the market is not monopoly market.

Firms may also have recourse to invoicing in a currency whose fluctuations are less erratic then those of the national currency. For example, in the countries of the European Union, the use of Euro is gaining popularity.

Illustration 1:

Aman Ltd exports software for an invoice value $ 100 Million Spot rate is Rs.45. Forward is Rs.46. If the forward rate is an indicator of future spot rate, in which currency should Aman Ltd Invoice? What will be its approach, if the forward rate were to Rs.44? Will the position change if it were importing, and not exporting, software for a value of $100 Million?

Solution:

a. Export: Spot Rs.45. Forward Rs.46. Re is depreciating against the $. By invoicing in FC, i.e., $ it ends up getting more Rs. Hence it should invoice in FC.

b. Export: Spot Rs.45. Forward Rs.44. Re is appreciating against the $. By invoicing in FC it ends up getting less Rs. Hence, it should invoice in home currency.

c. Import: Spot Rs.45. Forward Rs.46. Re is depreciating against the $. By accepting invoicing in FC it ends up in paying more Rs. Hence it should negotiate for invoicing in home currency.

d. Import: Spot 45. Forward Rs.44. Re is appreciating against the $. By accepting invoicing in foreign currency it ends up in paying less. Hence it should accept invoicing in home currency.

Illustration 2:

Other things being equal, determine whether arranging for invoicing in rupees is advantageous in the following cases:

a. Ambika P. Ltd. is exporting pepper to a trader in New Jersey for on invoice value of Rs.84,32,000/-. Payment terms are 90 days. Spot rate Re/$ is 42.16 – 36. Rupee is expected to gain, is it advantageous to invoice in Rupees?

b. Maruti Enterprises and Co., Dibrugarh, imports spare parts for machine from Messrs. Magayachi, Osaka, Japan. Value of consignment is Rs.1 3,25,000/-. Payment terms are 50% in 90 days, balance 50% in 180 days from date of shipment from Japan. Spot rate Re/¥ 0. 4010. An estimate of what would be the forward rate is not available, though it is known that ¥ is expected to move in synchrony with $ Rupee may either gain or lose on $. Is it advantageous to have the import invoiced in Rupees?

Solution:

“Other things being equal” is a critical phrase. It is assumed that the overseas customer is indifferent to the mode of invoicing. Hence,

a. The transaction is one of exports. Asset is in $. If Rupee strengthens against $, the exporter will get less rupee for each $ asset value. It would not therefore be advantageous to invoice in $. Hence, he should invoice in Rupees.

b. Yen is expected to move in synchrony with $. Rupee may gain or lose on Dollar. Two situations are possible.

i. If rupee gains on dollar, Dollar is in effect depreciating against the Re, and hence ¥ also will depreciate against rupee. If the imports are invoiced in ¥, we would end up paying less. Hence, it is not advantageous to have it invoiced in Rupees.

ii. On the contrary, if rupee loses on dollar, dollar in effect would be appreciating, and Yen will also be appreciating against rupee. If imports are invoiced in Yen, we would end up paying more rupees for each Yen. Hence, it is advantageous to raise invoice in Indian Rupees.

Hence, in import transactions, it is preferable to accept the invoiced in home currency only where rupee is likely to depreciate against the foreign currency.

 

Transaction, Rupee and Hence

Internal Strategy # 2. Netting and Offsetting:

A firm having multiple transactions with rest of the world will also have the exposure with receivables and payables in different currencies. To reduce the exposure risk in each currency, firm can net out its exposure in each currency by matching its receivables with payables.

 

This technique consists of accelerating or delaying receipt or payment in foreign exchange as warranted by the position or expected position of the exchange rate. Sometimes, a currency might have a receivable in one currency say, DM and a payable not in the same currency but a closely related currency such as Swiss francs; the exposure arising from the same can be offset.

 

Netting (Internal Compensation):

A firm may reduce its exchange risk by making and receiving payment in the same currency. Exposure position in this method is only on the net balance, whether receivable or payable with respect to particular foreign currency. Thus, we can say, that if the firm limits the number of currencies in which it trades, it can effectively reduce its exchange risk. This method can prove to be more effective if the choice of currency is made along with the dates of settlement.

Bilateral:

Netting can be of two ways. It is bilateral, when, two firms have trade relations and they buy and sell products to each other reciprocally.

Multilateral:

Netting can equally be multilateral. This recourse can be taken when internal transactions are numerous. Volume of transactions will be reduced because each company of the group will pay or be paid only net amount of its debit or credit.

Illustration 3:

Avail P. Ltd., is exporting pepper to a trader in New Jersey for an invoice value of Rs.35,00,000/-. The New Jersey importer had also supplied canned-cherries to Avail, invoiced in Rupees at Rs.84,32,000/-. Shows how bilateral netting can reduce the value of inter-company dues?

Solution:

The currency of invoicing for the two transactions is incidentally common i.e. Re. The two inter­company balances can be set off against each other. The net balance is Rs.49,32,000 being amount owed by Avail to New Jersey trader. Avail can make a payment of Rs.49,32,000/- on the due date, if the invoicing had been made in Rupees. When the Indian rupees will be received, New Jersey trader will have the rupee converted into $ at the spot rate.

Illustration 4:

A group of companies is controlled from the USA. This group has subsidiaries in UK, Euro land and Japan. For convenience, these are referred to as UK, EL and JP.

As on 31st March, inter-company Indebtedness stood as under:

Debtor, Creditor and Amount

US Headquarters follow the multi-lateral netting policy, and adopt the following exchange rates: US $ 1 = € 0.90; Sterling 0.70; ¥ 120

Compute and show net payments to be made by subsidiaries, after netting off.

Solution:

Step I: Convert the Balances into US D (Common Currency):

US $ 1 = € 0.90; Sterling 0.70; ¥ 120

Convert the Balances into Usd

Step II: Incorporate the Information in a Matrix form as under:

Incorporate the Information in a Matrix form

Step III: Arrangement:

a. UK will receive a net of – $ 259.52

b. EL will pay a net of – $ 192.85

c. JP will pay a net of – $ 66.67

Internal Strategy # 3. Leading and Lagging:

The exporting firm is expecting to receive the payment after few period in future from the customer to whom goods, commodities or services are sold, and of the opinion that local currency will depreciate, in such case he will like to receive the payment later on, because monetary gain will happen.

Such concept of delay the receipt of remittance is known as Lagging. In case of payable in foreign currency, and if the local currency is expected to be depreciated then local importer would like to release the payment at an early date, is known as Leading.

It is common parlance, to clear the dues payable in foreign currency at an early date, if the depreciation of domestic currency is expected. At the same moment, the exporter would prefer to delay the receipt of remittances from overseas buyer, when the local currency depreciation is expected.

The opposite way actions are needed in the case of expectation of local currency appreciation. Leading and lagging strategy supports the multinational firm to improve the cash management, when extensive intra company transactions are taking place.

Illustration 5:

Poonam Products Ltd. (PPL) had already received the invoice for HKD 2,10,000/- Spot rate Rs./HKD is 6.50 and 60-day forward rate is 6.60. Determine whether Poonam Products should avail of the full credit period of 60 days, or lead the payment – if interest rate in India is (a) 11 % p.a. (b) 6.5% p.a. What would you suggest if the company is running a cash surplus?

Solution:

WN 1:

Invoice is in foreign currency i.e., HKD. If PPL pays today, the rupee outflow computed at the spot rate of 6.50 would be Rs.13,65,000/.

WN 2:

The Re is depreciating against i.e., HKD. Paying later would entail a larger Rupee outflow. In this case it would be 2,10,000 × 6.6 = Rs.13,86,000

WN 3:

The company would be indifferent between the two options if it can borrow today at Rs.13,65,000 and repay Rs.13,86,000 two months Later. This entails a borrowing cost of 1.53846% per 60 days or 9.36% per annum (considering 365 days in a year).

WN 4:

If the company can borrow at less than 9.36% it should lead the payment. When the borrowing rate is 11 % p.a. it should avail of full credit. When the borrowing rate is 6.5% p.a. it should lead the payment.

WN 5:

If the company has surplus money the decision would depend on what rate it can invest the surplus money. If the Return on Investment is < = 9.36%, lead the payment. If the Return on Investment > 9.36%, Delay (lag) the payment and reap the benefit of difference between ROI and 9.36%.

Illustration 6:

Icenole Glass Co. Ltd. has exported goods worth Kuwaiti Dinars 20,000. Kuwaiti buyer has sought a credit period of 90 days. Exchange rates for this currency read as Spot rate is Rs.1 54.10 and 3-month forward rate is Rs.155.80. Should Icenole accept the credit terms, or insist on immediate payment? Will your decision change, if interest rate in India for borrowings is 8% and for investment are 6%?

Solution:

a. If Kuwaiti buyer pays today, the rupee inflow (at spot rate of 1 54. 10) would be Rs.30.82 lacs. The rupee is depreciating against KD. Receiving later implies a larger inflow of Rs.31.16 lacs. Prima facie, the company can (lag) and accept the credit terms. However, the appreciation rate of KD is to be compared with the alternative of receiving the funds, and investing in India at 6%.

b. KD appreciation rate 4.412%

Forward rate – Spot rate/Forward rate × 12 MONTHS/n × 100 = Premium Discount

155.80 – 154.10/154.10 × 12/3 × 100 = 4.412%

c. KD received now, converted into rupees at spot rate, will mean an inflow of Rs.30.82 lacs. If invested for three months at 6% the maturity proceeds will be 31.2823 lacs. Receiving later would be Rs.31.16 Lakhs. Hence receive now, and invest in India.

Internal Strategy # 4. Indexation Clauses in Contracts:

For protecting against the Exchange rate risk due to the inflation in the prices, various indexation clauses are included in a contract by the importers or exporters. This clause adjusts the prices to the tune of the indexation, so that the major impacts of the fluctuations in the exchange rate are absorbed by it. If the currency of the exporting country depreciates, the price of export is decreased to the same extent or vice-versa.

Therefore, the exporter receives almost the same amount in local currency. Thus, in such circumstances, the exchange rate risk is borne by the overseas buyer. Another alternative available is the indexation of price to a third currency accepted by both parties under contract or links it to a basket of currencies like ECU or SDR. An indexation contract may be done with a variation, which stipulates that an appreciation or depreciation would be taken only when it is beyond certain level, which may be around 5%.

There is another possibility where the contracting parties may decide to share the risk, at the time of entering into business transaction. They may stipulate that part of exchange rate variations, interring between the date of contract and payment, will be shared by the two in accordance with a certain proportion, for example, half-half or one-third, two-third, etc.

Internal Strategy # 5. Switching the Base of Manufacture:

To achieve benefits of the cost advantage and revenue maximisation, and creating a safeguard against the foreign exchange risk, a manufacturing concern can switch its bases of manufacture / production from one place in the globe to the another place in the globe. For example, European car manufacturers have opened factories in India.

Internal Strategy # 6. Re-Invoicing Center:

A multi-national group can make its billing in the respective currencies of its subsidiary company and receives the payment in the foreign currency from each one of them. This method would be more preferable if the location of the re-invoicing center is made in a country where the exchange rate regulations are least stringent.

The rein-voicing center is normally a part of the parent company may be in the form of subsidiary company. The methodology of working is quite simple. The subsidiary unit will raise the invoices in foreign currencies and in the name of the Rein-voicing center. The rein-voicing center will in turn remit the equivalent sum of invoice in the national currency of subsidiary unit.

In the same way, whenever the payment to be released for import of goods, commodities or services, the payments in foreign currencies to suppliers will be made by rein-voicing center. The equivalent sums in the national currencies will be recovered by rein-voicing center from the concerned subsidiary for payment made by them for import transactions of subsidiary.

When the firm adopts the rein-voicing center concept, then it indicates that firm has adopted Centralized management for the management of exchange risk. This method in turn helps the parent firm in overall reduction in the volumes of foreign currency transfers, transactions costs and hedging costs.

The method prima facie seems to be very easy, but in practical way, the problems encounter where dates of maturity of transactions do not match one to one. In addition to that, in some countries the exchange regulations may not permit rein-voicing center, because of possibility of losing the tax revenue.

Submitted by : Dr. Anathi, Category : Foreign Exchange, Tag : Internat Strategies