6-3.
Overview
Today, we’ll discuss how to avoid that kind of risk.
There are other options you can use.
I’d like you to tell me.
Learning Points
- Exchange Risk Mitigation with Banking Solutions
- Non-Banking Solution
- Pros and Cons
Banking Solutions
In transactions conducted in foreign currencies, there are potential risks for losses due to fluctuations in exchange rates.
In international trade, the time gap between contract conclusion and payment/collection of funds creates significant exchange risk. In risk hedging facilitated through banks, there are the following methods:
- Forward Contract
- Currency Option
(1) Forward Contract
A forward contract, also known as a forward foreign exchange contract, is an agreement to lock in and set a predetermined exchange rate for a future currency transaction.
The reservation methods are divided into the two types below, depending on the delivery timing.
・Optional delivery: Reserving a rate for a certain period and executing it during that period.
Forward contracts require credit examination before reservation. Once made, changes or cancellations are generally not allowed except in unavoidable circumstances.
(2) Currency Option
A currency option is a financial contract that gives the exporter or importer the right, but not the obligation, to buy or sell a foreign currency at a fixed exchange rate within a specified period.
It provides flexibility for managing risks related to currency exchange rates.
There are two main types:
- Call Option: Gives the right to buy at the strike price (rate)
- Put Option: Gives the right to sell at the strike price (rate)
Unlike a forward contract, the key feature is that the holder can choose whether to exercise the option or not.
Case Study
Transaction Flow:
1. The Japanese importer procures the right to buy dollars at 100 yen per dollar from a bank.
2. When the payment period comes, the importer decides whether to:
・Exercise the right or
・Abandon the right
This is called the “Yen Put, Dollar Call Option. (selling yen to buy dollars). “
Case Study – How to Use:
When exercising the right is preferable:
In the case of the exchange rate being 1 dollar = 110 yen. Exercising the option to pay at 1 dollar = 100 yen would be cheaper for the importer.
When abandoning the right is preferable:
In the case of the exchange rate being 1 dollar = 90 yen. Abandoning the currency option is cheaper for the importer.
Non-Banking Solutions
There are also methods without involving banks:
- Local Currency Transaction
- Leads and Lags
- Currency Matching
- Netting
(1) Local Currency Transaction
This is a method of conducting transactions using your currency.
However, the counterparty will bear the exchange rate risk. Therefore, it is necessary to negotiate and reach an agreement with the partner.
(2) Leads and Lags
This is a method where exporters or importers intentionally adjust the timing of payments or receipts based on anticipated movements in the exchange rate.
Imagine a Japanese importer has upcoming payments in dollars, and they think that the exchange rate might move unfavorably soon.
However, as the movement of exchange rates is uncertain, this method is not foolproof. Additionally, since the adjustment of settlement timing is based on one’s considerations, it requires discussions with the trading partner.
(3) Currency Matching
Currency matching is a strategy where a company retains foreign currency it receives from exports and uses it to settle payments for imports.
The point is the company does not convert it into the local currency. This method helps avoid exchange rate fluctuations and allows for smoother international transactions.
Even our company holds currencies in yen, dollars, and Thai baht.
(4) Netting
Netting is a method of offsetting receivables and payables with the same trading partner. Reducing the actual transaction amounts makes it possible to minimize the impact of exchange rate risks.
Imagine you buy $200 worth of goods from a supplier, and at the same time, you sell $100 worth of goods to the same supplier.
Pros and Cons
The choice of which method to use should be made by considering the merits and demerits. Below are the pros and cons of using a bank.
Pros
- Incurs commission fees
- Reliable means to avoid risk
Cons
- Need to negotiate based on a trusting relationship with a business partner
- It may not be foolproof and should be carefully considered
Summary
There are banking solutions to avoid exchange risk when dealing with foreign currency, such as a forward contract or a currency option.
In addition to banking methods, there are non-banking methods such as local currency transactions, Leads and Lags, currency matching, netting, etc. It is important to choose the appropriate way depending on the type of transaction to ensure your needs are met.
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Test Yourself
Reinforce your understanding of this topic by working through the exercises. Attempting the exercises without referring to the material as much as possible is advisable.
