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Financial Markets

Frequently asked questions

  1. What is exchange rate risk?
  2. What are the advantages of FX hedging?
  3. What is the best way to hedge against exchange rate risk?
  4. Other than natural hedge, are there other ways of hedging against exchange rate risk?
  5. Which are the main financial derivatives used in FX hedging?
  6. The price of forward FX sale/purchase– how is it set and what it reflects?
  7. What is potentially lost by entering into a contract on forward FX sale/purchase?
  8. What is a covered forex forward?
  9. How to offset the shortage of one currency by a surplus of another, while at the same time hedging against exchange rate risk?
  10. Which banks offer contracts on FX hedging and on what terms?

1. What is exchange rate risk?

The exchange rate risk is faced by all companies with an asset-liability currency mismatch in the conditions of a more or less fluctuating exchange rate. Due to the nature of their business, international trade companies are particularly vulnerable to this type of risk.

For instance, importers are obligated to pay for imported goods in a foreign currency on a specific future date. If the home currency weakens, they will record a loss, having to pay more dinars than planned on the day of settling their foreign currency obligation. By contrast, if the home currency strengthens, the importer will profit as he would need less dinars to settle his obligation on a future date.

For exporters, home currency strengthening means a potential loss as they would get less dinars when exchanging export proceeds, while domestic currency weakening means a potential gain or more dinars earned when exchanging export proceeds.

2. What are the advantages of FX hedging?

The exchange rate risk makes the end financial result uncertain for both importers and exporters. For this reason, they are unable to price their products in a way that reflects exchange rate risk exposure, which makes business planning difficult. The key purpose of FX hedging is, therefore, to eliminate the consequences of uncertainties regarding future exchange rate fluctuations.

FX hedging enables both importers and exporters to:

  1. make a clear calculation of future cash flows,
  2. set prices in a way which ensures business plan implementation,
  3. ensure operational stability and focus on their core activity

3. What is the best way to hedge against exchange rate risk?

The best way to hedge against exchange rate risk is for a company to achieve a full matching of cash flows (revenues and expenses), thus entirely eliminating the foreign exchange risk from its operations (natural hedge).

This is the best way to hedge against exchange rate risk as it is cost free and related exclusively to the operations of the company. However, it is only a few companies that can achieve such type of risk protection.

4. Other than natural hedge, are there other ways of hedging against exchange rate risk?

Companies that cannot implement “natural hedging” may protect against exchange rate risk by resorting to FX hedge instruments – contracts on the purchase or sale of currency at a predetermined exchange rate. As the price of these instruments (contracts) practically derives from other financial instruments (currency exchange rates, interest rates, indices, etc.), they are called financial derivatives.

5. Which are the main financial derivatives used in FX hedging?

The main derivatives used in FX hedging are:

  1. forex forwards – contracts to buy or sell a particular currency for another at an agreed future date and at an exchange rate agreed in advance;
  2. forex swaps – involving simultaneous purchase and sale of two currencies at predetermined exchange rates but at two different value dates;
  3. forex options – giving the option buyer the right (but not the obligation) to buy or sell a specific currency at a predetermined exchange rate within a predetermined time period or at a predetermined future date, for which the option buyer pays a premium.

6. The price of forward FX sale/purchase– how is it set and what it reflects?

The pricing of forex forwards or swaps is primarily a computation category. It is based on the current exchange rate of the currency being bought/sold and the difference in the interest rates on the two currencies involved. This formula starts from the premise of levelling off the yield on the two currencies over the contract time. If interest on foreign currency is lower than that on dinars, the buyers of foreign currency will, in the future, pay a forward rate which is higher than the current exchange rate (compensation of yield to the seller). The forward rate should not be seen as a forecast of future exchange rate movements, but rather as a computation category derived from the interest rate differential. Based on a selected methodology, a forward price calculator (link) has been created to help determine the forward price of specific currency pairs, enabling the user to set the forward rate depending on transaction maturity and interest rates applied.

7. What is potentially lost by entering into a contract on forward FX sale/purchase?

In the case of forward purchase, a company will bear extra costs if the exchange rate at transaction date is lower than the agreed forward rate (as it would be cheaper to buy foreign currency at the exchange rate as at transaction date). Forward sale of foreign currency means that a company will lose potential extra profit if the exchange rate at transaction date is higher than the agreed forward rate (as more dinars could be earned by selling foreign currency in the market at the current exchange rate).

Both these cases illustrate the opportunity cost of forward sale/purchase of foreign currency. In effect, it is a small price companies choose to pay in return for certainty, safety and responsibility for themselves, their shareholders and their staff.

The purchase of adequate options is recommended for such companies that wish to hedge against exchange rate risk, but are reluctant to give up the potential gain.

8. What is a covered forex forward?

Before entering into a forward contract, companies should pay attention to the type of forwards offered to them. Local banks often offer the so-called covered forwards, requesting that all or part of the dinar equivalent value be paid in advance, while the company receives the purchased currency on a desired future date. In this way, banks safeguard against credit risk (the risk of company’s default on future obligations), while at the same time offering a more favourable forward rate. Which type of forward contract will be more profitable depends on whether a company currently has enough dinars for forward foreign currency purchase, whether interest is paid on the dinar deposit and which interest rates and methodology are used in calculating the forward rate. To enable a comparison between the profitability of standard and covered forward purchase of foreign currency, we have provided a calculator for comparing the prices of forward contracts on the purchase of foreign currency (link).

9. How to offset the shortage of one currency by a surplus of another, while at the same time hedging against exchange rate risk?

In this case, a company can enter into a forex swap arrangement. In the first leg of this transaction, the company would sell foreign currency for dinars, and buy such foreign currency back at the forward rate after a certain time period. In this way, the company eliminates the exchange rate risk and ensures adequate pricing of its products. An example of currency swaps is provided in the publication Financial Derivatives (link).

10. Which banks offer contracts on FX hedging and on what terms?

Click to access the list of banks (link) offering FX hedging instruments in the domestic market, with Web links to their Internet presentations and detailed terms of entering into and performing these transactions.
 


Questions relating to foreign exchange hedging may be sent to the e-mail address: devizni.hedzing@nbs.rs.