Sunday, December 25, 2011

Managing Foreign Exchange Risk in volatile times


Managing Foreign Exchange Risk in volatile times

The foreign exchange market is witnessing unprecedented volatility with the Rupee-dollar exchange rates moving from Rs. 44.1 per USD to Rs. 54.2 and back to Rs. 52.7, all within the last five months. Expert opinion on the direction of future rates is divided, with predictions across the spectrum. While many experts expect further depreciation to as high as Rs. 58 per USD, equally strong is the assertion of others who claim this to be an aberration and expect exchange rates to revert to Rs. 45 per USD. Such divided opinion leaves corporates that have foreign currency exposures perplexed on the strategy they need to adopt.  A robust risk management policy, founded on few simple ground rules, can help manage foreign exchange risk and avoid serious consequences.

PREDICTIONS ARE FOR EXPERTS

Guessing the direction of exchange rate is like predicting the weather.  It is a full-time job for professionals and experts, and not the business of an entrepreneur or a corporate finance manager. Even predictions by experts are fraught with risks; relying on such predictions and exposing the company to such risks can seriously affect the financial health of the company.  Unless the balance sheet can withstand big shocks, companies – especially small and medium enterprises – should mitigate all their foreign currency risks through appropriate hedging.  Companies that leave foreign exchange exposures un-hedged in the hope of exchange gains more often than not end up hurting their profitability.

NATURAL HEDGE MITIGATES RISK

Exchange rates have strong influence on prices of several products, especially those involving commodities such as petrochemicals, aluminium, copper and steel.  This is because the base commodity prices are more often determined using landed prices of imports. Companies in such sector may enjoy certain natural hedges against adverse exchange rate movements, and the need for hedging their foreign currency liabilities could reduce to this extent.   Companies with significant foreign exchange transactions should seek professional help to quantify net foreign currency exposure and identify strategies to mitigate the same.

RISK MANAGEMENT POLICY

A sound risk management policy is a must for medium and large businesses to serve as guide for business managers in managing foreign currency exposure.  This helps in calibrated degree of risk taking, quantifying stop-loss levels and also prevents speculative positions which have wrecked havoc in many companies in the past.

The current weak global economic outlook has added to the volatility of exchange rates, rendering any meaningful prediction of exchange rates extremely difficult even for experts. In such vulnerable economic environment, companies should avoid guessing and put in place strong risk mitigation strategies.

N. Muthuraman is Director, RiverBridge Investment Advisors Pvt. Ltd., a boutique financial advisory firm and can be reached at muthuraman@riverbridge.in 

This is the blog of the Print Version published in Business Line dated 26th Dec 2011 

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