Mitigating Exchange Rate Risk

MSMEs are exposed to many forms of risk in their course of business, such as interest rate risk, foreign exchange risk, and natural disasters. These could result in financial loss and minimize their profit. Since MSMEs work on tighter budgets than larger firms, and have weaker capital base, losses through exposure to various risks can result in more severe impact on profits and operating efficiencies for MSMEs than for large firms.

Foreign exchange risk in particular, impacts firms engaged in exporting, importing, and borrowing in foreign currency. Rupee appreciation benefits importers as it decreases rupee prices of imported goods and harms exporters as it increases foreign currency prices of exported goods. Rupee depreciation harms borrowers who take loans in foreign currencies that are cheaper than Indian loans.

Since currency fluctuations adversely impact MSMEs, they should determine their risk exposure to various currencies, as well as adopt risk mitigation strategies and methods.

Determining Risk Exposures Involves Identifying:

  • The currencies to which the firm is exposed to
  • The extent of sales / purchases /receivables / payables denominated in foreign currencies
  • The extent to which price fluctuations can be passed on to customers (by increasing price or by entering price variance clauses)
  • Cash flow position of the firm and ability to withstand currency fluctuations
  • Impact of currency fluctuation on overall profitability of the firm

Determining risk mitigation strategies involves assessing whether the firm should hedge foreign exchange risk at all, and if it should, to what extent.

  • Selective hedging could be undertaken when the firm has limited exposure to foreign currency, and /or the currency movement may move favorably so that the firm wants to take advantage of the situation and hence not hedge its position completely.
  • Systematic hedging could be undertaken to hedge any foreign currency position that the firm enters in.

Risk mitigation tools and methods involve diversification of currency base, as well as hedging currency exposure by entering into forward contracts, swaps, purchasing call and put options, and using currency futures.

1. Diversification of risk across currencies is beneficial as different currencies move differently, as loss due to exposure in one currency could occur simultaneously with gain due to exposure in another currency.

2. Also, various hedging instruments traded on the counter and at the exchange houses are available for hedging currency risk:

  • Foreign exchange forward contracts allows locking in of a pre-agreed exchange rate for a pre-agreed date
  • Foreign currency option contracts provide the buyer of the contract the right, but not the obligation to execute foreign exchange transactions at a future date.
  • Currency futures are exchange-traded products, and provide more transparency and flexibility, but no customization to hedge foreign currency exposure.

Selection of hedging instrument for exports depends upon availability, flexibility and cost. The most common hedging instruments in India are forward contracts offered by most banks.

Hedging currency risk exposure involves developing risk management strategies, and taking well-timed hedging decisions. Prepare daily scan reports and analyzing of trend and factors affecting exchange rates of the currency in which the firm is exposed to help in taking well-informed hedging decisions. Primary factors that affect demand / supply and hence price of any currency include

  • Macroeconomic environment and indicators such as GDP, CPI, industrial production, international trade, etc.
  • Stock market and demand for equity of a country
  • Political stability and fiscal policies of the relevant countries
  • Interest rate differentials across countries
  • Purchasing power parity

MSME firms need to study and understand the markets and factors affecting exchange rates to take timely hedging decisions and secure better exchange rates.

As per RBI Guidelines on Foreign Exchange Derivatives and Hedging Commodity Price Risk and Freight Risk Overseas, SMEs in India are permitted to book forward foreign exchange contracts without production of underlying documents for hedging their direct / indirect exposure to foreign exchange risk. Click here to access the detailed RBI guidelines. SMEs can book forward contracts without underlying exposures or any past records of export or import, and are also permitted to freely cancel and rebook the contracts.

The announcement was made by RBI in its Annual Policy Statement 2007-08, the details of which are as follows:

  • SMEs having direct and / or indirect exposures to foreign exchange risk can book / cancel / rebook / roll over forward contracts in order to manage their exposures effectively
  • Such contracts may be booked through AD Category – I banks with whom the SMEs have credit facilities and / or banking relationship and the total forward contracts booked should be in alignment with the credit facilities availed by them for their foreign exchange requirements or their working capital requirements or capital expenditure.
  • Also, SMEs availing this facility should furnish a declaration to the AD Category – I bank regarding the amounts of forward contracts already booked, if any, with other AD Category – I banks under this facility.
  • SMEs are also permitted to use foreign currency rupee options for hedging their exposures.

Sources: Reserve Bank of India and Federation of Indian Micro, Small and Medium Enterprises (FISME)

Read a FISME paper on mitigating exchange rate risk here