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The Colour of Money - V - Outside View by Vikram Murarka
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The Colour of Money - V
Jun 9, 2012

Speaking to a number of exporters, importers, CFOs over the last several years, we have felt that most people find forex to be a tough beast to tame and view it with fear. Granted, managing forex risk is not easy, but it is not impossible either. To start with, there is a need to throw light on some fundamental concepts of forex risk management. In this series of articles, we will deal with questions such as:

  • What is your actual risk?
  • How much should you hedge?
  • What is Early Delivery?
  • Is the Forward Rate a forecast?
  • How to choose a Benchmark?

Use a Forecast for Budgeting

Most exporters price their goods on a "cost plus" basis. They add a certain cushion for forex volatility to their domestic costs and quote a Dollar price accordingly. Importers take whatever Dollar price they are able to negotiate. Both the export/ import contracts are then accounted for in the books at the current exchange rates.

Thereafter, the exporter/ importer hopes that the rate on the date of actual receipt/ payment should remain the same as that on the date of the business contract, so that he does not have any forex profit/ loss. Thus, most export/ import deals are, by default, cost-budgeted on the present. But, the future is usually different from the present and when the time for payment/ receipt comes, there is a forex profit/ loss compared to the booked value of the deal. This is a problem. How does one budget for the future transaction?

Forwards or Forecasts? A faceoff
Issues Forward Forecast
Unambiguity It is a single rate, unambiguous, commonly known. So, it can easily pass auditor scrutiny. There are many forecasts, possibly contradictory. Therefore confusing.
Impartial Advantageous to Exporter, disadvantageous to Importers. Impartial to both.
Indicator of Future? No. Forward rates are based on Spot rates, they are not indicators of the future. Not related to Spot. Direct indicator of the future.
The only advantge going for Forwards is that they are unambiguous.
The Forecast does better on the other two counts.
If the future were known, one could have used the future rate to price the export/ import transaction and to budget accordingly. But, nobody knows the future, right? So, some businesses tend to use the Forward Rate as a proxy for the future, simply because it is a rate that pertains to the future.

THE FORWARD IS A FAULTY BENCHMARK

But, using the Forward Rate has two problems. The first is that the Dollar is usually at a premium to the Rupee in the forward market. This premium is an earning for an exporter, but is a cost for the importer. The Exporter may be able to accept a lower Dollar price for his goods (being compensated by the premium for the dent in his profit) but the Importer would have to be ready to pay a higher Rupee cost. This is a conundrum for companies that have both exports and imports. A true benchmark should be impartial to both the exporter and the importer.

The second problem is that the forward rate is not a forecast and it is incorrect to use it to budget for a transaction that is to take place in the future. So, what is the solution?

USE A FORECAST AS A BUDGET

The answer is to use a currency forecast as the budget rate for the future payment/ receipt. "If only it were possible!" you would say, Dear Reader. "I would do it, if I had a reliable forecast. But, nobody can forecast currencies!"

This notion is true to some extent and untrue to some extent. Yes, currencies cannot be forecasted exactly. However, they can be forecasted with a reasonable degree of accuracy, within an acceptable degree of variance. And, such forecasts can serve as better budget rates than the Forward rates.

MARKETERS DO IT ALL THE TIME

Let us, for a moment, look at forex risk management not as something esoteric but as a normal part of business. The sales and marketing departments in all companies make their budgets and fix their targets based on market forecasts. These forecasts are not expected to be sacrosanct. A degree of variance is always assumed. The sales forecasts/ targets are revised periodically, on a quarterly or monthly basis. This is the normal business practice. Thereafter, the company tries to meet or beat its internal sales targets.

Currency forecasts are to be approached in the same manner. Neither the professional forecaster nor the user of the forecast should harbour the notion that the forecast is sacrosanct. The forecaster should also not stubbornly stick to his forecast (even as it is going wrong) just because he has done the forecast. Nor should the user berate the forecaster for getting it wrong.

Of course, this does not mean there should be no accountability and the forecaster can say just anything and get away with it. The professional forecaster should pursue his craft with diligence, keep track of his performance, inform the user of the reliability of his forecast, of the degree of variance that may be expected and will constantly try to improve upon his work. Our own forecasts have a reliability factor of 72%.

Working with a reliable currency forecast can yield dramatically improved results in forex risk management. Try it. It works. This article has been authored by Vikram Murarka. He is the Founder of and Chief Currency Strategist at Kshitij Consultancy Services, India's first forex website, started back in 1998. Vikram has been forecasting and trading currencies since 1991.

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