Several non-contractual techniques may be used. These include:
Undertaking transactions denominated in home currency only.
- Entering into transactions denominated in foreign currency which is considered to be stable. E.g. dollar, sterling pound, Yen, etc.
- The use of leads or lags. Leads are advance payments while lags are delayed payments.
Contractual techniques include forward exchange rates, money market hedge currency options, currency futures and swaps. These techniques are explained below:
Forward Exchange Contract
A forward exchange contract is an immediate, firm and binding contract between the bank and its customer for the purchase or sale of a specified quantity of a stated foreign currency at a rate of exchange fixed when the contract is made but requiring performance at a specified future date.
A forward exchange contract can either be fixed or option. A fixed forward exchange contract requires performance to take place on a specified future date. While an option forward exchange contract requires performance to take place at any date between two specified dates
Quoting a forward rate
Forward exchange rate might be higher or lower than the spot rate. If it is higher, then the quoted currency would be cheaper forward than spot (using indirect quote)
Closing Out A Forward Exchange Contract
When the time to carry out the transaction in a forward exchange contract is due but the party buying or selling the foreign currency does not have the required currency, then the party may organize a cross out of the contract. If the customer had contracted to sell foreign currency to the bank but cannot perform his part of the contract, then the bank will sell the currency at the spot rate to the customer and then buy it back at the agreed rate. If the difference in this transaction is a loss (on the part of the customer), then the bank is compensated by the customer to offset the loss. If there is a gain then the bank compensates the customer.
Cost Of The Forward Cover
= (Premium or (discount)) x 12/months forward) x 100
An exporter who invoices foreign customers in foreign currency can hedge against the exchange risk by:
- Borrowing an amount in foreign currency immediately
- Converting the foreign currency to domestic currency at the spot rate
- Repaying the loan and interest out of the foreign currency received from the customer
Similarly, if a company has to make foreign currency payment in the future, it can buy the currency now at the spot rate and put it in a foreign currency deposit account. Eventually the company should use the principle and interest earned to make the payment when they fall due.