Foreign exchange transactions

Hedging Of Foreign Exchange Transactions In International Trade

International Trade In India

This would cover some of the trade practices adopted by India over the years. Thesis would try to incorporate the ancient trade practices followed by India as well as the current trends of imports & exports. It would also try to cover the products, markets, industries in which India as a country and the corporate trade. This would also cover the current Balance of Payment conditions of India

Modes Of Settlement:

Thesis would try and undertake study on different modes of settlement available to settle international trade transactions. This would vary from corporate to corporate and country to country. Examples: “Letter of credit”.

Impact Of Foreign Exchange In International Trade Deals:

In this we will see that how the impacts of foreign exchange are important. Foreign exchange is one of the vital elements involved in international trade deals. Foreign exchange impacts on international trade deals can be lethal. Hence it is very important that we understand foreign exchange market and its components very well.

Regulations In International Trade:

Regulations are at the centre of any international trade. There are many regulatory bodies, who are intermediaries while we undertake international trade may be imports or exports. Some examples of such regulatory bodies are World Bank, WTO, IMF, UN etc. All these institutions are important for controlling trade activities by countries or at times even by corporate or individual.

Regulation In Foreign Exchange Transactions By RBI In International Trade:

Over and above, the overall trade regulations by these authorities for local trade transactions which involved foreign exchange payments or transactions. RBI regulates and takes necessary actions, when there is any violation in the rules set by RBI.

Risk In Foreign Exchange Transactions:

There are many risks attached while undertaking foreign exchange transactions for the settlement of trade payments. Such risks may be on the part of importer or exporter or at times even the intermediaries as importer's bank advising bank, exporter's bank etc. Such risks may be related to foreign exchange exposure currency risk and other economic risks.

Risk Hedging Strategies:

It is very important to hedge the risks attached in foreign exchange settlement of trade. There are many hedging strategies available with the parties to trade for hedging the exposure to risk. Some of the hedging strategies that the thesis would cover are as follow:

¨ Derivatives contracts

¨ Hedging of different foreign exchange exposures

¨ Netting techniques used for the trade settlement between the countries

¨ Arbitrage opportunities measurement

¨ IRP and hedging currency risk

Best Hedging Practices By Corporate

Thesis would also try and understand some of the best hedging practices followed by corporate in India as Adani, Reliance etc. These would be taken in to consideration by primary research.

Research Methodology:

Thesis would basically consist of primary and secondary survey. The primary survey would try together data on various products and markets available for international trade, different modes of settlement, impacts of foreign exchange on trade, risks associated with trade transactions, measuring exchange rate risks, different hedging strategies in managing international transactions etc. by a way of focus group interview, questionnaires, and interviews.

The secondary research would comprise of international foreign trades books, internet, articles, magazines, research papers etc.

Introduction:

The main objective of the Indian International Trade Policy has been to protect its market from foreign competition. Up until the 1980s, India was not interested in exporting its goods and services abroad and not ready to open its economy to foreign investments. The aim of its economic policy was to ensure the country's independent development. At the end of the 1980s, India was one of the most closed economies in the world. Its bilateral trade policy, heavily skewed toward the former communist countries, was full of grand statements about technology transfer, mutually helpful relations and partnership for development to very little purpose. The idea of a Free Trade Zone was abhorrent. Therefore, India was left out of the Asian economic boom. India was a founding member of the General Agreement on Tariffs and Trade (GATT) in 1947 and of the World Trade Organization (WTO) in 1995, and so has actively participated in the different rounds of negotiations. In many ways, it is still partial by its policy of non-alignment, since most favored nation and the non discrimination-based GATT principles accord with India's desire to be treated as an equal by more powerful trading partners, while defending the situation of developing countries. In the multilateral field, and during successive rounds of negotiations in Geneva, where India was an active player) it was mainly interested in promoting with some success the idea of a Special and Differential Treatment (SDT) (Special and differential treatment is a set of GATT provisions that exempts developing countries from the same strict trade rules and disciplines of more industrialized countries. In the Uruguay Round Agreement on Agriculture, for example, developing countries are given longer time periods to phase in export subsidy and tariff reductions than the more industrialized countries. The least developed countries are exempt from any reduction commitments), allowing developing countries to exempt themselves from the central commitments made by developed countries. Furthermore, India was not interested in regional policy and did nothing to join any of the various regional groupings that were starting to emerge.

Nevertheless, it eventually became necessary for India to develop a regional trade policy, since, up until 2000 India had remained lonely from important regional strategic deals, not having joined either the Asia-Pacific Economic Community (APEC) or the Asia- Europe Meeting (ASEM, an informal process of dialog and cooperation). Today, Indian Regional Trade Agreements are a multilateral rather than a regional strategy, strictly speaking. In addition, most Indian trade partners are members of multiple economic and trade blocs. India has found like-minded and economically convergent partners in Brazil and South Africa. As a coalition, these three are called IBSA. China could also be a strategic partner for India in the Doha round of talks, while it remains interested in balancing the power of the EU and the US. India must also show that it is an attractive destination for goods, services, technology, and capital investments. Its relations with Association of South-East Asian Nations (ASEAN), for instance, are particularly important from this point of view, because they provide a powerful model and backing for further economic liberalization and structural reform. Finally, India needs to make its regional relationships more formal and comprehensive, as they are not traditionally part of New Delhi's foreign policy. One of the newer concerns of Indian trade policy is to secure its energy supply. Considering the value India is placing on energy supply, the latter seems to be highly strategic. However, some tensions have arisen around the inclusion or exclusion of crude oil in the FTA. Besides agreements of cooperation signed with the United States and France in the civil nuclear sector, preferential oil and gas supply from Russia to India is envisaged in the India-Russia Joint Study Group's report. The most recent new trend in Indian economic and trade policy is a response to the spaghetti bowl effect, which term refers to the development of overlapping bilateral and regional trade agreements. This effect can be perceived as a failure of regional integration, which is certainly the case in South Asia, but also as result of experiencing a rapid increase in trade relations. Recognizing this effect also foregrounds the fact that these days Indian trade policy is multifaceted, since it is composed of multilateral, regional and bilateral relations. Even its “regional” policy can be divided into two major trends. One is for increased dealings with international blocs on other continents, in two different directions towards developed countries, in particular the United States and the European Union, India's main trading partners; and towards southern blocs such as MERCOSUR (South American trading group) and Southern African Customs Union (SACU). The second and certainly most important trend today because of the growing importance of Asia in the world economy and trade is towards more commerce with East Asia; although India is not thus far a competitor in this region, it will certainly soon become one. In the final assessment, whether it has been multilateral or bilateral, India's strategy has essentially remained the same pursuing trade and economic liberalization while defending its interests as a developing but already powerful country.

There are especially two terms which are used in the introduction part of the thesis, as are Bilateral Trade Policy & Multilateral Trade Policy.

Multilateral Trade Policy (A Defensive Policy):

As the Indian Government declared, that India has taken important policy initiatives since July 1991 to emerge as a significant player in an increasingly inter-dependent world economy. The policy reforms provided a free and conducive environment for trade and include various measures which helped to achieve the high export growth rates in some recent years. Thus, trade has now become a major plank of Indian economic policy. The Indian position in the multilateral trade system is to profit from and claim different trade preferences allowed to developing countries. As such, it has not fundamentally changed its stance in international negotiations, nor particularly in the negotiation of the Doha Development Agenda. Its objectives are, today as previously, to retain full control of its policy; to refuse, as far as possible, to make enforceable commitments; and, in the Doha Development Agenda, to prevent new commitments limiting the freedom of developing countries. However, while engaging only reluctantly in new trade, India has also become an efficient user of WTO mechanisms such as the Dispute Settlement Mechanism.

Bilateral Trade Agreements between India and its South Asian neighbors: India's South Asian neighbors should make natural trade partners, but with the exception of Sri Lanka, the players are not equal in view of the size and power of the Indian economy. Bhutan and Nepal have a long history of trade and legal relations with India, because of their geographical positioning and their historical political ties with India. Agreements with both countries include clauses on transit, which are of primary importance for these two landlocked Himalayan countries. Between Bhutan and India, all products are included in free trade arrangements. Between Nepal and India, free trade arrangements concern agricultural goods from both States but manufactured Nepalese goods only. Furthermore, as India is the largest foreign investor in Nepal, since 2003 New Delhi has been asking for a bilateral investment agreement between the two parties, since the political events in the Himalayan country could endanger its FDI. India and Bangladesh were discussing the prospect of signing a Free Trade Agreement when the World Bank delivered a very negative report on this project. Finally, the World Bank Report suggested that other cooperative endeavors could be encouraged. This undoubtedly led to the signing of the 2006 trade agreement, which deals with the unilateral elimination of non-tariff barriers and with the development of financial and trade facilitation. The arrangement also emphasizes the role of the two countries in the evolution of the international trading system, for India as leader of developing countries and for Bangladesh as a leader among the LDCs. Finally, it should be pointed out that this is not an agreement on tariffs, which is why the arrangement seems compatible with WTO rules on RTA.

Trade Practices In India:

Balance Of Payment:

A country's balance of payments is commonly defined as the record of transactions between its residents and foreign residents over a specified period. Each transaction is recorded in accordance with the principles of double-entry bookkeeping, meaning that the amount involved is entered on each of the two sides of the balance-of-payments accounts. Consequently, the sums of the two sides of the complete balance-of-payments accounts should always be the same, and in this sense the balance of payments always balances.

The balance-of-payments accounts are commonly grouped into three major categories: (1) accounts dealing with goods, services, and income; (2) accounts recording gifts, or unilateral transfers; and (3) accounts dealing basically with financial claims (such as bank deposits and stocks and bonds). This section shows how typical transactions in each of these major categories are recorded.

Commercial Exports: Transaction 1

Suppose that a firm in India ships merchandise to an overseas buyer with the understanding that the price of Rs. 50 crores, including freight, is to be paid within 90 days. In addition, assume that the merchandise is transported on an Indian ship. In this case India residents are parting with two things of value, or two assets: merchandise and transportation service. (Transportation service, like other services supplied to foreigners, can be viewed as an asset that is created by Indian residents, transferred to foreigners, and consumed by foreigners all at the same time.) In return for giving up these two assets, India residents are acquiring a financial asset, namely, a promise from the foreign customer to make payment within 90 days. In accordance with the principles outlined above, the bookkeeping entries required to record these transactions are as follows: first, a debit of Rs. 50 crores to an account we shall call, “Indian private short-term claims,” to show the increase in this kind of asset held by India residents; second, a credit of Rs. 49 crores to “Goods,” and third, a credit of Rs. 1 crore to “Services.” The credit entries, both in the export category, show the decreases in the assets available to Indian residents.

Payment For Commercial Exports: Transaction 2

To make payment in dollars for the merchandise received from India, the foreign customer might purchase from his local bank a demand deposit held by his bank in an Indian bank, and then transfer the deposit to the Indian exporter. As a result Indian demand deposit liabilities to foreign residents (that is, foreign private short-term claims) would be debited. The payment by the foreign buyer would also cancel his obligation to the Indian exporter, so that Indian private short-term claims on foreigners would be credited.

Receipt Of Income From Investments Abroad: Transaction 3

Each year residents of the India receive billions of Rs. in interest and dividends from capital investments in foreign stocks, bonds, and the like. Indian residents receive these payments in return for allowing foreign residents to use Indian capital that otherwise could be put to work in India. Foreign residents receive similar returns from investments in India. Suppose that an Indian firm has a long-standing capital investment in a profitable subsidiary abroad, and that the subsidiary transfers to the Indian parent (as one of a series of such transfers) some Rs. 10 crores in dividends in the form of funds held in a foreign bank. The Indian firm then has a new (or enlarged) demand deposit in a foreign bank, as compensation for allowing its capital (and associated managerial services) to be used by its subsidiary.

Commercial Imports: Transaction 4

In the balance-of-payments accounts Indian commercial imports of goods and services have opposite results from Indian commercial exports. Residents of India are acquiring goods and services rather than giving them up and in return are transferring financial claims to foreigners rather than acquiring them. To take an illustration, assume that Indian residents import merchandise valued at Rs. 65 crores, making payment by transferring Rs. 10 crores from balances that they hold in foreign banks and Rs. 55 crores from balances held in Indian banks.

Modes Of Settlement:

Letter Of Credit:

The documentary letter of credit (also known as a documentary credit) has been used for more than 150 years to facilitate trade by providing payment against presentation of documents relating to the transaction as specified in the credit. They are used widely for international trade, covering transactions valued from as little as a few hundred pounds to many millions. They are used primarily at the request of the commercial parties for effecting payment; they may also be used because some importing countries require letters of credit as part of their exchange control regulations.

A letter of credit is defined as an undertaking by an issuing bank to the beneficiary to make payment within a specified time, against the presentation of documents which comply strictly with the terms of the credit. Therefore, the risk to the seller of nonpayment by the buyer is transferred to the issuing bank (and the confirming bank if the letter of credit is confirmed) as long as the exporter presents the documents in strict compliance with the credit. It is important to remember that all parties in the letter of credit transaction deal with documents, not goods. Other than cash in advance, a letter of credit is the most secure method of payment in international trade, with the payment undertaking of the bank, as long as the terms of the credit are met. The letter of credit also provides security for the importer who can ensure all contractual documentary requirements are met by making them conditions of the letter of credit.

Those Involved In A Letter Of Credit Transaction

Applicant - the importer

Issuing Bank - the bank issuing the credit on the instructions of the applicant.

Beneficiary - the exporter

Advising Bank - usually the correspondent bank of the issuing bank in the exporter's country, which verifies the authenticity of the letter of credit and forwards it to the beneficiary.

Nominated Bank - the bank authorized, within the letter of credit, to make payment to the exporter and to whom the documents are presented. The payment undertaking, however, is purely from the issuing bank so the country risk is not covered.

Confirming Bank - usually the advising bank in the beneficiary's country, which adds its confirmation (where this is required) to the credit and undertakes an independent obligation to pay the exporter provided the terms of the credit are met. It is important to negotiate, at contractual stage if possible, which party will bear bank charges. It is worth remembering that on a small transaction these may be totally out of proportion and if these costs are not included in the pricing any profit may be completely eroded.

Types Of Letter Of Credit

Revocable

A revocable letter of credit can be amended or cancelled at any time without the beneficiary's agreement (unless documents have been taken up by the nominated bank). Little protection is offered to the beneficiary with a revocable credit and they are rarely seen.

Irrevocable

An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise stated.

Unconfirmed

An unconfirmed letter of credit is forwarded by the advising bank directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity.

Confirmed

A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment. The added security of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the buyer's country. A bank will make an additional charge for confirming a letter of credit.

Standby Letters Of Credit

A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the buyer he may claim under the standby letter of credit? Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit - ISP98 International Standby Practices. .

Revolving Letter Of Credit

The revolving credit is used for regular shipments of the same commodity to the same buyer. It can revolve in relation to time or value. If the credit is time revolving once utilized it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilized and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit.

Transferable Letter Of Credit

A transferable letter of credit is one in which the beneficiary has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers.

Back-To-Back Letter Of Credit

A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favor of his supplier. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed - a transferable credit will not expose them to higher risk than under the original credit.

Region Letters Of Credit Usage By Geographic Region

European Union 9%

Rest of Europe 20%

North America 11%

Latin America 27%

Middle East 52%

Asia Pacific 43%

Africa 49%

Asia 46%

Aust. & New Zealand 17%

Benefits By Using Letter Of Credit:

  • New trading relationship
  • Letter of credit required by credit issuer
  • Always traded this way
  • Legal reasons
  • Recommended by banks
  • Strategic decision made by the exporter

Risk In Foreign Exchange Transactions:

Foreign exchange risk is the exposure of an institution to the potential impact of movements in foreign exchange rates. Foreign exchange risk arises from two factors: currency mismatches in an institution's assets and liabilities (both on- and off-balance sheet) that are not subject to a fixed exchange rate, and currency cash flow mismatches. Such risk continues until the foreign exchange position is covered. This risk may arise from a variety of sources such as foreign currency retail accounts and retail cash transactions and services, foreign exchange trading, investments denominated in foreign currencies and investments in foreign companies. The amount at risk is a function of the magnitude of potential exchange rate changes and the size and duration of the foreign currency exposure.

Transaction risk refers to the impact of exchange rate changes on the value of committed cash flows (cash flows that lie in the future, but the nominal value of which is known). These are mostly receivables (payables) from export (import) contracts and repatriation of dividends.

Economic risk refers to the impact of exchange rate movements on the present value of uncertain future cash flows. It comprises the impact of exchange rate variation on future revenues and expenses through both variations in price and volume.

Translation risk refers to the impact of exchange rate changes on the valuation of foreign assets (mainly foreign subsidiaries) and liabilities on a multinational company's consolidated balance sheet.

Forecasted risk refers to the effect of exchange rates on forecasted or committed Foreign Exchange exposures.

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