Risk in Foreign Exchange Business

Any person dealing in foreign exchange business must familiar with the risks involved.Some of the risks are peculiar to foreign exchange business, while some of them are on par with inland banking.

  1. Risks which are common to inland and foreign business:
  1. Risk of non payment
  2. Risk of non delivery of goods
  3. Risk of receiving sub-standard goods
  4. Risks of fraud in goods
  1. Risks peculiar to foreign exchange business
  1. Exchange risk
  2. Failure of Foreign banks
  3. Sudden change in policies
  4. Country risk
  5. Interest risk
  6. Liquidity risk
  7. Payment risk

While these risks cannot be mostly avoid, the losses which arise out of such risks can be minimized through proper planning and adopting remedial steps. For this, first let us analyse the gravity of the risks involved.

  1. Risk of non payment: A risk like this arises when the buyer fails to honour his commitments. The best way to avoid such a risk is to deal only with customers with whom one is having past dealings. This is easier said than done. In business, occasion will arise where, the seller will have to deal with unknown buyers, especially in the area of International Trade. A way to minimize the risk is to get a credit report on the buyer from his banker. Even if the initial export orders are backed by LCs. still a credit report will be useful in the long run. The alternative available to the seller is to ask for advance payment or a guarantee of the buyer’s bank for due payment. This types of guarantee is extended by the buyer’s bank to the seller by issuing Letter of credit. In the international and even in the national trade.LCs have come to play an important role. Payment risk can be minimized to a very great extent by obtaining the LCs of acceptable banks.
  1. Risks of non-delivery goods:This is also referred to as TRANSIT risk. The goods shipped may not be delivered to the buyer due to some mishaps, frauds or any other reason. In such cases both the seller and the buyer may be blameless too. The risk of non-delivery is quite high in international business as the goods have to pass thousands of miles my different modes of transport. This risk can be minimized by obtaining suitable Insurance cover. The terms of trade, like CIF, FOB,C&F determine responsibilities of buyer/seller in regard to insurance.
  1. Risk of receiving sub-standard goods: Tile the time the goods are received under a shipment none cane be sure of the quality of the goods involved. It is possible that the goods received are below the standard expected by the buyer. To avoid such problems, wherever possible the buyers will insist for quality certificate/ Inspection certificate of an independent agency acceptable to the buyer.
  1. Risks of fraud in goods: An important risk faced by the buyers is the possibility of frauds in goods which has contracted to buy. For example, let us presume that one person had contacted to buy cement but he got sand powder instead. That will be clear-cut case of fraud in goods. Even though the seller is genuine and has not played any anymischief such frauds are possible. The only way to avoid such a possibility is to (1) deal with a reputed seller (2) insist that the goods are transported though reputed transport agencies. It has been reported that often the middlemen transport agencies pre-perpetrate frauds in goods.

The risks under items 1 to 4 covered earlier are common to inland trade as also the foreign trade.But there are some risks which are peculiar to foreign exchange business, due to the nature of trade and the commercial transactions involved. They are covered below:

  1. Exchange Risk:In foreign trade the dealings will be between two countries and some time it will be even with more than two two countries. When more than one country is involved, there will arise a need to exchange one currency in lieu of another currency. Such an exchange of currencies can cause loss to some parties-seller or buyer due to the inherent risk of exchange rate fluctuations. The exchange rate is highly volatile.As the risk is very much prevalent in foreign business, the banks are offering the FORWARD BOOKING OF CONTRACTS facility to the exporters and importers so that undue loss on account of exchange rate fluctuations will not be felt by the parties. Ads are able to guide the customers on the selection of currency, the need to book forward contracts and other technical details on export pricing and import payments. The ultimate risk of gain/loss must rests with the customers. Hence banks are selective in giving such advices.
  1. Failure of Foreign banks:As the banks in foreign countries are mostly in private sector one cannot be sure about the solvency of such banks for all time. There are numerous cases of bank failure too. Branch people should be aware of this risk and should take reasonable precautions to safeguard their interest.

The standing of the foreign banks can be assessed by referring to the Bankers Almanac available with all AD branches. This Almanac will provide details about the banks origin, cap[ital, profit, management, exposure and other details.

  1. Sudden change in policies: This is referred to as political risk too. In such cases the Exchange Control Regulations, import-export policies and trade regulations have been changed overnight, which will put the parties in difficulties.

To avoid this risk, the exporter/ banks ought to study the political setup in the buying country. The past history will be an indicator about the future events too and accordingly steps can be taken. Today most of the exporters will not be keen to export to African and Latin American countries. The reasons indeed is the fluid political and economic set up in these countries. The exports to Nigeria have given bitter lessons to exporting community, due to delayed realization of export earnings, on account of the foreign exchange shotages faced by the importing nation.

  1. Country Risk : Today, in the risk analysis, the prominent position is occupied by the country risk analysis. Before entertaining any exports, the seller will have to see the credit standing of the country of import.Detailed country risk analysis is also made by many foreign agencies. The Branch Manager must be quite conscious about this risk. Data on various aspects used for the assessment of “country risk”. They include factors such as :economic policies, political stability, foreign debt position of the country, exchange rates, energy dependency, international relations, economic growth, distribution of GDP, natural resources, export potential, development potential, industry base, inflation factors, balance of payments position a foreign reserves.
  2. Interest Risk : This has assumed great significance in Forex transaction specially due to the volatility seen in the rate of interest across the countries. In arbitrage operations, where profits are made by investing to take advantage of rate differences, managing interest risk is of paramount importance. This is mostly a dealing related function.
  3. Liquidity Risk: Today great thrust is given to the subject Asset-Liability management, in which one of the significant aspectsaremanaging liquidity risks. In forex and inland operations, banks do face the problem of liquidity. Many banks face the problem of liquidity crunch, which arises due to mismatch of operations leading to liquidity risks. Banks have started paying vital importance to managing liquidity risks.
  4. Payment Risk or Settlement risks: This risk is related to non-payment by banks with which contracts have been entered into.So far banks failures have been far and few. But during the last 4-5 years very many big and reputed banks failed due to managerial deficiencies and over trading by senior officials of banks. This has created uncertainties of settlement by banks in general. In development countries, hour wise settlement is devised to minimize the risk of non-settlement. In our country settlements are made at the end of the day.

Foreign exchange business: It's significance, growth and impact on profitability

Business firms engaged in foreign trade receive and make payment though foreign currency. In order to facilitate such transactions and also help exporters and importers, there are banking institutions which primarily engage in transactions involving foreign exchange,These are known as foreign exchange dealing branch or banks.

History:The modern foreign exchange system has its roots in the 1944 Bretton Woods agreement, signed by the Allied powers in hopes of creating a new postwar system for international currency trade, debt exchange and import/export harmonization.

Significance: The main reason foreign exchange is so significant is because the modern world is so intertwined and globalized. More corporations than ever have extensive business operations in almost every country around the world. McDonald’s, for instance, derives some 65 percent of its revenue from outside the U.S. Given this dependence on foreign markets, many international corporations use the foreign exchange system to minimize risk in the event of adverse currency movements, and maximize revenue optimization when conditions appear advantageous.

International Trade:

• Cross border exchange of goods and services.

• Exporter/Seller’s responsibility is just to make the shipment accord

to the agreed upon terms and conditions.

• Importer/Buyer’s task is to make the payment according to the contract.

Role of Banks in international trade:

• Facilitating trade payment

• Extending trade finance

• Working as an intermediary between the buyer and the seller

Foreign Exchange Market : To facilitate foreign business there exists aForex Market. The Foreign Exchange Market is the Financial market inwhich currencies are bought and sold that is a transaction is entered intowhere a given amount of currency is exchanged for another amount of currency. The need for the Foreign Exchange Market (commonly referred toas the Forex Market) developed to facilitate International trade wherecurrencies were required to be settled from the country of both the importer

and the exporter. It therefore plays an extremely impotent role in facilitatingcross- border trade, financial transactions and investment.

Need of Foreign Exchange:

1. Consumers generally come into the fray to foreign exchange when theytravel one place to another. They either go to bank for a foreign exchangebureau to exchange one currency into another currency.

2. When there is some business which needs to operate from other countriestoo than this type of foreign exchange system comes in to play.

3. Sometimes investors require currency exchange whenever they are doingany foreign investment or any real state investment.

4. All banks i.e. Commercial and Investment Banks trade currencies as aservice for their commercial banking, deposit and lending customersbase.

Foreign Exchange Business impact on profitability: Banks can earn profit in financing foreign exchange business through following.

> Import Finance:

• Loan Against Imported Merchandise (LIM)

• Loan Against Trust Receipt (LTR)

• Loan Against Export Development Fund (EDF)

• Payment against Document (PAD)

> Export Finance:

• Export Cash Credit.

• Pre-shipment credit.

• Packing Credit.

• Foreign Bills Purchased (FBP).

LIM (Loan Against Imported Merchandise) : This type of finance isoffered to the importer to finance their needs for meeting the cost of customsand excise duty payable on the imported merchandise. The Lending bankmostly pledges the imported goods. The merchandise is released for the useof the importer (borrower) upon repayment of the bank’s finance and chargeseither fully or partially, on production of the Delivery Order issued by thebanker in favor of the borrower.

Packing Creit : Packing credit is short-term advance granted by a bank to an

exporter against valid export L/C/contract for the purpose of purchase of

materials or finished goods or manufacturing, Processing, packing,

transporting up to ware house/port of shipment etc. of exportable for export.

This type of credit is sanctioned for the transitional period from dispatch of

the goods till negotiation of the export documents.

Bill Discounted : Bank allows credit to the clients by discounting Usance

bill (Bill of Exchange) which matured after a fixed tenor. It may be clean or

documentary.

Bill Purchased : Bank allows credit to the clients by purchasing Demand

bills (Bill of Exchange) Which the bank collects immediately. It may be

clean or documentary. There are two types of bill purchase.

1) IBP (Inland Bill purchased)
2) FBP (Foreign Bill Purchased).
IBP (Inland Bill Purchased): A draft for a sum of money to be same country. A bill of exchange that is both drawn and made pa same country.
FBP (Foreign Bill purchased): A draft for a sum of money to be another country. A bill of exchange that is drawn in one country ai payable in another used extensively in foreign trade.
Loan Against Trust Receipt (LTR) This is a loan against a Tru R provided to the client for meeting the cost of customs and excise dut L this system, the dent will hold the goods of their sale proceeds in tru L.. bank, until the loan allowed against the Trust Receipt is fully paid. Payment Against Document (PAD) : Arrangement under which t issuing bank execute payment under its commitment to an exporter the delivery of goods.
Loan Against Export Development Fund (EDF) : The EDF is inten facilitate access to financing in foreign exchange for input procuremc manufacturer exporters. The EDF Loan is provided to the exporters• want to open BTB LC on sight basis.
Letter Of Credit : Under an LC the exporter is assured regarding pay by the LC issuing bank. This is the most popular payment method in international trade.
Banks realize commissions, charges, interests, Postages etc. on the facil mentioned above, which play a positive impact on profitability.