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Risk Management

Risk Hedging

Foreign Exchange Risk

Santander offers the most effective management of exchange rate risk to maximizing your profits. The solution we propose is the simplest, fastest and most convenient way to manage your exchange rate risk, enabling you to reduce potential fluctuations in the exchange rates of the various currencies. Santander can provide all the instruments you need to set exchange rates at a future date; for more information click any of the following options.

Foreign Exchange (Forex) Market

This refers to the organizational structure through which national currencies are bought and sold. The principal operators are banks or financial intermediaries, the central banks of the respective countries, brokers and companies.

The concept of currency

Any means of payment (cheque, bank transfer, etc.) denominated in a currency other than the domestic currency. The concept of currency also encompasses foreign bank notes.

Currency fluctuations

Currencies are in constant flux owing to a series of factors such as:

  • Import and export operations
  • The socio-political situation
  • Economic indicators (rates of interest, inflation etc.)
  • Events in the money markets
  • Central bank interventions
  • Market liquidity

Basic divisions of the currency market

There are two basic segments of the foreign exchange market, depending on the time which elapses between the making and the settling of contracts; they comprise two specific groups of operations and two distinct prices or exchange rates:

  • The spot market In this type of transaction, foreign exchange is bought and sold against the domestic currency, and settlement is carried out up to two business days after the contract has been made.
  • The forward market or foreign exchange insurance This refers to the buying and selling of foreign exchange against the domestic currency, the rate of exchange being set on the day the contract is entered into, with settlement made at some future date starting from the third business day after the transaction is agreed.

Foreign Exchange Insurance

This is a forward operation involving the buying and selling of currencies that has the effect of eliminating the uncertainty arising from any future payment or collection of payment to be carried out in a foreign currency.

The contract is thus signed by a financial institution and an exporter/importer, creating a two main obligations:

  • On the part of the exporter/importer, to sell/buy from the bank the currency of the export/import operation on a specific date.
  • On the part of the bank, to buy from/sell to the exporter/importer the transaction currency at a fixed exchange rate agreed at the time the contract was signed, regardless of the quoted rate prevailing at the time of the payment.

General characteristics

  • Foreign exchange insurance can cover all or part of an operation.
  • It can be arranged from the moment the trade operation is sealed or at any other time prior to final payment maturity.
  • Foreign exchange insurance is fixed by the bank.
  • There is no maximum time in law for implementing a hedge although, in practice, the maximum insurable time is one year.
  • The quoted prices for foreign exchange insurance are approximately equivalent to the difference in interest rates between the currencies.

Quoted prices for foreign exchange insurance

Let us take an export operation by way of example. When an exporter and a bank arrange foreign exchange insurance, the latter fixes a currency rate against the euro at a specific date. So, if the spot price for the US dollar is quoted at 1.25 (€1 = $1.25), and the exporter takes out foreign exchange insurance for three months (the time it will take to collect payment in dollars), the bank will set the insurance at, for example, 1.247. As a result the exporter now knows that whatever happens in the next 90 days, the bank is committed to buying the US dollars from him at 1.247 and:

  • If the exchange rate for the US dollar falls he will not suffer losses
  • If the US dollar appreciates, he will miss out on earnings
  • Therefore the foreign exchange insurance covers the losses

How does the bank calculate the exchange rate for the insurance?

A simple example (using a Spanish exporter) illustrates the theoretical steps the bank follows. Imagine the following scenario:

Sum insured: 100,000 US dollars (value of the export operation to be collected in 90 days) US dollar Libor: 2% Euribor: 3% Spot rate for the US dollar: 1.25 (€1 = $1.25)

The theoretical steps taken by the bank to calculate the foreign exchange insurance are:

  1. It would borrow 100,000 US dollars at 90 days on the Interbank Market
  2. For this loan it would pay the US dollar Libor rate: 2%.
  3. It would sell the US dollars on the spot market for euros.
  4. It would place the euros on the interbank market for 90 days at 3% (Euribor).
  5. Once the 90 days had elapsed the bank would redeem the loan in US dollars using the dollars paid to it by the customer using the proceeds of the export operation and in turn the bank would pass on to the exporting customer the euros it had placed on the Interbank Market.

Maintaining the same example, the mathematical calculation is as follows:

It has cost the insuring bank 2% to borrow the US dollars. On the other hand, the same insuring bank has earned 3% (Euribor) by placing the euros on the Interbank Market. The upshot is that the bank has obtained a difference in interest of 1%, which it passes on to the exporter in the forward price.

So: Foreign Exchange Insurance = 1.250 (spot rate) – 0.003 = 1.247

From this it follows that:

  • If Libor < Euribor , the currency insured has a higher rate in the future, so the exporter will receive more euros (if it is an import operation, the importer will have to pay more euros)
  • If Libor > Euribor, the currency insured has a lower rate in the future and the exporter will receive fewer euros (in this case, an importer would have to pay fewer euros for his purchases)

Cancellation of Foreign Exchange Insurance

  • Cancellation at the agreed time: In this case, no problems arise. On receiving payment, the exporter pays in the currency to the bank to cancel the Foreign Exchange Insurance contract.
  • Breach of contract: This arises when the customer does not use the contracted Foreign Exchange Insurance. Once the deadline has expired, the bank will go to the spot market to sell or buy the currency that it had reserved for its customer. It will credit or debit the difference in exchange rates to the customer.
  • Early cancellation: This takes place by mutual agreement, and as a general rule it is done by signing a foreign exchange insurance contract for a different currency with same expiry date as the one agreed previously.
  • Extension of Foreign Exchange Insurance: If the period of the contract expires and the customer is certain he is going to be paid at some future date, he can negotiate the extension of the foreign exchange insurance with the bank for the number of days the payment will be delayed. This can also be done in advance of the expiry date.

Advantages for the customer

Elimination of exchange rate risks, whereby future results in foreign currency transactions are fixed in cases where payment is deferred.

There is no up-front expenditure, because payment is made upon expiry.

Open Foreign Exchange Insurance

  • This refers to a type of foreign exchange insurance whereby the customer and the bank are mutually bound to respect an agreed exchange rate for the purchase or sale of one currency against another within a pre-established period of time.
  • It differs from conventional foreign exchange insurance in that, with conventional foreign exchange insurance, the price is fixed for a specific day, while in open foreign exchange insurance the price is fixed for a length of time (15 days, 2 months and so on).
  • The customer may conduct as many partial transactions as he wishes, within the time limit and the total sum remaining, at the same price and without penalties.
  • In order to make the fixed exchange rate competitive, the customer gives us an advance estimate of his cash streams.

Advantages for the customer

  • It eliminates possible adverse currency fluctuations with one single contract.
  • It enables the maximum cost or the minimum yield of a commercial operation to be known in advance.
  • It simplifies the management of payments divided into many instalments and with uncertain dates.
  • There is no up-front expenditure.

To enable Santander to offer a price that accurately reflects the market, the customer needs to tell us about the estimated dates and amounts AS REALISTICALLY AS POSSIBLE, depending on how he envisages the open foreign exchange insurance will be used.

Foreign Exchange Options

This refers to a contract that confers a right (not an obligation) to buy (Call Option) or sell (Put Option) a specific amount of one currency for another, at a pre-agreed exchange rate (strike price) during a stipulated period of time. In return for this right, the buyer of the option (the customer) has to pay the seller (the bank) a premium.

The basic difference between foreign exchange insurance and options is that in foreign exchange insurance a fulfilment obligation is contracted, whereas with options, a right, but not an obligation, is acquired.

Parties involved in foreign exchange options

The Buyer (Customer)

Acquires the right (not the obligation) to buy or sell the currency. The consequences are: losses limited by the price of the premium or the possibility of obtaining unlimited profits.

The Seller (Bank)

Has the obligation to fulfil the contract when the option is exercised.

The Option Premium

This is the price of the contract, the fee paid by the Buyer (Customer) and received by the Seller (Bank).

The Strike or Exercise Price

This is the price or exchange rate at which, if better than the spot price, the Option Buyer (Customer) will have the right to buy or sell the currency.

Cost of Options

It is the exporter or importer, in other words, the purchaser of the option, who negotiates and fixes the price (Strike Price) at which he wishes to acquire or sell a specific currency on a particular day.

Depending on the exchange rate that is set, the buyer has to pay a premium to the selling bank. This premium is paid at the time of acquisition. Another basic difference from foreign exchange insurance is that in the latter nothing is paid (except the bank’s fee) while with options a premium is paid.

Once the buyer pays the premium, the final cost of the option is:

Premium + Loss of profit

Loss of profit is here taken to mean the yield that would have been obtained by an alternative investment of the money paid for the premium.

Exercise of the Option (European Option)

When the option settlement date arrives the buyer (customer) decides whether he is interested in exercising it.

Suppose for example that an exporter is going to receive 100,000 US dollars within three months. The spot price for the dollar is 1.250 and the rate quoted for foreign exchange insurance is 1.247. The exporter however wishes to exchange his dollars at 1.230. He will acquire an option to sell (put option) at 1.230. The selling bank charges him a premium, say $0.017 for every US dollar.

When the option settlement day comes round (three months later) the spot market offers a US dollar exchange rate of 1.260. Obviously the exporter will exercise his right to sell his US dollars to the bank at 1.230.

Strike price $1.230 + 0.017 premium = 1.247 US dollars for every euro. This result works out just the same as if he had taken out foreign exchange insurance at 1.247. It could have transpired that at the settlement date the US dollar was quoted at, for example, 1.200. In this eventuality the exporter would not exercise the option and would sell the dollars on the market at 1.200.

American Options

An option that can only be exercised on the day it expires is known as a European option.

There is also the American option, which can be exercised at any time during its term, in other words from the moment it is acquired to the time it expires.

Zero-Premium Options (Tunnel)

This is based on a simultaneous option to buy and an option to sell for the same amount and the same expiry date, in such a way that the premiums cancel each other out. In this way a sort of price tunnel is created, ensuring the exchange rate for some fixed values of the strike prices, and restricting the possibilities for making both profits and losses.

Other Exchange Rate derivatives

In addition to foreign exchange insurance and currency options, Santander offers other exchange rate derivatives to reduce or eliminate the exchange rate risks of international trade.

These include:

  • Foreign Exchange Insurance Extra (Forward Extra)
  • Foreign Exchange Insurance with a Ceiling

Foreign Exchange Insurance Extra (Forward Extra)

  • Imports The customer is insured for a maximum purchase price and benefits from any favourable development up to a level of depreciation; if this level is reached or exceeded during a specific period, the customer buys at the maximum price.
  • Exports The customer is insured for a minimum sale price and benefits from any favourable development up to an appreciation level; if this level is reached or exceeded during a specific period, the customer sells at the minimum price.

Foreign Exchange Insurance with a Ceiling

  • Imports The customer is insured for the purchase price (better than the conventional foreign exchange insurance), but if during a certain period the quoted rate reaches or exceeds a ceiling, the insurance disappears.
  • Exports The customer is insured for the sale price (better than the conventional foreign exchange insurance), but if during a certain period a ceiling is reached or exceeded, the insurance disappears.

Insolvency Risk

The two most fundamental components of a sales transaction, whether the transaction is domestic or international, are the delivery of the merchandise and collection of payment. The latter is undoubtedly crucial for an exporter. Obviously, any problem connected to the collection of payment for goods sold will be more difficult to resolve in foreign than in domestic trade operations. It is therefore in the interests of the exporter to build in as much security as possible when collecting the money owed from a sale.

This greater degree of security in international trade payments may be obtained in a variety of ways; payments in advance, mechanisms involving documentary payments or bank guarantees, for example. Another way is "credit insurance" - in other words, the exporter obtains a guarantee, through an insurance company, that if the money from a sale is not collected, the insurance company will indemnify him for the loss incurred by non-payment. Credit insurance for domestic transactions works on a similar basis.


An insurance contract that covers the exporter against the risk of non-payment, as well as other risks associated with selling abroad. In return for a premium, the insurance company agrees to indemnify the exporter against the loss incurred by the occurrence, as well as other risks connected to export operations.

Types of risk

The greatest risk normally covered by credit insurance is non-payment on the part of the buyer, which is specifically known as credit risk, in other words, the risk that exists from the moment the goods are sent until they are paid for.

The other important risk that can be covered is the one where the manufacturer is given an order which is subsequently cancelled. This risk is particularly significant in the case of products that are made to order, as is the case with many capital goods and equipment (machinery, ships etc.). This contingency is known as the contract resolution risk, in other words, the risk that exists from the moment the contract is signed until the goods are despatched.

Similarly, the non-collection of merchandise risk can be covered, in other words when the buyer, in breach of the sales contract, does not take possession of the merchandise at the time and place agreed, and it has to be recovered by the exporter.

However, there is another important way in which risks may be classified, which overlies the one above, depending on the reason for the non-payment. The risks are:

  • Commercial risk arising from the insolvency or prolonged indebtedness of private debtors and their guarantors.
  • Political risk, which includes transfer risk (the impossibility of transferring a currency for political reasons, generally originating in the State where the buyer is located) and sovereign risk (non-payment of government debt).
  • Extraordinary risks, arising from catastrophic situations.

This is the classification of the most important types of risk to consider in a trade operation from the exporter’s point of view.

Institutions supplying cover

Insurance companies that provide export credit insurance (specialist or general) including this type of cover:

  • Spain: CESCE (, Crédito y Caución, Mapfre Caución y Crédito and COFACE Ibérica.
  • Portugal: To be identified by each country concerned
  • United Kingdom: To be identified by each country concerned
  • Poland: To be identified by each country concerned
  • Chile: To be identified by each country concerned
  • Brazil: To be identified by each country concerned
  • Argentina: To be identified by each country concerned
  • Mexico: To be identified by each country concerned
  • USA: To be identified by each country concerned
  • Uruguay: To be identified by each country concerned
  • Peru: To be identified by each country concerned
  • Puerto Rico: To be identified by each country concerned

Shared characteristics of export credit policies

Degree of coverage for the exporter: Export credit insurance policies do not cover 100% of the value of the export. There is always a percentage of the total value that is uninsured (around 20%).

Indemnification period: The exporter is not indemnified immediately for the incident.

Cost of insurance: The cost of the insurance always depends on the assessment of the risk involved in the operation as adjudged by the insurance company. Factors such as the total value of the export operation, the customer’s characteristics, the industry in which the exporter operates, the destination countries, the buyer’s credit terms, payment methods, the average quantity of the operation and non-payment histories are all taken into account when calculating a premium.

Countries in which short term credit insurance tends to be used more: It is used much more frequently for operations with developed as opposed to developing countries, given the fact that in the formerformer, buyers tend to avoid the most secure payment and collection of payment methods (owing due to their greater cost and inferior flexibility) and the exporter has to look for alternative ways of covering the risk of non-payment. The greater availability of company information and a more securely grounded judicial system also encourage their use in developed countries.

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