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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

Description

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

Description

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.

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