Payments and Cash Management

Risk management, hedging imports and exports

ING Belgium SA/NV– Bank – avenue Marnix 24, B-1000 Brussels – Brussels RPM/RPR – VAT BE 0403.200.393 – BIC (SWIFT): BBRUBEBB – Account: 310-9156027-89 (IBAN: BE45 3109 1560 2789).Publisher: P. Wallez – avenue Marnix 24, B-1000 Brussels – Z51005E – 01-08.

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The business of many companies confronts them with transactions in foreign currencies or

outstanding loans. Such activities entail real risks, such as interest rate or exchange rate risks,

derivatives can be used to hedge against such risks. Derivatives can relate to different products

(the underlying assets), for instance an interest rate or a currency couple, a share, etc. The premium

for such products is calculated according to the value of the underlying assets, the duration, the

volatility (fluctuations of the underlying assets) etc.

Do such derivatives offer reliable and appropriate cover? Yes, undoubtedly. All derivatives are

especially designed to hedge against risks.

In that way an exporter incorporates the ex-

change rate in its commercial margin. In fact,

an invoice paid with a three-month deadline

can be settled at an exchange rate which is far

less attractive than at the time the contract was

concluded. A substantial drop in the foreign

currency is likely to shrivel the expected com-

mercial margin, or in a worst case scenario

reduce it to a loss. Logically the risk of unlim-

ited loss is matched by the just as unlimited

possibility of benefi ting from a positive trend in

exchange rates.

Reckless exchange risk management is certain

to be penalised. The cost of funding is already

diffi cult to estimate, and therefore to budget,

forecasting possible interest rate trends and

taking them into account is a practically impos-

sible mission. In this regard, hedging can again

prove useful. Your hedging will guarantee

a given interest rate meaning that you can

budget very tightly without needing to worry

about unfavourable interest rate trends and

possibly benefi t from a favourable develop-

ment.

The trend in the exchange rate is of the utmost importance.

It can have both positive and negative consequences on your

total cost price. All companies hope for a favourable trend and

therefore have a certain development in mind, however reality

teaches us that fi nancial markets are unpredictable. The chal-

lenge consists in hedging now against an unfavourable trend

and nonetheless making the most of a possible favourable

trend.

Hedging against interest ratesDerivatives can also hedge against changes in interest rates.

Have you borrowed at a fl oating rate? The risk is that interest

rates might rise. You can protect yourself with an IRS, buy a

cap or a collar, etc. Are you a depositor? A possible fall in inter-

est rates could be to your disadvantage. Derivatives can also

provide effi cient cover through the purchase of a fl oor, an IRS,

etc. Whether you are a depositor or a borrower, there are many

opportunities thanks to the fl exibility of derivatives. You can

choose solutions according to your needs and objectives.

As is the case with the exchange rate risk, it is diffi cult to fore-

see the trend in interest rates, consequently you are subject to

the interest rate risk. Whether or not it is linked to a derivative,

the interest rate is a risk factor you need to include in your

calculations from the outset. Therefore you must select the

cover which suits your company’s needs, objectives and culture

best. Important elements to be taken into consideration when

making your choice include the trend in the budget, the level

of protection, the premiums, etc.

Managing the credit risk, a complex decisionUnfortunately the road towards international business is not

always paved with good intentions. A customer’s good faith

can be damaged by sudden change to its situation. Market

conditions are themselves subject to fl uctuations which are

not always foreseeable. The credit risk relates not only to the

value of goods, currency fl uctuations, interest charges but also

a customer’s solvency. Again appropriate solutions exist.

Risk management and its pitfallsExchange rates can vary at the pace of a rollercoaster. If you are

not, or insuffi ciently covered, severe losses can ensue meaning

that the expected profi t could turn into a heavy loss.

deadlines, resulting in a loss of value of the

currency you must sell and a possibly negative

impact on your margin and profi t. Thanks to

their remarkable fl exibility and many possibili-

ties, derivatives offer an excellent solution to

protect your profi t against a negative trend in

exchange rates.

Hedging against exchange rate risksYou have obtained substantial payment deadlines from your

suppliers? Well done! Yet the currency you must buy to settle

your payments can rise sharply in value. As a result your invoice

can turn out to be a lot more expansive than initially planned.

Conversely, you can be exposed to a drop in the value of the

currency you need to buy if you grant your customers payment

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ing rate to a fi xed rate or the opposite. It is possible by means

of an Interest Rate Swap. For that purpose your vision and

requirements are important to determine the IRS. With this

formula you can hedge against the risk of interest rates fl uc-

tuating without exchanging any capital. ING offers functional

fl exibility: starting date in the future, amortisation and con-

tract amendments can be considered. The rate is fi xed for the

whole of the term chosen. Just like with the other derivatives,

ING guarantees that the transaction can be settled at market

conditions at any time during its lifetime.

Purchase of a cap. You buy an option on an interest rate which

implies the payment of a premium. Consequently, you are en-

titled to take out a loan at a predetermined rate for a chosen

period. You only exercise your right if the short-term rate is

higher than that fi xed by the cap.

An example: you borrow in the form of three-month advances

at the 3M Euribor + the credit margin. To hedge against a pos-

sible rise in the 3M Euribor you bought a cap. The cap guaran-

tees a maximum interest rate for the 3-M Euribor at which you

can borrow in the event of an unfavourable trend in interest

rates.

Purchase of a fl oor. A fl oor is for depositors who want to

hedge against a possible drop in interest rates. Imagine that

you invest capital for 3 months at the Euribor rate minus the

commercial margin but your intuition is that interest rates will

drop over the long term. By buying a fl oor, you are certain of a

guaranteed minimum rate for the agreed period.

Purchase of a collar. A company which wants to use advances

and to hedge against a rise in interest rates, but does not want

to pay a premium, can buy a collar. The structure of a collar is

based on the purchase of a cap (protection) which is funded

you will have to relinquish part of your gain.

The structure set up (purchase of a call option

funded through the sale of a put option)

provides protection against an unfavourable

trend, nonetheless you can still benefi t from a

favourable trend.

Ratio 1/2 contracts. You buy (sell) a foreign

currency forward and want to protect your-

self against an unfavourable trend in the

exchange rate. Moreover you do not want to

pay a premium. Therefore you will have to

relinquish part of your gain yet as a result of

the supplementary risk (double amount) you

can benefi t longer from a favourable trend.

The structure set up (purchase of a call option

funded through the sale of two put options)

offers protection against an unfavourable

trend, but on the other hand you can still

benefi t a little from a favourable trend. The

strike prices of the options are more attractive

than for tunnel structures, but you must pay

twice the amount if ING actually exercises the

options sold. A ratio 1/2 contract is particularly

suitable for companies with a constant fl ow in

foreign currencies.

Tunnels with reverse knock-in. RKI Tunnels

in short. As is the case with a tunnel, you can

hedge your exchange risk and benefi t partly

from a favourable trend. The difference lies

in the level of protection or the level up to

which it is possible to improve the profi t by

implementing the RKI. Yet if the trigger of the

RKI (level up to which it is possible to benefi t)

is reached during the lifetime of the option,

you will be obliged to buy or sell your foreign

currencies at a less favourable rate than market

conditions.

ING’s proposals to hedge interest risksIRSs (Interest Rate Swaps). You are a borrower

or a depositor and you want to change your

interest rate structure, switching from a fl oat-

ING’s global Payments & Cash Management approach

focuses on the individual needs of each company. Derivatives

are decision and implementation instruments which can be

negotiated on the over-the-counter market. ING guarantees

the essential liquidity to enable you to exit at your discretion

from a product during its lifetime and at market conditions.

Your adviser can examine your requirements with a view to

making a precise and detailed analysis.▶ Do you want to pay a premium or not for the hedging

planned? ▶ How do you expect interest rates or exchange rates to

evolve?▶ Do you want to take out a credit line to implement the

strategy?

The purchase of a derivative requires a minimum amount:

250,000 euros to hedge interest rates, 10,000 euros to hedge

the exchange risk.

ING’s proposals to hedge exchange risksForward exchange contracts. You buy (sell) a currency forward

and fi x the purchase (selling) rate now, as protection against

a rise (drop) in the value of the currency. The forward rate is

determined on the basis of the spot rate and the difference in

the exchange rate of the currencies exchanged.

Buying a call option. You need to buy forward a foreign

currency you expect to fall. To hedge against an unexpected

rise, you pay a premium when you buy the option. The option

contract maximises your fl exibility: you are covered against a

drop in the currency – through the maximum purchase rate

– yet at the same time you will still benefi t without any restric-

tions from a possible drop.

Buying a put option. You need to sell forward a foreign

currency and you foresee a rise. To hedge against a drop, you

pay a premium when you buy the option. The option contract

maximises your fl exibility: you are covered against a drop in

the currency – through the minimum selling rate – yet at

the same time you can benefi t without any restrictions from a

possible rise.

Tunnels. You buy (sell) a foreign currency forward and want to

protect yourself against an unfavourable trend in the exchange

rate. Moreover you do not want to pay a premium, therefore

Risk management. ING’s practical and tailor-made solutions

through the sale of a fl oor (restriction on fa-

vourable trends).

Purchase of a swaption. You are planning to

take out a loan within a certain deadline and

you want to hedge your interest rate risk now

over that future period. You buy a swaption

- an option on an IRS – with the payment of a

premium. When the swaption matures, you

have the right to conclude this IRS. The rate is

set for the future loan whereas you can ben-

efi t from a positive trend on the market (lower

long-term rate) when the swaption matures.

Hedging the credit risk

Documentary credit. It is in the interest of

businesses which import and export a lot to

implement payment procedures which protect

it against the risks inherent in international

trade. In that regard we refer in particular

to the credit risk, political risks, country and

transfer risks. Given its variability and its high

level of security, for both sellers and buyers, a

document credit is an extremely recommend-

able payment instrument. To optimise its use,

it is important to know about the form and

contents as well as the terms and conditions.

A documentary credit is an undertaking to

make a payment upon presentation of certain

documents within a set deadline and for a set

amount. The issuing bank opens the credit at

the request of the purchaser (the applicant) in

favour of the seller or provider of services (the

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benefi ciary). These documents can take the shape of invoices,

transport documents, insurance contracts, or certifi cates or

statements substantiating that the benefi ciary has fulfi lled

its undertakings. In addition to the ordinary processing of

transactions, ING also offers a range of electronic applications

which simplify communication between companies and ING.

ING Inside Business Documentary Payments (IIBDP) is a new

on-line module. All the user needs is a contract, user name

and password, and a browser. A business can thus submit its

application to open – or to amend – a docu-

mentary credit. Exporters can also receive their

incoming documentary credits electronically.

Furthermore the system also provides informa-

tion about payments, reporting, etc.

This system can also process incoming and

outgoing documentary credit collections in the

same way.

Company profi leToledo International specialises in the development and

production of ingredients for top quality prepared deep-

frozen products. The processing of beef and chicken is organ-

ised with selected south-American producers. The level of

quality attained does not prevent Toledo International from

offering competitive prices, highly appreciated by the leading

European food brands.

The problem encounteredMr Stevens, managing director: “In our line of business we

work with different currencies. Our south-American suppliers

are paid in US dollars and our European customers pay us in

euros. Therefore the exchange risks between the two curren-

cies are strong and opposing.”

“For several years, we have hedged this risk by means of

forward exchange contracts. With this type of contract, we

buy US dollars at a predefi ned rate but with deferred delivery

and payment, on a later date also set in the contract. There-

fore we know beforehand the purchase price of the dollars we

need. The forward rate is calculated on the basis of the spot

rate and the interest rate spread between the two currencies.

The contracts are concluded for a period of 1 to 12 months.

This method offers us security on the one hand – the rate

of the dollar is known in advance – and covers us against a

possible rise in the dollar. If, at maturity, the American currency

has risen, it will not have a negative impact on the payments

we will have to make on that date.”

One thing bothers Mr Stevens, if the dollar has dropped at

maturity and therefore is cheaper than the contractu-

ally agreed rate, Toledo International cannot benefi t from the

favourable development.

Case historiesWhen the euro and the dollar see-saw

The solution arranged by INGING’s Financial Market specialists examined

the problem and recommended an extremely

effi cient solution to protect us in another way

against the exchange risks and at the same

time to benefi t from a drop in the dollar. Via a

tunnel and a ratio contract, we have two-way

hedging: we know the maximum rate for the

US dollars we must buy and at the same time

allows us to benefi t from the gain resulting

from a possible drop in the American currency.

At no cost to us!”

For more details, please consult the “Documentary credits” brochure available from your ING branch or

contact your Cash Management Adviser. They will be happy to discuss documentary credits with you.

By defi nition, a documentary credit strengthens trust

between two distant partners, operating in different

countries and who do not know each other well.