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Extra-Contractual FX Risks

Not all exchange risks arise in the sales/purchase contract. They can also crop up unexpectedly in certain contract clauses and extra-contractual documents such as:
 

  • Contract penalty clause

  • Liquidated damages clause

  • Warranty clause

  • Payment delay penalty interest

  • Contract overseas administration costs

  • Payment guarantees

  • Performance bonds

  • Standby letters of credit

  • Marine insurance

  • Freight contracts

  • Bunkering clauses

The key feature of the currency exposure related to these areas of international trade is that the FX risk is activated only after an event has occurred or failed to occur.
 

It is beyond the scope of these notes to explain all these areas of potential FX risk, some of which may be obvious to the more experienced exporter or importer. However, a brief explanation on some of them is appropriate.
 

Payment Guarantees

Parent companies may give guarantees in respect of the financial activities of subsidiary companies that are expressed in a currency that is not the currency of the parent company. The charge on the balance sheet would fluctuate as the currency fluctuated.
 

If this guarantee was provided by a bank at the request of the parent company, then this fluctuation would be reflected in the utilisation of the banking facility. Where a fee was being charged by the bank, then this fee would rise or fall in line with the value of the guarantee which would change as the currency fluctuated.

If either guarantee was called then the charge to the parent company's Profit & Loss account, either direct or through the bank's recourse agreement, would be at the then current Spot Rate.
 

This is not a risk that can be readily hedged as the amount and date of any payment is unknown. Some form of contingency insurance may be an option if the consequences of a claim were significant to the company.

 
Contract Bonds

Contract bonds appear in several forms and include:
 

  • performance guarantees
  • advance payment repayment bonds
  • warranty bonds
  • retention bonds

They are usually issued by banks or surety companies and represent a contingent liability on the company's balance sheet.
 

In the banks and surety companies charge fees on their value for issuing and maintaining guarantees. As this value fluctuates in line with FX rate movements, so do the fees and the contingent liability on the company's balance sheet. Similarly, the value of contract bonds is reflected in the level of banking facilities permitted by the bank.
 

If a bond expressed in a foreign currency is called the bank will pay the claimant and recover the Spot Sterling equivalent from the company, whatever that might be at the time of payment.
 

Sometimes the wording of the bond can help protect the company against unfair call, where this can be negotiated with a reasonable buyer. Certain bonds with wording, which permits payment on demand, can sometimes be insured against unfair call and this can include the FX risk.
 

Stand-by Letters of Credit

The FX risks associated with standby letters of credit are similar in many ways to those for bonds. They are issued by banks on the instructions of the exporter with recourse to the exporter should the beneficiary make a claim.
 

Credit Insurance Cover

Credit insurance against non-payment can usually be obtained for contracts expressed in most convertible currencies. Cover is for 90-95% of the contract value if cause of loss occurs after the goods have been shipped or services performed. (0-95% of costs if the cause of loss is prior to shipment.
 

Credit insurance provides a safety net against non-payment but it will not normally cover exchange losses as such, but in the event of non-payment of a contract expressed in foreign currency the credit insurer may agree to pay the claim in the currency. However, the cover is only as good as the export contract and the way it is administered. It does not make a bad contract into a risk free contract. In any event the exporter is exposed to FX risks on the uninsured percentage of 5-10%.
 

In situations where exchange control regulations prevent the buyer transferring payment, or where unforeseen logistical problems frustrate the contract, credit insurance may help minimise FX losses.

 
In situations where the company has sold the foreign currency forward, the FX contracts can be rolled over to the date of payment by the credit insurer. The company would be responsible for any difference between the amount paid out by the credit insurer and the amount of the FX contract.