Netting and Offsetting

Netting and Offsetting

A firm with receivables and payables in diverse currency can net out its exposure in each currency by matching receivables with payables. Thus a firm with exports to and imports from say Germany need not cover each transaction separately. It can use a receivable to settle all or part of a payable, and take a hedge only for the net DEM payable or receivable.

Netting also assumes importance in the context of cash management in a multinational corporation with a number of subsidiaries and extensive intra-company transactions. Eg: American parent co. with subsidiary in UK and France. Suppose that the UK subsidiary has to make a dividend payment to the parent of GDP 2,50,000 in three months time, the parent has three months payable of EUR 5,00,000 to the French subsidiary, and French subsidiary has 3 months payable of GBP 3,00,000 to a British supplier (who is not a part of the Multinational). A netting system might work as follows.

The forecasts of spot rates these matters here are

GBP/ USD: 1.50 EUR/ USD: 0.9000 implying GBP/EUR: 1.667. The UK subsidiary is asked to pay GBP 2, 50,000 to the French subsidiary’s UK supplier. Thus the French firm has to hedge only the residual payable of GBP 50,000. GBP 2, 50,000 converted into EUR at the forecast exchange rate amount to EUR 4, 16,675. The Parent may obtain a hedge for the residual amount of EUR 83,325.

Netting involves associated companies which trade with each other. The technique is simple. Group companies merely settle inter-affiliate indebtedness for the net amount owing. Gross intra-group trade receivables and payables are netted out. The simplest scheme is known as bilateral netting.

Multi-Lateral Netting

It is more complicated but in principle is no different from bilateral netting. Multi- lateral netting involves more than two associated companies. Inter-group debt virtually always involves the services of the group treasury.

Scheme for Multi-Lateral Netting

Netting reduces banking cost and increases central control of inter-company settlements. The reduced number and amount of payments yields savings in terms of buy/ sell spreads in the spot and forward markets and reduced bank charges.

Matching

Netting is a term applied to potential flows with in a group of companies whereas matching can be applied to both intra-group and third-party balancing.

Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing. The pre- requisite for a matching operation is two-way cash flow in the same foreign currency within a group of companies. This gives rise to a potential for natural matching.

Leading and Lagging

Another internal way of managing transaction exposure is to shift the timing of exposures by leading or lagging payables and receivables. The general rule is lead, that is, advance payables and lag, that is, postpone receivables in ‘Strong’ currency and conversely, lead receivable and lag payables in weak currencies.

An American firm has a 180 day payable of AUD 1,00,000 to an Australian supplier.

The market rates are:-

USD/ AUD SPOT: 1.3475, 180 day forward: 1.3347

Euro US $ 180 day interest rate 10% p.a

Euro AUD 180 day interest rate 8% p.a

The Australian authorities have imposed a restriction on Australian firms which prevents them from borrowing in the Euro AUD market. The American firm wants to evaluate the following four alterative hedging strategies:-

Buy AUD 1,00,000 180 day forward (forward)

Borrow US$, convert Spot to AUD, invest in a Euro AUD deposit, settle the payable with the deposit proceeds (Money market cover)

Borrow AUD in the Euro market, settle the payable, buy AUD 180 day forward to pay off the loan (lead with a forward).

Let us determine US $ outflow 180 day have under each strategy:-

1. Forward Cover:- US $ outflow = 1,00,000 / 1.3347 = 74923.204

Money market cover:- The firm must invest AUD (1,00,000/ 1.04) ie,

AUD 9,61,538.46 to get AUD 1,00,000 on maturity. To obtain ie, must borrow and sell spot US (961538.46 / 1.3475) = US 7,13,572.

Lead:- The American firm can possibly extract a discount at 9.5% p.a. from the Australian firm since this is the latter opportunity cost of short term funds. Thus leading would require cash payment of AUD ( 1,00,000 / 1.0475) = AUD 9,54,653.94

Lead with a forward:- The firm must borrow AUD 9,54,653.94 at 8% p.a requiring repayment of AUD 9,92,840.10 which must be bought forward requiring an outflow of US $ 7,43,867.61. This is equivalent to the lead strategy. You can convince yourself that if the American firm’s borrowing cost were higher than the Euro US $ rate, the lead with forward strategy would have been better than a simple lead.

In effect, leading and lagging involve trading off interest rate differentials against expected currency appreciation or depreciation.

Risk Sharing

Another non-market based hedging possibility is to work out a currency risk sharing agreement between the two parties. For instance, the exporter and importer.

Let us work an illustrative example:-

An Indian company has exported a shipment of garments to an American buyer on 90 days credit terms. The current USD/ INR Spot is 46.25 and 90 days forward is 47.00. The payment terms are designed as follows:-

The National amount of the invoice is USD 1,00,000. If at settlement, the Spot USD/ INR rate, ST, is greater than or equal to 46.00 but less than or equal to 48.00, the national invoice amount of USD 1,00,000 would be translated into rupees at a rate of ` 47 per dollar, i.e. `   47,00,000 buyer cost will vary between USD 97916.67 ( = 47,00,000 / 48) & USD 102173.91 ( = 47,00,000 / 46).

If the spot rate at settlement is less then 46.00, the conversion rate would be [( 47.00- 0.5) ( 46.00 - ST)]. The buyer cost would be USD (4500000 / 42) = USD 107142.86.