Question

Explain how risk sharing works, providing example.

Risk sharing is a contract, where a buyer and seller agree to split or share any impact on the payment due to movement of the foreign currency exchange rate.

Answer 1

Answer.

In a forex transaction both the counterparties can agree to share the risk . In addition to, or instead of, a traditional hedge two parties to the transaction can agree to share the currency risks associated with their deal. For any transaction, in a typical risk sharing arrangement the base price would be first set at specific level and a range of rates around this level is decided. If the final settlement rate of the transaction is beyond this range, risk would be shared by both the parties as per mutual agreement. mostly equally. No one takes the risk or share the risk if the ultimate settlement is to takes place within this range. The currency range in which risk is not shared is called the newtral zone.

For example,

Let us assume that, ABC Fashion has entered into an agreement with XYZ a US company to supply garment worth USD 1 million, in a month time. As per the risk sharing agreement a neutral zone is fixed i.e. zone or a range of foreign exchange level when no sharing of risk would be undertaken. Consider that currently 1$= Rs. 45 and Normal fluctuation in dollar in the next one month is expected between Rs. 44.50 and $45.50 so this is the neutral zone, which means both the company cannot share the risk but have to accept the market rates for settlement within this range. If value of $ would goes beyond this range then both the company would share the burden equally .Now suppose that at the time of settlement 1$ is equal to Rs. 46.50 i.e. Rs. 1 more per dollar than the upper boundary level of neutral zone, so in this case both the companies would share additional risk i.e. Rs. 0.50 per dollar (In this case ABC Fashions is giving up gains of Rs. 0.50 per dollar to help XYZ a US company). Similarly if dollar at the time of the settlement is Rs. 43.50 i.e. Rs. 1 less per dollar than the lower boundary level of the neutral zone. So both the company would share the additional risk i.e. Rs. 0.50 per dollar (here the XYZ a US company is giving up gains of Rs. 0.50 to help the ABC Fashion India).