Question

Currency risk can be hedged by buying swaps, futures, and forwards in the open market. It can also be hedged by using U.S. government guarantees through the Import Export Bank. What are the advantages and dis-advantages of this dual system? Should the US government be in this business and is it a

mechanism of subsiding certain businesses?

Answer 1

The currency risk can be hedged by the forwards, future and Swaps but the letter of guarantee that is issued by banks does not normally eliminate the currency risk completely but it reduces the default risk for the payment. When the banks guarantee that it pays the sellers if the customer does not make the payment then it is actually reducing the probability of default on the payment side from the customer side. There are benefits to these guarantees by the export-import banks. The seller can be assured that the he will receive the payment even if the customer defaults on the obligation. These banks promote the business of trade and in that process actually contribute to the economic growth. These banks help in maintaining the trade imbalance with another country where goods can be exported. Bank guarantee can actually help in increasing the demand of a particular product across the world, customer is assured of the standard quality and sellers are assured of the payment. There can be certain disadvantage when people intentionally misuse the import export payment mechanism for simply lending and borrowing process. If the customer defaults and exposure of that customer is large that can cause liquidity issues for the bank. Sometimes sellers do not meet the standard quality and customer will not pay and this causes legal issues for the bank.

The government normally comes in these types of business because it wants to promote the export of its goods and services to the other parts of the world and to maintain trade balance. This is not necessarily a subsidizing mechanism because the export-import bank charges commission from both the seller as well as the buyer but it is more of a mechanism to promote trade.