international business unit4

THE UGANDA INSTITUTE OF BANKING & FINANCIAL SERVICES

UIBFS

ISO 9001:2008 CERTIFIED

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Trade Finance FacilitiesSwift and Other Bank International PaymentsVostro Accounts and Nostro AccountsDealing in Foreign Currencies

Currency OptionsForward Contracts

MODULE COVERAGE

How Collections WorkFactoring


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What is foreign currency?• A foreign currency is the currency of any foreign country generally accepted or

authorized as medium of exchange for goods and services in that particular country. • In short, foreign currency in the eyes of a Ugandan is a currency other than Uganda

shillings. Examples are Kenya Shillings, US dollars, British pounds, Japanese Yen etc.• These currencies are issued and controlled by the central Banks in their respective

countries while Uganda Shillings are issued by Bank of UgandaMajor world currenciesExamples of major world currencies include:- US Dollar ($), Euro(€), Pound Sterling(£),

Australian Dollar(AU$), New Zealand Dollar(NZ$), Canadian Dollar, United Arab Emirates Dirham, South African Rand, Hong Kong Dollar, Swiss Franc, Japanese Yen, Swedish Kroner.

Dealing in foreign currencies• The foreign currency market in Uganda is liberalized and therefore has many authorized

dealers. The main dealers are banks and Forex Bureaus. Foreign currencies are mainly sourced from exports, tourism, Foreign Direct Investment and borrowing. The price of a currency is mainly determined by market forces of demand and supply.


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Factors influencing Exchange rates• Demand and supply • Government policies • Domestic growth • Balance of payments-government

budget deficit/surplus • Relative inflation-difference in

inflation rates• State of economy • Political incidents • Settlement of forward transactions

(leads and lags)• Natural disasters and other acts of

God


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Purchase of foreign currency and the different ratesBanks use different rates for different types of purchases. Banks buy Currency notes (cash),

Travellers cheques (TCs), Telegraphic transfers (TTs), and cheques (clean bills)-currency notes- if the demand is high banks are likely to quote a good buying rate, however,

if the demand is low the rate quoted will be low because the bank is likely to keep idle funds on which it is not earning interest

-Swift/Telegraphic Transfers (TT) – Banks normally quote best rates for this because they are risk-free cleared funds having been transferred to Nostro Account

From - Travellers cheques (TTCs) – Banks don’t give the best of rates because of risks involved. The TC may have been stolen or forged and even if that isn’t the case the bank will be out of pocket until cheque has been cleared

-Cheques – these are personal cheques purchased from individuals sent on a collection basis. The nostro account will be credited when cheques have been paid. Because of the risks involved and the bank being out of pocket for sometime the bank buys at low rates

Types of rates (base, cross, spot, forward)• Base rate – Linking to a strong foreign rate for trading purposes such as the dollar. In the

case of Uganda, rates are based on the dollar (USD)


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• Cross rate- is used to calculate the foreign currency rates Visa avis local rate. For instance if a customer wants to purchase Japanese yen, you will first establish a conversion rate between the dollar and the yen to be able to convert to local currency

• Spot Rate- This is an exchange rate agreed between two parties where settlement must be completed within two days. The deal of this kind is called a Spot deal

• Forward Rate – This is an exchange rate agreed between two parties for settlement at a future date. The transaction is known as a forward deal or forward exchange contract

Foreign exchange reserves Foreign exchange reserves (also called Forex reserves or FX reserves) in a strict sense are the

foreign currency deposits and bonds held by central banks and monetary authorities such as Bank of Uganda in our case. The assets of the central bank held in different reserve currencies, mostly the US dollar, and to a lesser extent the euro, the UK pound, and the Japanese yen, are used to back the countries’ liabilities.

Foreign currency coverMost banks have specialised treasury departments that manage inflows and outflows of

foreign currency as well as adequate local funds to meet various operational obligations


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Foreign currencies can be traded directly or indirectly in the following ways:

• Spot Contracts – These refer to transactions of buying or selling foreign currency at current market rates where settlement must be effected within two business days of concluding the contract. In the interbank market, currency is bought and sold for delivery and settlement within two days, with the banks acting as wholesalers or "market makers". While in retail markets made up of private traders, deals can be over the telephone or the internet or through other intermediaries.

• Foreign currencies trading can also be over-the-counter deals agreed and settled by individual counterparties known to one another. Trading currencies entails risk and demands constant vigilance. The Forex market has no centralized exchanges.


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Forwards and futures • Unlike spot dealings where currency must be delivered within two days, foreign currency

purchased for delivery at a future date longer than the two days is referred to as a forward deal. Although the delivery is made in the future, the price is determined on the initial trading date.

• If the trading date is today, then the exchange rate will be fixed today. In foreign currency markets, prices fluctuate from time to time depending on demand and supply. This may be unsettling for an exporter who expects to get foreign currency at a future date but cannot be sure how these fluctuations will affect his budgets and profits.

• To ascertain how much he will get in Uganda shillings he will approach his bank and fix the rate at which he will exchange his foreign currency eliminating the impact of a rate fluctuation on the profit margins when future foreign currency payments and receipts are made. This is known as a forward contract.

• By fixing the exchange rate now, the customer eliminates the risk of depreciation in Uganda shillings. However, if the foreign currency appreciates against the shilling, the customer will have missed out on the opportunity of earning more in shillings for his exports.


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Foreign currency options Foreign currency options give the customer far more flexibility than the traditional

forward contracts. A foreign currency option is an agreement whereby a customer can pay a premium to the bank for the right but not the obligation to buy or sell to the bank a specified amount of foreign currency at an agreed exchange rate. Since it confers a right to buy or sell to the bank it the option is exercisable at the discretion of the customer at any time up to a specified expiry date. Alternatively the customer can simply allow it to lapse at the expiry date or sell it back to the bank.

Swap transactions allow protecting the value of an initial overseas investment in a foreign currency and any receivables generated in the future. A swap transaction is the simultaneous purchase and sale of currency to cover short- and long-term exposures.

Risks in dealing in foreign currenciesCurrency risk or exchange risk – Currencies, under normal circumstances, will appreciate

or depreciate depending on demand and supply. For instance if there is a big demand for US dollars from importers, the Uganda shilling will depreciate assuming the supply of dollars remains constant. Conversely, if the supply of dollars is boosted without an increase in demand, the Uganda shilling is likely to appreciate against the dollar.


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Exchange rate - is the rate at which one currency will be exchanged for another.

Assuming there is a supply of 1 million dollars in the money market and demand is for dollars is about 1.5 million dollars the rate at which importers will buy dollars in Uganda shillings will go up if the supply of dollars remains constant. However, should the supply of dollars increase to say 2 million dollars and demand remains at 1 million dollars, the dollar exchange rate is likely to go down in Uganda shillings.

In practice there are so many other factors that affect exchange rates including speculation, political instability, foreign investment flows, country’s monetary policies etc. Suffice it to say, however, that whatever changes may affect exchange rates, fluctuations pose risks to importers and exporters and therefore prudence requires that they be fixed or mitigated.

Forward exchange contracts and options are designed to help customers avoid losses that may occur as a result of fluctuations in exchange rates.


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Currency OptionsForward Contracts

MODULE COVERAGE

How Collections WorkFactoring


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What are Forward Contracts?A forward exchange contract is a binding contract between a bank and its customer for

purchase or sale of a specified amount of foreign currency at an agreed future date at a rate of exchange fixed at the time the contract is made. A fixed forward contract will specify the date the sale or purchase will be made whereas an option contract gives the customer the flexibility to deliver any time within the specified future period. These contracts are common in commodity and currency markets.

Key features of Forward Contracts • They are mainly used by exporters and importers who want to be sure about the

value of their exports in local currency and also of total cost of imports in local currency. If a customer does not take out a forward contract he is actually gambling as currency rates sometimes fluctuate wildly

• Forward contracts are widely used in foreign exchange markets. The profit or loss from a forward contract depends on the difference between the forward price and the spot price of the asset on the day the forward contract matures

• Forward contracts are settled only at maturity• Transactions are mostly executed between banks and customers


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Benefits of forward contracts • The purpose of forward contracts is to hedge or

reduce risk and uncertainty. Forward contracts therefore help:

• The exporter to know exactly how much he will receive in Uganda shillings and will be able to plan his business operations

• The importer will know exactly how much he will pay for his goods and plan for prices, taxes etc accordingly

• Both importers and exporters will avoid losses that may occur as a result of fluctuations in exchange rates

• These contracts do not require collateral• Some forward contracts are so flexible that a

customer may simply opt out before expiry of the contract without incurring any liability


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Forward optionsForward Contracts

MODULE COVERAGE

How Collections Work

Currency optionsFactoring


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What is an option?• An option is a derivative financial product that gives the buyer the right (not the

obligation) to buy (call) or sell (put) specified assets at a specified exchange rate during a specified period of time.

• The contract grants the holder the right, but not the obligation, to buy or sell specified asset. The option owner exercises this right when it is to his/her advantage or at expiry dates.

• A “call” option is the right to buy a share of a stock, the underlying security, at a specified price, called the exercise price or the strike price.

• A “put” option is the right to sell a share of a stock at a specified price, the exercise price or the strike price.

What is a forward option?• A forward option is an option that commences at some specified future date

with expiration further in the future. • Like a standard option, a forward option is paid for in the present; however the

strike price is not fully determined until an intermediate date before expiration.


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Basic characteristics of optionsBoth put and call forward options have three basic characteristics namely; the exercise

price; expiration date; and time to expiration. • The exercise price is also called the fixed price, strike price or just the strike and is

determined at the beginning of the transaction. It is the fixed price at which the holder of the call or put can buy or sell the underlying asset.

Exercising is using this right the option grants you to buy or sell the underlying asset. The seller may have a potential commitment to buy or sell the asset if the buyer exercises his right on the option.

• The expiration date is the final date that the option holder has to exercise her right to buy or sell the underlying asset.

• Time to expiration is the amount of time from the purchase of the option until the expiration date. At expiration, the call holder will pay the exercise price and receive the underlying securities (or an equivalent cash settlement) if the option expires in the money.

The call seller will deliver the securities at the exercise price and receive the cash value of those securities or receive equivalent cash settlement in lieu of delivering the securities.


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MODULE COVERAGE




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What is currency option?• A currency option (also FX or forex option) is a financial derivative that gives the buyer the right

(not the obligation) to buy (call) or sell (put) a currency at a specified exchange rate during a specified period of time. The contract grants the holder the right, but not the obligation, to buy or sell currency. The option owner can exercise this right when it is to his/her advantage before the expiry.

• For this right, a premium is paid to the bank/broker. Currency options are one of the best ways for corporations or individuals to hedge against adverse exposure movements in exchange rates at future dates and to also take advantage of favorable movements in the exchange rates. Investors can hedge against foreign currency risk by purchasing a currency option “put” or “call”. When the Currency option is bought, the risk is limited to the premium paid for the derivative.

The value of an option contract at its expiry date is the value which is realized by the holder in exercising his option at that point. For example:

• If the option contract lapses and the holder gains or the contract has intrinsic value it is said to be 'in the money'

• If the option contract lapses and the holder loses or the contract has negative intrinsic value it is said to be 'out of the money'

• If the option contract lapses and the holder neither gains nor loses (the contract has no intrinsic value) it is said to be ‘at the money' or ‘at par’


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There are two types of currency options:a. Put option- This gives the right but not the obligation to sell one currency and

receive another currency at the strike rate.” Put” options give the option to sell at a certain price, so the buyer would want the rate to go down in order to gain.

b. Call option- This gives the customer the right but not the obligation to buy the currency with another currency at the strike rate. “Call” options give the option to buy at certain price, so the buyer would want the rate to go up in order to gain.

Features of currency option contracts1. The currency pair should be indicated- e.g. US Dollar - Uganda Shillings (USD-

UGX) spot rate. 2. The type of option should be clearly stated either “call” or “put” options. 3. The contract amount should be stated - e.g. USD 1,0004. The currency of the premium should be quoted- e.g. UGX 5. The currency outstanding position shall be in USD. 6. The maturity of the contracts should be indicated- e.g. Shall not exceed twelve

months.


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• c7. The mode of payment

and currency in which the contracts should be settled- e.g. cash in Uganda Shillings.

8. The basis of the settlement price should be stated- e.g. Bank of Uganda Reference Rate on the date of expiry of the contracts.


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How the currency option worksThe pricing of an option uses a formula which looks at both the current value of the currency and

a time value, calculated on the basis of market expectations, volatility and any difference in interest rates between the two currencies specified in the contract. The best way in pricing an option is to set the price low enough to attract buyers, but also to set it high enough to attract sellers and guarantors for the contract.

Options can be used to reduce the risk of unexpected movements in the currency market. When a currency option is bought, then losses will be limited simply to the price of the option. However, when a currency option is sold; the losses can be more substantial and are potentially unlimited.

The advantages and disadvantages of a forex options• Currency options have the following advantages:• The customer can choose to exercise the currency option when the rates are favaourable.

Alternatively, he may choose not to exercise the foreign currency option or to let the option expire (not exercise).

• Limited risk - Provides protection against adverse currency movements with the potential to financially benefit from favourable Currency movements.

• Considerable profit potential due to taking advantage of favourable changes in the exchange rate.


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• dCurrency options have the following disadvantages:a. If the foreign currency option

expires and is not exercised, it is worthless as the premium you paid becomes an additional cost since it is not refundable

b. The expiry date or term cannot be extended

c. The currency option holder may not recoup the full premium paid if the foreign currency option is terminated prior to the expiry date

d. Premium has to be paid up-front.


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MODULE COVERAGE




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What is Factoring?• Factoring is a flexible form of business financing that allows a business to sell accounts

receivable in exchange for immediate cash at a discount, to a factoring company (Factor). • The factoring company then assumes the credit risk of the account-debtors and receives

cash as the debtors settle their accounts. The factoring company makes a profit by paying less cash than the face value of the invoice.

• How factoring works• When a business enters into a contract with a factoring company, the factor agrees to

control the invoices of the business, in return for a fee.• The company delivers the goods or services to the customer. Invoices are generated and

sent to the factoring company. The factoring company becomes the legal owner of the invoice and collects the money.

• When the factoring company assumes control of the invoice, they advance a percentage of its total value – sometimes up to 90% of the gross value of the invoice.

• Factoring implies a sale or assignment of accounts receivables for immediate cash. It provides businesses with access to quick cash and improved cash flow for expansion. The essence of factoring lies in the following aspects:


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Usual preconditions for factoring 1. The business must sell to good credit worthy customers. A business qualifies for factoring

if it generates sales on open credit terms to customers with financial credit strength.2. The receivables or invoices can be verified or has an acceptance (signed off) by the

account debtor3. Available to all sectors that provide services, or deliver products to commercial accounts. 4. The sale must be "final sale" with no contingencies or disputes. 5. The service or product must be completely delivered in order for an invoice (receivable)

to be eligible for funding.The following factors make a business unsuitable for factoring: a. When there are too many small invoices b. When goods/ services are sold to the public. Factoring is only available for sales to

commercial customers c. There is a provision for the customers to make part payments d. When there are disputes and queries e. When the business is not reliable, credible and sound in its operations


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UsualTypes of factoring Factoring can be on a full recourse and non-recourse basis.Non-recourse factoring - Receivables purchased on a non-recourse basis, the factoring company

assumes risk and therefore the loss on those receivables.Full Recourse Factoring - the factoring company retains the collection function of the receivables

it has funded. But if the client’s customer fails to pay they will have recourse on the customer. Advantages and disadvantages of factoringFactoring is a quick and easy way to replenish business with urgently needed cash in quickest

possible time. However, this financing option is not hassle free and has its disadvantages too. Advantages of factoring: • Flexibility -Factoring is a quick and easy way of turning invoices into cash. Factoring provides

predictable cash flow and no longer having the uncertainty of not knowing when payment will be made.

• Transfer of risk - The factoring firm assumes the credit risk as the factor may have no recourse in case of default.

Disadvantage of Factoring: Risk to business relations with customers - Customers have to deal with the factoring companies

and this could affect cordial business relations.


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MODULE COVERAGE




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What are collections?• Banks provide many services to exporters including collecting proceeds of sale arising

out bills of exchange which are at the centre of documentary collections. • A bill of exchange is an unconditional order in writing addressed by one person

(Drawer/exporter) to another (Drawee-importer) signed by the drawer requiring the person to whom it is addressed (drawee) to pay on demand a certain sum in money to or to the order of a specified person (payee) or to bearer

• What happens in practice is that the exporter will ship his goods, say through Mombasa Port and obtain shipping documents from the shipping company. The exporter (Principal) will hand over documents to his Bank, say Bank of Baroda Uganda (Remitting Bank).

• These documents will normally include a bill of exchange drawn on the importer with a sight or term draft, a complete set of on board bills of lading and insurance policy/certificate as well as collection instructions to the remitting bank.

• The remitting bank (Bank of Baroda) completes its collection instructions to the importer’s bank and sends them along with all relevant documents.

• Depending on the terms in the bills of exchange, the importer’s bank will release documents against payment (D/P) or against acceptance (D/A).


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Sight draft or on Demand draft• The bill of exchange will normally require that the draft be paid at sight or at a future

date after sight. With a sight draft payment must be made by the drawee (importer) as soon as it is presented.

• Term Drafts If a bill of exchange stipulates that the draft will be paid say 90 days after sight, this will be a

term draft. To establish the exact date of payment the drawee (importer) will accept it by signing on the face of it and then insert the date of acceptance

• Uniform Rules for collections (URC)This is an internationally accepted code of practice covering documentary collections. They

are binding on parties who have agreed to use them and collections will generally state that they are subject to URC.

Documents in TradeBanks deal in documents and documents only and not the actual goods. • Financial Documents – refers to documents used in trade to obtain or claim payments

like bills of exchange, promissory notes, drafts or any other instruments used in obtaining payment of money


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Commercial Documents- are mainly used for operational and administration purposes such as commercial invoices, pro-forma invoices, insurance certificates, inspection certificates etc. They relate to goods themselvesTransport documents – provide evidence of dispatch, loads, carrying or taking charge of goods e. g parcel post receipts, air consignment reports/airways bills/bills of lading, rail consignment notes


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Sight draft or on Demand draftThe bill of exchange will normally require that the draft be paid at sight or at a future

date after sight. With a sight draft payment must be made by the drawee (importer) as soon as it is presented.

Term Drafts If a bill of exchange stipulates that the draft will be paid say 90 days after sight, this will

be a term draft. To establish the exact date of payment the drawee (importer) will accept it by signing on the face of it and then insert the date of acceptance

Uniform Rules for collections (URC)This is an internationally accepted code of practice covering documentary collections.

They are binding on parties who have agreed to use them and collections will generally state that they are subject to URC.

Documents in TradeBanks deal in documents and documents only and not the actual goods. Financial Documents – refers to documents used in trade to obtain or claim payments

like bills of exchange, promissory notes, drafts or any other instruments used in obtaining payment of money


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END

international business unit4

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