Exchange rate risk is simply the risk to which businesses and investors are exposed to because changes in exchange rates may have an adverse effect on them. An exporter is likely to find its sales falling or its gross margin shrinking, or both when an appreciation occurs in its domestic currency. Therefore, fluctuation in exchange rate can impact a business, especially SMEs to a significant extent.

Fluctuations in exchange rates affect different stakeholders differently. In general, when the domestic currency appreciates, importers benefit and exporters are adversely impacted and vice versa. However, the impact varies from sector to sector. Furthermore, the ability of different sectors to withstand is different. As the IT sector sector has higher margin than the handicraft sector, an IT company has a greater capacity to withstand the adverse impact of the appreciation of the rupee.   

1. Impact on exporters: Currency fluctuation impact exporters significantly. Currency appreciation adversely impact exporters while currency depreciation benefits exporters.

2. Impact on importer: Currency appreciation or depreciation impacts importers as well. Currency appreciation impacts the importers favourably as it reduces the cost of imported goods.

3. Impact on borrowers: Increasingly, Indian firms are availing of loans in foreign currencies as these loans are cheaper than Rupee loans. However, when taking a foreign currency loan, there is a risk related to exchange rate fluctuations.

How market forces affect exchange rate movements
Similar to any other goods or services, the exchange rates are also driven by the demand-supply principle i.e. if the demand of any good is more than its supply, the price would increase and vice versa. The USD/INR exchange rate is nothing but the price of dollars in terms of INR. If the demand for INR increases vis-a-vis its supply, the exchange rate will move up. If the supply of INR increases vis-a-vis its demand, the exchange rate will go down.

Some of the important factors affecting the demand and supply of any currency are-

1. Interest rate parity: If capital is allowed to flow freely, exchange rate becomes stable at a point where equality of real interest rate is established. The real interest rate is the nominal interest rate adjusted for the prevailing inflation rate in the country.

2. Law of one price: In an ideal situation, the same goods should sell at the same price anywhere in the world (net of costs arising out of barriers of free trade). This implies that either the price of goods or the exchange rate should adjust so that one price remains the same everywhere.

3. Macro-economic environment: A positive macro-economic environment like government policies, competitive advantages, etc. increases the demand for a currency. Economic data such as Consumer Price Indices (CPI), Producer Price Indices (PPI), Gross Domestic Product (GDP), international trade, productivity, industrial production also affect fluctuations in currency exchange rates.

4. Stock market: The major stock indices also have a correlation with the currency rates. The demand for the equity of a country gives rise to the demand for the currency of that country.

5. Political factors: All exchange rate are susceptible to political instability and anticpations about the new government.

Foreign exchange risk management tips for SMEs
As currency fluctuations can adversely impact SMEs, it is very important from the SMEs' perspective to manage their foreign exchange risk efficiently and effectively. In order to manage its foreign exchange risks, an SME should take the following steps-

Step 1. Determine risk exposure: Consider the following factors will help determine the foreign exchange risk an SME is exposed to-

• What percentage of your sales or purchase (especially receivables and payables) are in foreign currencies?
• Are you in a price competitive market where you cannot pass on currency losses to customers by increasing prices?
• Can you enter into price variance clauses with your customer based on exchange fluctuations?
• Is your cash flow position tight, such that an adverse currency fluctuation can cause problems?
• At what point will a change in exchange rates affect your profitability significantly?
• To which currencies you are exposed to?
  

Step 2. Determine risk mitigation strategy: Based on the quanta of foreign exchange risk the SME is exposed to, it can choose one of the following strategies-

A. No hedging: it implies that the SME can accept the foreign exchange risk and it need not plan for it. Hedging is not necessary when either an SME transacts only an insignificant part of its total business in foreign currency or when an SME can completely pass on the benefit or loss arising from the foreign currency transactions to the customers.

B. Selective hedging: It implies that the SME will hedge only a part of its total foreign exchange exposure. SMEs can choose this strategy when they have significant but short term exposure to foreign currency and when the SMEs are expecting a favourable movement in the exchange rate. In such a scenario, SMEs can decide to hedge 50% to 60% of their total exposure and take benefit or loss from the unhedged portion.
 
C. Systematic hedging: It implies that the SMEs hedge their foreign exchange risk as soon as they enter into any foreign currency commitment. As a general rule the more an SME relies on its foreign exchange cash flow in its business, the more it should hedge against foreign risk. 

Step 3. Determine risk mitigation tools: An SME can choose from any of these options to hedge themselves against currency risk-

A. Currency diversification: SMEs can reduce exchange risk relative to a particular currency by diversifying the currency base. For example, SMEs can reduce their dependence on USD/INR exchange rate by accepting orders in other currencies such as Euro, Yen, etc.

B. Forward contracts: The foreign exchange forward contract is an agreement to convert a given amount of currency into another at a predetermined exchange rate and date. It is the preferred instrument for hedging again foreign exchange risks.

C. Swaps: The swap involves simultaneous spot and period transactions of one currency against another. it is typically used when a firm has receivables and payables in the same currency but whose due dates are not matched.

D. Call and put options: Forward contracts and swaps mitigates risks but do not allow you to benefit from a favourable movement in exchange rates. Call and put option can be thought as an insurance policy. It allows an SME to profit when exchange rates shift in its favour and also protect it when the opposite happens. For call and put option, an SME must pay a premium much like an insurance policy.

• Call option: The call option gives an SME the rights but not obligation to buy currencies at a predetermined date and rate. An importer can buy the call option and freeze the 'buying' price for the foreign currency and remove foreign exchange fluctuation risk from the decision making process.
• Put option: It gives an SME the right but not the obligation to sell currencies at a predetermined date and rate. An exporter can buy a put option and freeze the 'selling' price for the foreign currency and remove foreign exchange fluctuation risk.
  

In addition, there are various modified versions of these risk mitigation tools which have uses in more specialised cases.

As exchange rate fluctuations can adversely impact SMEs, each and every SME should determine how much exposure it has to foreign currency risk. If the risk is significant then it should hedge to the extent required. SMEs should always keep in mind that while it is very difficult to predict exchange rate movements, it is comparatively easier to prepare for adverse fluctuations. Prevention is the best way for SMEs to keep themselves protected from the adverse effects exchange rate fluctuations.