TRANSACTIONS IN FOREIGN CURRENCY ARE IMPOSSIBLE, HUH? THEN IT'S A GOOD THING WE HAVE A MAGIC WAND

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OVERVIEW

In many jurisdictions, transactions in foreign currency between residents are prohibited. This requirement has a number of legitimate aims. For example, it allows the state to process statistical information related to its internal currency market and use that information to shape its currency policy, as well as to avoid marginalization of national currency. However, there might be situations where the transaction is totally dependent on a foreign currency and not exercising it in that currency would pose great risks for the persons willing to engage in it. Fortunately, the legislation provides for a number of opportunities which might come to the rescue of persons willing to handle such situations.

One of such opportunities is the use of derivative financial instruments (derivatives). In accordance with the Law of the Republic of Armenia on Securities Market, derivative financial instruments are options, futures, swaps, forward rate agreements and any other contracts derived from securities. [1] It is also possible to structure derivatives the underlying asset whereof is a derivative (e. g. option, future, etc.). Usually derivatives are legally binding for all parties thereto.[2] With the help of derivatives one can structure effective mechanisms on how to mitigate risks related to fluctuations of foreign currency exchange rates.

 

USE OF DERIVATIVES IN MULTI CURRENCY TRANSACTIONS

Because it is always possible that the exchange rates fluctuate in the most unexpected ways, extensive currency risks are inherent in multi-currency transactions. In such cases, derivatives may become great instruments for mitigating such risks.

 

CURRENCY SWAPS

When speaking about the use of derivatives in multi-currency transactions, currency swaps would definitely come to an expert’s mind. A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency.

Example

Imagine a situation where Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan. On trade date, Company A exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP (equivalent to 1.35 GBP/USD). During the course of the transaction, Company A pays a fixed rate in GBP to Company B in return for USD six-month LIBOR. The USD interest is calculated on $100 million USD, while the GBP interest payments are computed on the 74-million-pound amount. At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100 million USD and Company B receives 74 million pounds.[3]

 

OTHER DERIVATIVES

No definition of derivatives contains an exclusive list thereof,[4] which means that any contract satisfying the general requirements of derivatives (even contracts not envisaged either in any law or in theory) will qualify as a derivative. This leaves broad space for creativity and imagination in situations where fluctuations in foreign currency exchange rates can impose risks.

Example

Imagine another situation. Company A has made an investment in Company B through acquisition of shares thereof. At the same time, a put option agreement has been signed between the investor and other shareholders of Company B, in accordance with which after passage of the time designated by that agreement Company B will have the right to put option, and the other shareholders will be obligated to purchase suggested shares. Since the mentioned transactions are performed in Armenia and Company A and Company B are residents of the Republic of Armenia, the currency of the transactions is AMD;[5] even though the main activity of Company A is carried out outside of Armenia, mainly in USD, and it would have been more optimal for it to perform the transactions in USD. In particular, due to fluctuations of the USD/AMD rates, Company A may incur losses. In other words, even though the price (in AMD) of the shares at the time the put option is exercised will be much higher than at the time of purchase thereof by Company A,[6] fluctuations in exchange rates may cause a situation in which that price, when converted to USD, may not be so high, and, moreover, even lower than that of the purchase.[7]

 

In such case, Company A may sign an additional agreement with the other shareholders of Company B, under the terms of which the shareholders will be obliged to pay Company A money equivalent to the difference between the purchase price and put price converted to USD at the rate of the day of purchase, so that the return of investment in USD is equal to that in AMD.

 

HOW WE CAN HELP

Our team of lawyers possess all the necessary knowledge and expertise to help our clients to hedge risks associated with USD/AMD exchange rate fluctuations with the help of derivative financial instruments. We would be happy to advise on optimal mechanisms and draft elaborate contracts.

 

[1] See https://www.investopedia.com/ask/answers/12/derivative.asp.

[2] Nevertheless, it is worth mentioning that one of the most common types of derivatives – the option, usually envisages only a right for one party and a corresponding obligation for the other one.

[3] The example is taken from the Article “How do currency swaps work?” by Cory Mitchell (available at https://www.investopedia.com/ask/answers/042315/how-do-currency-swaps-work.asp).

[4] See e. g. https://www.investopedia.com/ask/answers/12/derivative.asp and Article 3 of the Law of the Republic of Armenia on Securities Market.

[5] Article 6 (1) of the Law of the Republic of Armenia on Currency Regulation and Currency Control provides that payments between residents of the Republic of Armenia against sale of goods (property), rendering of services, execution of work, use of property, including interest payments on financial operations, compensation for execution or transfer of rights or privilege and insurance contributions and indemnifications shall be accepted and made in drams of the Republic of Armenia, unless otherwise provided by that Law.

[6] This conclusion stems from the very essence of put options (also financial derivatives), since for one party options always imply a right to sell or buy, and consequently this right is exercised in circumstances when it is advantageous for the party having that right.

[7] The purchase price converted into USD at the rate of the day of purchase.