Foreign Exchange and Risk Management

Foreign Exchange and Risk Management

21 Nov 2018 05:29 PM

Foreign Exchange

Foreign exchange primarily refers to the exchange of one currency for another currency. In a primary foreign exchange transaction, one party purchases certain quantity of a particular currency by paying for it in some other currency.

Foreign Exchange Market

The foreign exchange market is the market where foreign currencies are actually dealt in. It refers to a market in which the different participants in the market are able to buy, sell, speculate and exchange various currencies. The major parties or stakeholders that actually form the foreign exchange market are investors, banks, retail foreign exchange brokers, commercial companies, central banks, hedge funds and investment management companies. The foreign exchange market facilitates international trade and international investment transactions by enabling the conversion of one currency into another.

Foreign exchange market is considered to be one of the most attractive, lucrative and unique market in the world. It is a highly liquid and volatile market since dealing takes place on a very frequent basis in the most liquid assets. It operates round the clock for 5 days a week. The trading takes place 24 hours a day since the currencies dealt in belong to various nations which have different working hours. Thus, when the foreign exchange market closes in one part of the world, the market opens in another part of the world. Hence the trading takes place all day long.

Foreign Exchange Risk

Every sort of business and related activities involves certain amount cost and hence the risk associated with it. This principle applies to the foreign exchange market as well. Foreign exchange market is known to be the riskiest market and business owing to its features like volatility of market, huge amount of funds involved and liquidity of assets involved. Foreign exchange market involves certain types of risks. Foreign exchange risk primarily refers to the financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. The different types of risk exposures involved the foreign exchange & risk management market are: Transaction Risk, Economic Risk, Translation risk and contingent risk.

Foreign Exchange Risk Management

Now that we know a bit about the various types of risks involved in the foreign exchange market, we know that we cannot turn a blind eye towards the intensity and frequency of this risk. This brings in the concept of management of foreign exchange risk. One must have an idea about the quantity or the measure of risk involved to be able to deal with it accordingly. In the foreign exchange market, the most commonly used financial risk management technique is Value at Risk commonly known as VaR which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Apart from this the techniques and strategies that can be used to prevent or mitigate risk can be internal or external strategies. Internal techniques should be considered to hedge the risk before moving forward with the external techniques. Internal techniques can be invoice in home currency, leading, lagging etc. The external techniques can be forward contracts, future contracts, options, forex and currency swaps.

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