For trading of currencies, the Foreign exchange market is a global decentralized or over the counter market. Foreign exchange is basically exchanging one currency for another currency. Anyone who is involved in foreign exchange would go through foreign exchange risk. Therefore risk management is major essential for any foreign exchange dealer in order to shut out financial losses.
Exchange rate volatility is unpredictable since there are so many factors that affect the movement of the exchange rates i.e. economic growth, relative inflation, interest rates, fiscal policy, capital movements, central bank intervention, forex reserves, domestic and foreign political factors, rumors, speculative factors, and technical forces. The exchange rate volatility causes a risk, called foreign exchange risk or currency risk, to the business sector, in particular, the importers and exporters or the ones who connect with international businesses.
Hedging is a risk management strategy. It deals with reducing or eliminating the risk of uncertainty. The reason for this strategy is to limit the losses that may arise due to factors unknown.
Internal techniques of hedging:
Following are major internal techniques of hedging;
Currency Invoicing: The foreign exchange risk can be transferred to other parties, by invoicing its exports in its home currency, when you have an opinion that home currency will appreciate.
Leading and lagging: If an importer expects that the currency it is due to pay will depreciate, it attempts to delay, and this is known as lagging. If an exporter expects that the currency it is due to receive will depreciate, it tries to obtain payment immediately this is known as leading.
Netting and Offsetting: A firm having multiple transactions may have exposure with receivables and payables in different currencies. To reduce the exposure risk in each currency, the firm can net out its exposure in each currency by matching its receivables with payables.
External techniques of hedging:
Forward Contract: is a contract to buy or sell a currency between two independent parties at an agreed rate and a specified date.
Futures Contract: is a standardized contract to buy or sell a currency between two independent parties at an agreed price, quantity, and a specified date.
Money Markets: is a technique of using financial market in which highly liquid and short-term instruments like treasury bills, banker’s acceptances, and commercial paper are traded.
Options: is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. A call option gives the holder the right to buy the currency and put option gives the holder the right to sell the currency.
Currency swaps: 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.
Foreign Exchange Risk Management is the foundation of trading in the currency market. Therefore, understanding and managing Forex risks have become a priority. The main problem in Forex trading comes from lack of planning, not using the right strategy at the right time and not analyzing the market properly.
Myforexeye is the solution to risk management problems faced by foreign exchange dealers across the globe. It provides research reports accustomized to your specific requirement based on fundamental and technical analysis with specific hedge recommendations to manage forex risk.
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