What is Foreign Exchange and Risk Management?

What is Foreign Exchange and Risk Management?

28 Dec 2018 11:41 AM
 

What is Foreign Exchange?


Foreign exchange or forex is basically the transfer of one currency in exchange for a different currency. In a basic forex transaction, one person or firm buys a specific amount of a particular currency and sells some other currency as payment.

What is a Foreign Exchange Market?

The place where trade in different currencies actually takes place is known as a foreign exchange market. It is a market where different stakeholders or participants i.e. financial institutions, traders, investors, hedge funds, investment management companies,brokers etc. are enabled to buy or sell, speculate and exchange different currencies. Foreign exchange market is a boon to the world market as it facilitates and enables international trade and provides ease in international investment dealings by providing the service of currency exchange and trade.


Forex market is the most lucrative, transparent, unique, volatile and attractive market. Since dealing takes place in highly liquid assets sensitive to changes on a regular basis, the market is volatile. This market never sleeps, it operates 24 hours a day as if the forex market on one nation ends its day, the market starts operating in some other part of the world.

What is Foreign Exchange Risk?

All sorts of decisions and activities in the world, business or non-business have some sort of uncertainty associated with it. Thus, every business and its related activities deal with the element of risk. Foreign exchange market is no exception. In fact, the forex market is known to be he most risk involving market in the world. This is due to the key features of volatility and large investment of funds in highly liquid assets.

The forex risk is known to be a financial risk which exists when a financial transaction is denominated in a currency other than the base or the domestic currency of the firm. The various types of risk exposures in a foreign exchange market can be transaction related risk, economic risk, translation or contingent risk.

What is Foreign Exchange and Risk Management

Being aware of the fact that foreign exchange market is a highly risk involving market and knowing about the various types of exposures that exist, one cannot be ignorant to this demon capable of destroying one’s earning. This brings into light the concept of foreign exchange risk management. It is essential for one to be aware about the quantity and the intensity of risk involved in the market to be able to deal with it. In the forex market, Value at Risk or VaR is commonly used as a foreign exchange risk management technique which primarily examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. There are various internal as ell as external techniques that can be used to deal with and mitigate the risk in the market. One should always consider internal strategies before external to manage forex risk. Invoice in home currency, leading and lagging, etc. are some of the internal techniques. Forwards, futures, swaps, options etc. form a part of the external methods.

Read more about forex risk management techniques

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