The Foreign exchange market is a place where individuals and institutes buy and sell foreign currencies, the purpose of the foreign exchange market is to permit transfer purchasing power denominated in one currency to another. The major participants of the Foreign exchange market are banks, importers, exporters, investors and tourists. Foreign exchange risk can affect businesses big or small to global enterprises. Changes in exchange rates can impact the value of your company’s assets and liabilities and also overall profitability. Foreign exchange volatility is unpredictable since there are so many factors that affect the movement of the Foreign exchange, economic fundamental, monetary policy, fiscal policy, global economy, speculation, domestic and foreign political issues are few of the factors.
The Foreign Exchange And Risk Management exposure may be classified under three broad categories.Transactional Risk is primarily associated with imports and exports due to undertaking transactions in a currency apart from your local currency, transaction risk is the risk of an exchange rate changing between the transaction date and final settlement date, this can result in a gain or loss at the conversion stage. The degree of exposure depends upon size of the transaction; the time period before the expected cash flows occurs and anticipated volatility of the exchange rates.
Translational Risk is a major threat if your organisation is conducting business in foreign markets, translation risk occurs when your company has any assets and liabilities denominated in a foreign currency which may shift in value due to changes in exchange rate.
Operating exposure is caused by unexpected changes in exchange rates on your company’s future cash flows from foreign operations. Affecting both revenues and operating expenses, economic exposure can be difficult to manage through hedging strategies as it deals with unanticipated changes in forex rates.
To overcome these risks, the main aim of the foreign exchange risk management is to stabilize the cash flow and reduce the uncertainty from financial forecasts. To hedge any transaction is to buy certainty to make sure that unexpected rate movement will have no impact on our operations. There are a number of strategies, methods and tools available for hedging Foreign exchange risks, aside from internal strategies like invoicing in your domestic currency or diversifying your supply chain in terms of location. There are also external hedging instruments to reduce the impact of foreign exchange risk
Forward contracts and Futures contract with slight differences in both the contracts are binding agreement between parties that aim is to fix an exchange rate at some future date, subject to basis risk.
Options give right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The option right would only be exercised to protect against an adverse movement, i.e. the worst-case scenario. Options are costlier than forward contracts and futures but result in an asymmetric risk exposure.
Forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The swap rate and quantity of forex is agreed in advance. The main objective of the forex swap is to hedge against forex risk, possibly for a longer period than is possible on the forward market. Forex swaps are useful when the exchange rate is controlled and there is higher volatility.
Currency swaps allows the two counter parties to swap interest rate commitments on borrowings in different currencies. The exchange principal in different currencies, which are swapped back at the original spot rate just like a forex swap. The timing depends on the individual contract. The swap of interest rates could be fixed for fixed or fixed for variable.
Thus foreign exchange and risk management is critical for any corporate having forex exposure and an internal forex policy should be formulated to keep mitigate the risk associated with it.
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