It is not an unknown fact that foreign exchange market is a totally decentralized market. Trading becomes extensively difficult as it occurs over the counter and at a tremendous speed. On an average, there are about $ 5 trillion trades taking place per day as NASDAQ data points out.
Forex trading is highly profitable if it is done in a calculative way. Corporate tend to face bottom line issues only when they are unable to adopt logical steps to avoid devastating effects of the negative foreign exchange exposure. By logical steps here it is implied, corporate into international trading must plan out simple risk management strategy which helps them tackle foreign exchange risks.
Foreign exchange rates fluctuate and are unpredictable due to a number of factors such like- economic fundamental, monetary policy, fiscal policy, global economy, speculation, domestic and foreign political issues and many more. So how do you strategically manage forex risk management? Let’s understand it level by level.
Foreign exchange exposure refers to the responsiveness to a firm’s cash flows to the changes in exchange rates. So in order to plan out Foreign Exchange & Risk Management strategy, it is first important to understand the various types of foreign exchange exposure that are
Transaction exposure component of foreign exchange rates is referred to as a short term economic exposure. Transaction risk is the risk of an exchange rate changing between the transaction date and final settlement date. It can result to either a gain or loss at the conversion stage.
Economic exposure refers to a long-term effect of the transaction exposure. It occurs when firms are continuously affected by an unavoidable exposure to forex over the long term.
Translational risk is a major threat if one’s organisation is conducting business in foreign markets. It 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 an individual company’s future cash flows from foreign operations.
Factors to Consider
In order to plan FX risk management, it is imperative to carefully assess FX exposure to foreign exchange rate risk. This assessment can be done in the following ways-
Understanding the Products
To overcome risks, the main aim of the foreign exchange risk management should be 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. So it is not just about employing certain internal strategies like invoicing in your domestic currency or diversifying your supply chain in terms of location that forex risk management implies.
There are three alternative methods available to manage the foreign exchange risks.
Currency Options & Futures 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. When there is a favourable movement in rates, in such a case companies can go for the lapse of option to take the advantage of the currency rate movements. Option right is generally exercised only in the worst case scenario because it is costlier than forward contracts and futures but result in an asymmetric risk exposure.
Developing a Conclusive Strategy
It might not always be a favourable option to manage foreign exchange risk making use of the three alternatives in isolation. Most businesses might go for a portfolio approach and rely on making use of a combination of spot, forward and currency options where ever it is available. It is advisable to rely on forex advisors to guide businesses in taking rational steps. These experts are highly professional at managing forex risks applying need based hedging tools and strategies. In this area, Myforexeye Forex advisors can help clients’ trade forex in profitable ways.
For example, for any corporate to take up decisions such like when should they transact 25% of the currency in spot, and fix 25% with a forward exchange contract and cover 50% with flexible solutions such as option can turn up slightly dicey. However, when forex advisors are present to support them, they can take such expert decisions on their behalf considering the uncertainty in exchange rate and how much of an exposure needs to be hedged at what level.
It is often tempting to defer a decision in order to implement foreign exchange risk management strategy, perhaps in the hope that rates may move in one’s favour in the short term. Historically it has been observed that currency markets have been extremely volatile and unpredictable. Therefore once a conclusive strategy has been formulated, it should be implemented so as to safeguard the profits. Thus foreign exchange and risk management is critical for any corporate having forex exposure and an internal forex policy should be formulated to mitigate the risk related to any forex transaction.
29 Jun 2020 05:35 PM
Dynamic hedging is a foreign exchange risk management strategy that allows businesses and individuals to readapt their hedging positions to evolving market conditions by providing flexible solutions to protect investments from exchange rate risks.
19 Jun 2020 05:01 PM
Management of Currency Exchange Risk is of paramount importance during turbulent times, like this pandemic. The currency fluctuations are very volatile and cannot be predicted as the circumstances are uncertain.
06 Jun 2020 03:59 PM
Outrights, in FX markets refer to the type of transactions where two parties agree to buy or sell a given amount of currency at a predetermined rate, on a specified date in future.
08 May 2020 05:21 PM
Converting one exchange rate into another at a particular price makes transferring rates. Ideally all nations should be treated as equal and there shouldn’t be any exchange rate applicable which would mean to have a universal currency.
24 Apr 2020 03:08 PM
Managing risk in a financial market is required to keep a check on the adverse movements in the instrument of the market. Particularly in the foreign exchange market.
10 Apr 2020 06:12 PM
So was India’s decision on locking down the country for 21 days required? The implication on the economic growth or rather slowdown has only made many doubt the timing and preparedness of the decision.