Foreign Exchange Risk Management is Decisive: Why is it so?

Foreign Exchange Risk Management is Decisive: Why is it so?

27 Aug 2019 04:15 PM
 

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.

Rationalizing FX Risk Management

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

  1. Transaction Exposure
  2. Economic Exposure
  3. Translation Exposure

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-

  • Figure out proportion of business relating to imports or exports or both
  • Identify the currencies involved
  • Analyze the timing of payments
  • Evaluate impacts of adverse rate movement on profitability
  • Understand if the level of overseas business is likely to change
  • Check if the payment and receipt of currency is made on the same foreign currency
  • Check if there is any possibility to mitigate exchange risk by using a foreign currency bank account.

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.

  1. Buying or Selling the Currency Simply in the Spot Market- One can act on the day that they want to buy or sell the foreign currency. Seek the help of advisors to help you with FX Exchange Rate Quote and based on it, the transaction can be settled two working days later. This approach means that, if one knows how much Pound/Euro one needs to pay or receive for their foreign currency until the day in question. True that, it might be a risky strategy no doubt as the exchange rate may have moved significantly since clients agree upon the price with their customer/supplier. When rates move the wrong way, it is implied that with it profits too would go in the downward side.
  2. Locking in to Fixed Rates- As long as one becomes aware of a need to exchange foreign exchange at a future date they can fix the exchange rate by booking a forward contract. This approach will offer certainty for no doubt but it does not guarantee a profit for sure. This is mainly because if rates subsequently move in your favour you cannot derive its benefits because you had locked in at the forward contract rate.

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. 

  1. Employing Flexible Products- Currency options can offer businesses the potential to avail upside benefits when the rates rise in one’s favour (spot deal). On the other side, a forward contract can give one protection to counter unfavourable rate movement. However, for such flexibility one will have to pay a premium.

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. 

Conclusion

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.