Foreign Exchange Risk Management Techniques

Foreign Exchange Risk Management Techniques

03 Jan 2019 02:48 PM
 
When we speak of foreign exchange markets, risk comes along with it mind. Risk is an inseparable element of forex markets. Risk being a primary element in this immensely dynamic market cannot be escaped or completely avoided. Since it cannot be completely avoided, it is necessary for the players in the market to be completely armed to deal with various types of exposures existing in the market. There are various Foreign Exchange Risk Management Techniques and strategies that can be classified into internal and external techniques. It should be a policy to use internal techniques and control risk internally, external strategies are applied only when internal techniques cannot solve the problem or cannot deal with the risk.

Internal Foreign exchange management techniques

There are various forex management techniques that make up the internal techniques and strategies:

Invoice in home or domestic currency or denomination

According to this technique a company dealing in international transactions must make all its payments in its domestic currency and must have the policy of accepting only domestic currency from the debtors. Thus, all incomes are received and all payments made in home currency. Such a technique does not minimize or mitigate the risk, it only passes over the risk to the other party of the transaction. This strategy however might spoil the relations of the company with the parties since they have to deal with the risks of dealing in foreign exchange. This internal technique proves to be viable and feasible only when there is a monopoly situation prevailing in the market for the company. However, this is a highly unrealistic environment.

Leading & Lagging In case the importer of the assets in a international transaction can see that the currency in which payment is to be made to the exporter is likely to depreciate in future he might try to lag the payment and shift it further. To avail such a benefit from depreciation in currency by exceeding credit limits or by making an agreement. On the opposite end the exporter with a notion of depreciation in currency in future might rush up the payment as soon as possible. Exporter might lure the importer by offering a discount to make this possible.

Matching

A company that regularly deals in foreign transactions f is an active member in international trade markets, might have payments to be made and incomes to be received in the same currency. In such a situation payments and incomes can be matched and risk assumed for only the unmatched amount in the forex markets. It is an effective internal forex management technique.

External Foreign Exchange Risk Management Techniques

There are some effective external forex risk management techniques that can be used when the internal techniques cannot be applied or prove to be ineffective. Some of them are:

Forward Contracts

It primarily is a contract where currency or asset can be bought or sold at a predetermined date at a predetermined rate in future. The rate for the transaction is decided upon today (known as forward rate) but the transaction takes place at a future date.

Future Contracts

These are standardized over the counter trade transactions and contracts which can be customized according to the respective needs of the parties involved in business. The exchange rate for currencies is fixed for trade at some future date. This is a highly effective forex external risk management technique.

Options

These are basically the rights extended to traders in forex markets. Such rights are only used when one has to deal with an unfavorable situation in the market. It can be a call option or a put currency. Options are considered to be expensive when compared with forwards or futures.

Swaps like currency and forex swaps are some other external forex management techniques that can be used.

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