27 Dec 2018 05:15 PM

Techniques of foreign exchange risk management

The value of a currency changes frequently due to various factors in the market such as inflation, interest rates, current account deficits, trade terms, political and economic performance etc. That ultimately affects firms and individuals engaged in international transactions. Foreign exchange risk is a form of financial risk that arises from the change in the price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face forex risk. Such risk must be managed in order to ensure better cash flows, manage unsystematic risks, avoid external financing, avoid financial distress, enhance shareholders wealth, and increases investor confidence.

The techniques of  foreign exchange risk management are as follows;

  • Risk Sharing
  • Diversification
  • Natural hedging
  • Payments netting
  • Leading and lagging
  • Cross hedging
  • Overseas loan
  • Money market hedge
  • Borrowing Policy

Derivative instruments of forex risk management are;

  • Forwards
  • Futures
  • Options
  • Swaps

Risk Sharing: The seller and buyer agree to share the currency risk in order to keep the long-term relationship based on the product quality and supplier reliability.

Diversification: It can be done by firms by using funds in more than one capital market and in more than one currency.

Natural hedging: The relationship between revenues and costs of a foreign subsidiary sometimes provides a natural hedge, giving the firm ongoing protection from exchange rate fluctuations.

Payments netting: This method can be used if the companies having exposed in the multiple currencies. This method gives an easy control to the company at the time of conversion, because all the payments are netted to one single transaction and allow the company follows a consistent policy and this also allows to reduce transaction cost also.

Leading and Lagging: This method works by adjusting the payments required reflecting future currency movements. It is a zero-sum game because if there is a receivable blocked in their respective currency it will allow them to use it against payable in the same currency.

Cross Hedging: If a conversion consists of more than one currency then cross hedging is used for example if an importer receiving payment in Chinese yuan, it cannot be directly converted into INR so it is first converted into USD and then INR so in these type of transaction Cross Hedging is used.

Overseas Loans/ Foreign currency: denominated debt: A Trade can avail the loan in two different currencies. Credit in home currency which have exchange rate risk and other is in foreign currency which is free from exchange rate risk. Usually, this method is used if your payments or receivables are in foreign currency.

Money market Hedge: It is a costly and unused strategy, In this method, the companies borrow in foreign currency and lends in same currency which will lead to losing on their spread. Instead of this strategy there can use forward hedging.

Borrowing Policy: Every company needs to have a strong borrowing policy. It needs to know whether to go for long-term loans or working capital loans.

Derivatives: Products whose values are derived from the underlying assets. The four different products are.

Forwards: It is a derivative product where contract holder enters into a forward contract made today for delivery of an asset at a predefined time in future at a price agreed upon today. These contracts are custom made; their quantity and time period can be adjusted according to the parties understanding. The basic disadvantage in these type of contacts are found a suitable counterparty and if the rates move unfavorably then the buyer ends up paying more.

Futures: These contracts work same as forwards but these contracts are traded through exchange and they have fixed quantity and time period.

Options: These types of contracts give the buyer the right to buy or sell but it is not an obligation to buy or sell. Options are considered as an appropriate hedging instrument because of it flexibilities in the conditions and avoid losses. A buyer if this contracts can avail them buy just paying premium. Options always provide unlimited gains and limited loss.

Currency Swaps: In these type of agreements two parties exchange there principle and interest amount into a different currency. The equivalent principal amounts of the two parties are exchanged at the spot rate.

Using the right technique at the right time is the key step to be taken by businesses and individuals. Forex markets are unpredictable and extremely volatile. Managing forex risk requires regular monitoring of the forex markets and loads of patience. The forex advisory team at Myforexeye has a lot of experience in forex risk management. The Myforexeye team provides market intelligence and industry best practices to its clients to manage their forex risk more efficiently.

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