When a corporate transacts in different currencies, it brings in the risk of currency fluctuation which needs to be actively dealt with. The transactions could stretch across country boundary through regional subsidiaries or maybe clients across geographies. This brings in the necessity of having forex risk management strategies in place to tackle the currency fluctuations. In the globalised market the finance personnel need to be more adept in dealing with risk inherent to foreign transactions.
A corporate forex policy is a must for having the Forex Risk Management Strategies in place. There are many tools available which help in reducing the risk which arise due to ever changing global markets. Sometimes these tools are used individually or need to be tailor-made as sometimes a combination of instruments put together provide an appropriate hedge. The risk assessments should be an ongoing exercise and not a one-time thing as with changing markets, many dynamics also change which call for a change in hedging strategy.
The most popular way of reducing the currency risk is by entering a forward contract. They are done over the counter (OTC) and not traded on any exchange. It is a contract which is customized and unique as it caters between two entities. One corporate and other a financial institutions say a bank. These entities agree to buy or sell a particular currency at a set forex rate at a future date. Post the contract, the firm is obliged to transact at the exchange rate agreed upon irrespective of the market movements. Thus is the price has moved in favor of the corporate, the currency would be converted at the forward contract price and not the market price. As these aren’t part of an exchange, there is no regulatory assigned to this type of contracts, thus the counter party risk is high in forward currency contracts. Any corporate having concerns on fluctuating currency and has payments at fixed time in the future will find forward contract in their favor.
To mitigate the counterparty risk, standard contracts traded over the exchange will prove beneficial to the corporate. Thus a firm may enter a futures or an option contract. With clearing houses, varied clients in picture, the counterparty risk is reduced considerably. Currency futures market is used mainly for speculative trading but can also be of importance when used as a mechanism to hedge currency. As when once a contract is entered, there is a formal obligation for all entities involved to buy or sell at the terms speculated in the contract.
Currency options contracts are the best available strategies when one wants to mitigate currency risk. In the options contract, both the entities agree to convert a set amount of currency at a given exchange rate for a future date, but the entity is not obliged to do so. It has the option to see execute the contract or cancel it. Thus if the market spot currency rate is favorable than the one in the option contract, the corporate has the option at their end to cancel the contract. The cost involved is the option price, cancellation price and strike price. But the cost is almost negligible when compared to the flexibility is provides in executing the transaction.
Thus forex risk management strategies prove to be beneficial to entities wanting to mitigate their currency risks.
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