Currency exchange risk is a part and parcel of international businesses as the purpose of doing business overseas to gain international exposure and thus earn profits. One cannot avoid the exchange rate risk as the currency market is a volatile and round the clock market which fluctuate with events across the globe and times. But the same can be mitigated through hedging strategies. Before we understand the hedging strategies, let us first understand what forex risk is?
Companies which have their business operations beyond their nations are exposed to the currency fluctuations. With every change in the value of one currency in relation to other currency, the risk also increases. For businesses which deal with import or export of products, they pay or receive money in lieu of the products. At the same time, understanding the cash flow helps in better management of linked operations. Thus the currency exchange flows form an integral part of one’s international business.
Why manage currency risk?
One must understand the necessity of Foreign Exchange and Risk Management. The aim of taming currency risk is to mitigate the possible losses which might arise due to sudden and sharp movement of currency prices.
Foreign exchange and risk management helps in the following –
If proper management of currency risk is not done, the term finance which may be needed for pushing the growth of a company may not be available which in turn hamper the growth prospects and give an edge to the competitors.
International events linked to Currency risk
With the advent of technology, the news reach and event updates are faster than ever which lead to immediate movement in currencies. From US President – Donald Trump’s twitter account for US- China trade war updates to Brexit discussion in the UK Parliament all give enough thrust to not only currency market but also other financial markets. Currency risk is associated with money which is invested in either equity or bond or commodities. The base of all markets in currency money, thus movement in any market would lead to a corresponding movement in currency market. The 9/11 terror attack or the US attack on Afghanistan or Syria – show how vulnerable the financial markets become. Even back home Indo-Pak war like situation early this year led to considerable foreign exchange risk and exposure.
Small businesses take for granted that the currency movement will affect only the bankers and traders while they need not be worried for the same. But a political decision may lead to severe consequences specially when managing business across borders. And it isn’t just the local businesses which are affected, but since a decision may have implications on other currencies too, the strong linkage of one currency with another which in turns triggers many stop losses leading to further drastic movement in prices.
Tools to mitigate foreign exchange risk and exposure
The foreign exchange market participants have few effective tools to manage or mitigate the currency risk. These tools are not specific to any particular business type but are applicable to all in the industry. Currency derivatives like forward contracts, future contracts and options are to name a few, along with stop loss and limit orders.
Forward Contract helps the trader – importer or exporter, to eliminate the forex fluctuations but locking in the price of the currency today instead of keeping an open un-hedged position for a delivery at a future date. This helps in forecasting the cash flows while protecting the cost. The transparency increases as companies know the amount involved while they deal with international suppliers. The assurance of price fixed when the market moves unfavorably helps in protecting the profit margin. But at the same time, if the market moves favorably, the opportunity loss is also there.
Thus for traders who do not want to miss the opportunity of probable profits the futures contracts fills the gap. But with an opportunity of earning profits comes the risk associated with it. A future contract though takes care of the non-compliance risk as they are exchange traded. They are marked to market and thus a margin is to be maintained for the same. Since these are traded over the exchange only major currency pairs are available. In a future contract the buyer has the obligation to honour the contract bought. Thus to further reduce the risk, the option contracts (you can read more Currency Options & Futures) are used by hedgers. A speculator would probably go for a future contract as higher profits come higher risks. But for a businesses, options work best. The buyer of the option contract has to right but not the obligation to honour the contract, whereas the seller of the option contract has the obligation to comply.
Manage risk to mitigate currency exchange risk
To conclude, it is impossible to fully avoid the currency exchange risk for international businesses, but at the same time it pays to mitigate the risk as that can lead to protection of capital and lead to better cash flow management. Currency or forex advisors do their bit in understanding the forex markets and thus prove to reduce the risk considerably. To tap the right advisor is the first step to start saving on the so called forex cost center. Forex Advisory Services help in realizing the pain points and thus plug such loop holes to hedge the currency risk.
04 Mar 2021 03:08 PM
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