How is International business linked with currency exchange risk

How is International business linked with currency exchange risk

07 Sep 2019 12:18 PM
 

What is foreign exchange risk?

The forex market is highly volatile, witnessing participation from all over the world by commercial banks, hedge funds, the central bank, investors, forex traders and more, making up a daily trade volume of over $5 trillion. All the forex transactions happening in the forex market are affected by the fluctuations in the foreign currency exchange rates, irrespective of the scale, including overseas money transfer, currency exchange for international travel, large volume transactions involving overseas buying and selling of goods, etc. The losses that international financial transactions and investments might be exposed to due to exchange rate fluctuations are called forex risks.  

Foreign exchange risk is also known as currency risk that dictates the profitability of an investment, trade or any transaction involving foreign currency, as the value one gets from completion of forex transactions might be increased or lowered due to the changes in the relative value of the involved currencies and their exchange rates.  For any transactions of a company denominated in any currency other than the home currency, the changes in the base currency or the denominated currency will directly impact the value one would receive upon its completion.  It affects the investors as well the businesses engaged in exports and imports of products and services across the domestic borders and to multiple countries alike. Certain factors like terms of trade, current account, inflation, geopolitical condition, interest rates, and more influence the movement in the foreign exchange rates and affect the value of a country's currency.     

How foreign exchange rates impact international trade?

In general, international trade carries certain risks ranging from payment defaults to changes in the countries' trade policies, which might add to the difficulty of executing overseas trade by exporters and importers. Beyond the risks associated with the occurrence of unforeseen circumstances with one's trade partner located overseas, including bankruptcy, non-fulfilment of payment obligations, damage to the goods, etc., the volatile forex's uncertainty market poses the biggest challenge. The fluctuations in the foreign currency exchange rates expose the account payables and receivables of an export/import business due to the gap between signing the contract and the actual delivery date causing potential losses to the parties involved in the overseas trade. When a business is involved in overseas trading, it is crucial for the exporter or the importer to implement proper risk management strategies to mitigate losses that can occur due to the fluctuations in the exchange rates. 

Let's understand the impact of fluctuations in foreign exchange rates on international trade through an example. Assume that an importer from India made a deal with an exporter in the US for the purchase of goods amounting to US$100,000 when the exchange rate for INR and the US dollar was 1$ = 65 INR. Thus, the cost incurred by the Indian exporter for the completion of trade would be Rs. 65,00,000. However, during the period between the supply of goods or shipping of goods and the payment delivery date, the exchange rate fluctuated to 1$ = 72 INR. This means that the importer from India would have to pay much more than what he was supposed to pay earlier for the same amount of goods, amounting to Rs 72,00,000. This would cause a loss of Rs. 700,000 to the Indian importer. 

To avoid these circumstances wherein a business can encounter losses due to forex risks, effective risk management strategies, including the right currency hedging tools, play a crucial role. The right strategies can enable the bottom line of companies to be safeguarded against forex exposure by protecting profit margins. 

Tools to mitigate foreign exchange risks

Hedging using currency derivatives is implemented by individuals and businesses to fortify against the forex risks. Forex risk management using the right tool considering the objective of the company enables enhanced security against the uncertainties that arise due to the volatility of the finance market. Forward contracts, futures contracts, options contracts are the instruments or tools utilized for hedging depending upon the specifics of the forex transactions, the potential risk and the hedging motive.

Hedging helps businesses and individuals in reducing unwanted risks due to the unfavourable forex market movements and securing profitability. It also ensures smoother operations with undivided attention to other aspects of a business without the fear of forex exposure affecting the profits of an organization. However, effective hedging can be difficult to execute for beginners as it requires expertise and understanding of the forex market. Therefore, it is recommended to take guidance from professional forex consultants. Following are the  various ways of currency hedging:

Forward contracts

A Forward Contract is a non-standardized agreement when two parties agree to exchange currencies at a predetermined rate on a fixed date. It is a customizable agreement between two parties wherein the contractual terms can be negotiated to consider the risk and returns of both. There is no need for margins to be deposited for the forward contracts. It is an over-the-counter contract and a popular hedging tool that is favourable to maintain the cash flow profitability from the transaction without worrying about the forex market volatility. However, there are few disadvantages associated with the forward contracts as well. If the currency exchange rates do not change unfavourably, then entering into an agreement could end up as a total waste as the parties involved are obliged to complete the transaction or currency exchange specified in the forward contracts. Another disadvantage is the counterparty risk due to the unregulated nature of the forward contracts, wherein there is always a chance that the counterparties might default on their end of the agreement.  

Future contracts

A futures contract is very similar to a forward contract in the manner that both entail settlement of the exchange of a currency pair at a predetermined exchange rate and at a specified date in the future. However, the disparity between the two occurs due to the standardized and non-customizable nature of future contracts. The future contacts will be the same for each, regardless of the counterparties.  They can be used for the purpose of hedging as well as trade speculation. Future contracts are traded on exchanges and thus have standardized contract specifications and are highly regulated, providing transparent contract and pricing data. Hence, future contracts do not expose the involved parties to counterparty risks. Both the parties entering a future contract are under the obligation to execute it on the settlement date. 

Options contracts

An option contract gives the investors the right but not the obligation to fulfil the specified transaction involving the purchase and sale of foreign currency at a pre-agreed rate and at a definite time. They allow for the parties involved to forego contract execution in case of unfavourable market movement and fulfil it in case of favourable market movements. Thus, it extends high flexibility to execute on profit earning opportunities and let go loss inducing transactions. There are two types of options- call and put. A call option extends to the call owner the right but he is not obliged to buy forex at a specified price and specified time. Similarly, a put option allows the option holder to take a call on whether to sell the specified currency pair or not at a predetermined strike price within the expiration date. 

The importance of forex risk management for an organization and especially MSMEs, with much more at stake, is very high to prevent losses caused by forex exposure. Access to the right knowledge and time for understanding the forex market as well as the right strategies, will determine the effectiveness of forex risk management which is not possible for all firms or individuals. They need to take guidance from a specialized team of experts and experienced people where Myforexeye comes into the picture. Myforexeye's Dr. Forex service provider empowers individuals and businesses with the right hedging recommendations and customizable hedging strategies considering the company's objective. One can consult our experts on a transactional basis via video and phone call wherein they can research-based forex reports and guidance from our advisory expert regarding their queries so that they are empowered to make informed decisions in the future. Besides Forex Risk Advisory, our services include transaction process outsourcing, quick and smooth financing, overseas money transfer, forex market updates, access to live forex rates, daily forex trading calls, etc. 

Conclusion

Myforexeye is committed to providing a resolution to your Forex and trade finance needs and filling the gap of the unmet demands in terms of credit and financial guidance to MSMEs and larger corporates. Through our team of experienced professionals and consultants well versed in the field of forex and trade finance, we provide streamlined forex solutions for one’s convenience at their disposal. Corroborating our efforts of providing solutions that are effective to companies for realizing their maximum potential are the latest technology and assistance from the veterans of the forex and trade finance industry. It is our objective to aid our clients in making savings and eliminating the aspect of hidden commission fees payable to the bank. Our user-friendly digital platforms - web portal and mobile app, enables one to access the best quotes for all types of forex conversions as well as avail import and export finance and calculate interest costs to make informed decisions. 

Speak to one of our specialists to acquire a detailed understanding of forex solutions offered by Myforexeye. 

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