Foreign exchange or forex or FX risk management is the strategy devised to mitigate the possible effects of the forex fluctuations on assets, liabilities or cash flows. Many companies have operations and branches across nations and cross international borders for transactions, which lead to exposure to the foreign exchange markets. The forex exposure entails participating in the forex volatility and thus calls for managing this volatility in order to protect the costing of each transaction. Thus forex risk management is of prime important when dealing in foreign exchange markets.
Objective of FX risk management
The main objective of FX risk management thus becomes to mitigate possible forex losses from the unpredictable foreign exchange rates. The fluctuation in currency markets are driven by several factors which are fundamental, global economy, fiscal and monetary policies, geo-political stability, market psychology, technical factors, speculation, etc. The risk associated with exchange rate volatility can lead to losses for the international business entities like exporters and importers. These entities cannot control the movement in the foreign exchange markets but the risk can be mitigated using risk hedging techniques to protect the capital and effectively manage costs and revenues. When the exposure is left un-hedged, one can get a chance of foreign exchange gains, but the potential losses are of equal or more probability for such un-hedged exposure.
FX risk management tools
Hedging the foreign exchange rate exposure is thus seen as a must even if done partially. The central bank makes it mandatory above a certain value. A borrower has to hedge in such a manner that the projected cash flows match the expectations irrespective of the foreign exchange fluctuation. From an earlier full hedge Reserve Bank of India (RBI) has reduced the hedging mandate to 70% for borrowers raising funds overseas last year. The compulsory hedging ensures protection of capital and margins.
Company foreign exchange risk management policy is formulated depending on the business cycle of the company. The exposure is identified and quantified so that the forex risk can be analyzed. Cash flows for contracts which are already entered into and future cash flows are forecasted and then the level of risk is determined. These policies have to have clear objectives and within which the parameters are set for strategizing. The extent of hedging is a key decision to ensure risk is covered appropriately. Sometimes, stop loss arrangements are required, when the forecast levels aren’t achieved, to prevent any sudden losses. Thus various financial tools are available to ensure the safety of the cash flows and mitigate the forex risk.
Forward contracts – this is an agreement between the buyer and the seller for a fixed quantity of a currency to buy or sell a specific quantity at a pre-determined price for a specified date in future. This is done over the counter, thus the counterparty risk is high. Mostly one participant is the company while the other is the bank. The fluctuating currency spot will not affect the rate at which the currency is exchanged when done through the forward contract, thus eliminating the foreign exchange exposure risk. This tool is widely used as the FX risk management tool.
Currency futures – this is a standardized contract between two parties who buy or sell currency on a specified date in the future at a fixed price. These are trade on exchanges and thus offer more liquidity when compared to forward contracts. A fall in currency can be hedged by selling futures, while an appreciating currency can be hedged by buying currency futures. This also eliminated the forex exposure. (Know More)
Currency options – In this contract, the buyer of the contract has the right to buy or sell a specified currency amount for a specified price over a given period of time. The owner of the contract is not obliged to buy or sell and has a choice to execute or not based on the prevailing rates. Since there is a choice given to the buyer of the contract, there is an option premium which is payable. Thus options give an opportunity to participate in the market if the price moves in this favor else if the spot goes as expected, then the option can be exercised. (Know More)
Currency swap – this involves an agreement between two parties wherein a series of cash flows in one currency to be exchanged with another currency cash flows for a pre-determined period over agreed intervals. In this one currency held by one party is swapped for another currency held by other party. Here the interest is payable by each party at regular intervals till the specified period. At the end of the period, the principal amount is exchanged again in both currencies. (Know More)
Reviewing FX risk management
Any risk management tool requires constant monitoring and reviewing to understand its efficiency in the prevailing market conditions. Many a times, policies suitable for an era may not be suitable at another period of time. Thus the validity of benchmarks is to be understood to know the effectiveness of the hedging strategy. Globally linked markets call for frequent reviewing of the risk management policies to mitigate the foreign exchange exposure.
Myforexeye has helped many a corporate formulate their foreign exchange risk management system and implement strategies based on their forex risk appetite which has led them to minimize the risk while protecting their benchmarks at all times. With the team of experienced forex experts along with state of the art dealing room, managing clientele across the country has helped many exporters and importers manage the FX risk effectively.
10 Dec 2019 05:19 PM
Most of us understand the importance of the global interest rate benchmark LIBOR – London Inter-Bank Offered Rate, especially when millions of dollars are benchmarked against it for decades since 1984.
29 Nov 2019 02:16 PM
Ideally a trade constitutes a foreign exchange transaction but currency can be traded without any underlying which makes it a risky proposition.
26 Nov 2019 12:29 PM
Foreign exchange risk is a financial risk which exists when a home currency is converted into another during the transaction.
14 Nov 2019 02:54 PM
A foreign exchange transaction is recorded in the books of accounts at an exchange rate though the payment is made at a different exchange rate. This leads to transactional foreign exchange loss or gain.
07 Nov 2019 10:48 AM
Modern foreign exchange market started its shift from a fixed exchange rate to a floating exchange rate system. Thus a global decentralized, over the counter (OTC) market for trading of currencies evolved which determines the forex rates.
29 Oct 2019 05:00 PM
Trading in the financial markets is what increases the volumes especially when some markets are open across the borders over different time zones. Each market has its underlying asset which is tradable over the exchange.