Foreign Exchange refers to the exchange or conversion of two or more currencies. Foreign exchange is a term that is also used to refer to global markets where currencies are traded mutually. The platform or market where foreign exchange is traded is known as currency exchange or the foreign exchange market. It basically is a global over the counter market for trade of currencies. The market determines foreign exchange rate.
This market works through intermediaries like financial institutions and operates on several levels Currencies are always traded in pairs here thus the market does not set a currency’s absolute value but analyses the relative values or currencies.
What is Foreign Exchange Risk?
Every business involves certain amount of risk. Foreign exchange market is the most liquid and dynamic market hence it is also the riskiest business to deal in. Foreign exchange risk is the risk that is involved in a financial transaction that is denominated in a foreign currency than the currency of the company. The risk is due to the adverse movement in the currencies due to certain externalities that might take place. Investors and businessmen who deal in the market have to deal with this risk on a regular basis. The importers and exporters of goods and services face this foreign exchange risk, Since the parties have to face this risk regularly that can have adverse consequences, there are certain techniques or steps that can be followed to manage the risk involved or to minimize the impact of movement in prices, such techniques are known as foreign exchange risk management techniques.
Foreign Exchange Risk Management
There are various internal as well as external techniques that can be used to hedge or manage the risk that is involved in foreign exchange dealing. Some of the techniques that can be used are:
An easy way to hedge the risk involved in trading is to insist all the foreign customers of the company to make payment in domestic currency of the company and to pay for imports in the domestic currency. This does not eradicate the risk involved but passes on the risk to the other party involved.
Matching is another way of dealing with the risk involved. A company that has to make payment and receive in the same currency can match the amounts and then has to deal with the unmatched position. Bilateral and multilateral matching tools can be used for the same. Leading and lagging is another internal technique to deal with the risk involved.
There are certain external risk management techniques that can be used.
Forward Contracts are the agreements that can be entered into by the buyer and seller of goods and services in the international market where in they can fix a future date and fixed amount. This helps both the parties in dealing with the risk involved in the market.
Future Contracts are another way to hedge the risk involved in a foreign exchange market. These are standardized trading instruments which are similar to forward contracts. The idea here is to fix the exchange rate at a future date subject to the risk involved.
Options; An option is a privilege that the people trading in the foreign exchange market hold that can be used to hedge the risk involved in transactions. It is the right to buy or sell a currency at an exercise price on a future date.
Forex swaps and currency swaps are other external instruments to manage risk involved in foreign exchange markets.
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