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Foreign exchange risk management is designed to preserve the value of currency

inflows, investments and loans, while enabling international businesses to compete
abroad. Although it is impossible to eliminate all risks, negative exchange
outcomes can be anticipated and managed effectively by individuals and corporate
entities. Businesses do so by becoming familiar with the typical foreign exchange
risks, demanding hard currency, diversifying properly and employing hedging
strategies.

 

1. Foreign exchange risk is generally associated with adverse currency
movements that negatively affect purchasing or pricing power. Merchants
that accept and hold foreign currency lose purchasing power when the value
of that foreign currency falls against their home currency. Meanwhile,
businesses that offer goods and services overseas are unfavorably affected
by increasing domestic currency values that raise the prices for exports.

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Politics influences foreign exchange risks.

 All international operators are challenged by political risks, which impede
the flow of global business. Exchange rates for domestic currency have a
bilateral cause and effect relationship with the home government. First,
political unrest and instability will cause currency values from that particular
nation to fall. Second, the nation's citizenry will pressure leadership to action
if they feel that foreign exchange and trade are not being coordinated
effectively.

The upheaval may result in trade wars, excessive taxes on international

commerce or the outright seizure of foreign assets.


 

3.

The U.S. dollar is hard currency.

Businesses and private citizens attempt to minimize foreign exchange risk

by demanding that all transactions are settled in hard currency. Hard
currency is associated with the industrialized, group of seven (G7) nations.
The G7 is made up of the United States, Canada, United Kingdom, France,
Germany, Italy and Japan. The currencies employed are the U.S. dollar,
Canadian dollar, British pound, Euro and Yen.

Hard currency values are relatively stable as they are associated with strong
economies and political regimes that protect individual rights.

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ÿ. All currencies fluctuate in value over time. Diversification allows people and
businesses to neutralize the risks of holding currency that deteriorates in
value, by carrying competing currency that is gaining in value. Doing
business within several different countries, converting profits into separate
foreign currency reserves and/or coordinating cash flow with basic hedging
strategies are ways to achieve diversification.
  

 


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Currency futures contracts trade at the Chicago Board of Trade.

Hedging strategies related to foreign exchange are executed to smooth

currency fluctuations by anticipating and locking in exchange rates.
Financial managers hedge against currency risks with futures contracts and
currency swaps.

Currency futures are contracts entered into by traders that set a fixed foreign
exchange rate between currencies into the future. Currency swaps allow
separate parties to switch the principal and interest payments upon debt that
is denominated in one currency for that of another. Lenders use currency
swaps to ensure that loans do not lose value. Borrowers use currency swaps
to hedge against the risk of loans becoming more expensive to pay off in
foreign currency.

Of course, hedging strategies carry the opportunity cost risk of losing out on
currency movements that are actually favorable.


Hedging Foreign Exchange Risk ±
Isn¶t it also a Risk?

  

Ôisk is the possibility of actual outcome being different from the expected
outcome. It includes both downside and upside potential. Downside potential is the
possibility of actual results being adverse compared to the expected results and
upside potential is the possibility of actual results being better than the expected
results.


 
    

It is the change in the domestic currency value of assets and liabilities to the
changes in the exchange rates. This may be positive or negative. Positive exposure
gives rise to Gain and negative exposure gives rise to loss.

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Foreign exchange risk is measured by the variance of the domestic currency value
of asset, liability or an operating income, which can be related to unexpected
changes in the exchange rates.

 

 
 

Hedging refers to process, whereby one can protect the price of financial
instrument at a date in the future by taking an opposite position in the present by
using derivatives like Currency Options, Currency Futures, Forward Contracts,
Currency Swaps, Money Markets, etc. It refers to technique of protecting the
financial exposures in the underlying asset or liability due to volatility in the
exchange rates by taking offsetting positions through derivatives to offset the
losses in the cash market by a corresponding gain in the derivatives market.