Forex Risk Management

Introduction
• Foreign Exchange Market is an inter-bank market that took shape in 1971
when global trade shifted from fixed exchange rates to floating ones.
• This is a set of transactions among forex market agents involving
exchange of specified sums of money in a currency unit of any given
nation for currency of another nation at an agreed rate as of any specified
date
• The exchange rate of one currency to another currency is determined
simply: by supply and demand – exchange to which both parties agree.
• As in the rest of the world, in India too, foreign exchange constitutes the
largest financial market by far.
• Another essential feature of the FOREX market, is its stability , unlike the
stock market, the FOREX market never falls , currency is an absolutely
liquid commodity and will be always traded in.
 Market Participants
 BANKS:
Inter banks market is at the top in forex trading. Inter-bank market accounts
53% of total transaction of the forex. Some of this trading is done on the
behalf of the customers, but proprietary desks, trading for bank’s own
account, conduct most.
 COMMERCIAL COMPANIES
Commercial companies play an important role in the forex market. They do
participate in forex trading to pay activities and goods they are using in
international market. Trading is done on current exchange rate.
 CENTRAL BANK
The central bank RBI (India) plays an important role in the forex market. The
central bank controls the liquidity of the foreign exchange market. They
try to control money supply, inflation and exchange rates.
 HEDGERS
 SPECULATORS
Another class of market participants involved with foreign exchange-related transactions is
speculators who attempt to make money by taking advantage of fluctuating exchange-
rate levels.
 RETAIL FOREIGN EXCHANGE BROKER:
 IMPORTERS:
Who may need to purchase their supplier’s domestic currency to pay for the goods he has
supplied.
 EXPORTERS:
Who may be paid a foreign currency by an overseas purchaser, and who need to convert it
into his or her own currency.
 TOURISTS:
Who often purchase foreign currency, traveler’s cheques and bank notes, prior to visiting
an overseas country.
 Key Features Of Forex Market
• Liquidity: The market operates the enormous money supply and gives
absolute freedom in opening or closing a position in the current market
quotation. .
• Promptness: With a 24-hour work schedule, participants in the FOREX
market need not wait to respond to any given event, as is the case in many
markets.
• Availability: A possibility to trade round-the-clock; a market participant
need not wait to respond to any given event.
• Flexible regulation of the trade arrangement system.
• Value: The Forex market has traditionally incurred no service charges,
except for the natural bid/ask market spread.
 Foreign Exchange Risk
Foreign exchange risk is the risk that the exchange rate will change
unfavorably before the currency is exchanged. Foreign exchange risk is linked
to unexpected fluctuations in the value of currencies.
Exposure is defined as a contracted, projected or contingent cash flow
whose magnitude is not certain at the moment and depends on the value of
the foreign exchange rates.

There are mainly three types of foreign exchange exposures:

•Translation exposure
•Transaction exposure
•Economic Exposure
• Translation Exposure
 It is the degree to which a firm’s foreign currency denominated financial statements
is affected by exchange rate changes.
 If a firm has subsidiaries in many countries, the fluctuations in exchange rate will
make the assets valuation different in different periods
 The changes in asset valuation due to fluctuations in exchange rate will affect the
group’s asset, capital structure ratios, profitability ratios, solvency ratios.
• Translation exposure = (Exposed assets - Exposed liabilities)*(change in the
exchange rate)

• Transaction exposure
 This exposure refers to the extent to which the future value of firm’s domestic cash
flow is affected by exchange rate fluctuations.
 The degree of transaction exposure depends on the extent to which a firm’s
transactions are in foreign currency
• Economic Exposure
Economic exposure refers to the degree to which a firm’s present value of
future cash flows can be influenced by exchange rate fluctuations.
Economic exposure to an exchange rate is the risk that a variation in the rate
will affect the company’s competitive position in the market and hence its
profits.
OTHER RISKS :
Country Risk
Exposure to potential loss or adverse effects on company operations and
profitability caused by developments in a country‘s political or legal
environments.
• Cross Cultural Risk
A situation or event where cultural miscommunication puts some human value
at stake.
• Commercial Risks
Exposure to market preferences and sentiments. This relates to establishing
credibility and taking much more trouble to settle down than the home-
grown company
• Currency Risk
Change in foreign exchange rates may result in huge amount of losses for an
MNC. Thus this is again a risk, which needs to be tackled
 Foreign Exchange Risk Management
Framework.
Once a firm recognises its exposure then it has to deploy
resources in managaing it.
Forecasts: After determining its exposure, the first step for a firm is to
develop a forecast on the market trends the main direction/trend is going to be
on the foreign exchange rate typically for 6 months.
Risk Estimation: Based on the forecast, a measure of the Value at Risk and
the probability of this risk should be ascertained.
Benchmarking: Given the exposures and the risk estimates, the firm has to
set its limits for handling foreign exchange exposure on a cost centre or profit
centre basis.
Hedging: Based on the limits a firm set for itself to manage exposure, the
firms then decides an appropriate hedging strategy.
• Stop Loss: The firms risk management decisions are based on forecasts of
reasonably unpredictable trends. It is imperative to have stop loss
arrangements in order to rescue the firm if the forecasts turn out wrong
• Reporting and Review: Risk management policies are typically subjected
to review based on periodic reporting.
 Hedging srategies/Instruments
A derivative is a financial contract whose value is derived from the value of
some other financial asset, such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of prices.
The instrumrents used are :
Forwards
Futures
Options
Swaps
Foreign Debt