Doing business abroad has never been an easy feat.

One has to be able to conclude the

transaction. Then he has to make sure you get paid, which as many exporters can
attest, is not a given. As if this was not complicated enough, exporters now run the
risk of losing revenue due to fluctuations on the foreign exchange market when the
transaction is conducted in a foreign currency. Slight fluctuations in the value of a
currency relative to the dollar can translate into losses of thousands of dollars or more,
according to the size of the transaction. Last February for instance, one dollar was
worth 1.6406 DMark. On May 6, it was exchanged for 1.7325 DMark. An American
exporter selling products in Germany for an amount of 100,000 DM would receive
$57720 instead of $60953 had he received the payment 4 months ago. The loss would
amount to a little more than three thousand dollars.

Evidently, the fluctuation would have resulted in a gain had the dollar fallen relative
to the foreign currency. But even that means you have to keep an eye on the foreign
exchange market.

If the transaction partner is located in a country with a currency that is difficult to

track, the problem can become even more acute.

The most common cause of the exchange risk arises from

 Making payments in foreign currency for imports that are priced in a foreign
currency
 Receiving foreign currency for exports.

The foreign exchange markets now being more unstable than they used to be,
companies that deal with international markets will have to design strategies to
manage foreign exchange risk and hedge against the fluctuations. How do you do
that? First of all, it's all a matter of which party will bear the risk, and that will depend
on the different bargaining positions. Of course, the best solution for the US exporter
is to get paid in US dollars, but most foreign clients will probably be reluctant to
comply. Moreover, the transaction currency increasingly becomes a crucial element of
the offering package. Insisting on a US dollar payment can therefore make you lose
customers. Another solution is to do nothing, which amounts to speculation, with all
the risks involved.

Besides those two options, companies can now use a broad range of financial
arrangements to reduce or eliminate their exposure, and the choice between those
instruments will depend on the nature of the exposure and how the company manages
risk. The most widely used financial arrangements are the forward market and the
options. The forward market allows the exporter to exchange two currencies on a
future date at an agreed rate, therefore enabling it to cover itself, were any fluctuation
to occur. In an option contract, the exporter agrees to buy foreign exchange on any
date between a set period of time, at a rate set conjointly with the bank. Companies
generally use options when they need to cover their exposure over a very long period
ranging from 6 months to one year

Foreign exchange risk is associated with adverse currency movements that translate
into lost profits and purchasing power. For example, American businessmen that hold
reserves of the Mexican peso lose purchasing power when pesos decline against
dollars. Alternatively, American consumers suffer when the peso strengthens, which
makes Mexican goods more expensive for American buyers. Private individuals and
businesses can manage foreign-exchange risk with diversification, currency
derivatives and currency swap techniques.

Diversification

Diversification is a currency risk management strategy that enables you to profit

across multiple economic scenarios. You may assemble a foreign exchange portfolio
of several currencies to diversify. For example, a currency portfolio featuring U.S.
dollars and Russian rubles could serve as a diversification play against commodity
prices. High commodity prices typically translate into economic recession and
inflation for the United States. At that point, the U.S. dollar weakens, as foreigners
begin to liquidate American assets. Meanwhile, your Russian rubles will be
appreciating in value, because Russia is a primary exporter of oil and natural gas, and
benefits from high commodity prices.

Beyond trading currencies, large corporations diversify against currency risk by

establishing global businesses within several different countries. For example, Coca
Cola's international profits stabilize the firm when the American economy and dollar
are weak. Individual investors, however, may lack the financial resources and
expertise to establish overseas businesses. Smaller investors may purchase shares of
stock in multinational corporations, such as Coca Cola, or buy global mutual funds to
protect themselves against currency risks.

Derivatives

Currency derivatives are financial contracts that manage foreign exchange risk by
establishing predetermined exchange rates for set periods of time. Currency
derivatives include futures, options and forwards. Currency futures and options
contracts trade upon organized financial exchanges, such as the Chicago Mercantile
Exchange. In exchange for premium payments, options grant you the choice to accept
foreign exchange rates until the contract expires. Futures contracts, however, enforce
the delivery of currencies at agreed upon valuations at later dates. Meanwhile,
forwards are customized agreements between two parties that negotiate future
exchange rates between themselves.

Currency Swaps

Currency swaps are agreements between separate parties to exchange payments in

different currencies between themselves. Instead of simultaneously exchanging
infinite currency payments, swaps feature netting. Netting calculates one payment,
where the winning party receives one payment for the total difference between
currency values that occurred during the contract's duration. Currency swaps may be
combined with interest rate swaps, where trading partners exchange fixed and
adjustable-rate interest payments.

Derivatives are used by investors to:

 provide leverage (or gearing), such that a small movement in the underlying
value can cause a large difference in the value of the derivative;
 speculate and make a profit if the value of the underlying asset moves the way
they expect (e.g., moves in a given direction, stays in or out of a specified
range, reaches a certain level);
 hedge or mitigate risk in the underlying, by entering into a derivative contract
whose value moves in the opposite direction to their underlying position and
cancels part or all of it out;
 obtain exposure to the underlying where it is not possible to trade in the
underlying (e.g., weather derivatives);
 create option ability where the value of the derivative is linked to a specific
condition or event (e.g., the underlying reaching a specific price level).

Financial assets that derive their value, from the value of underlying, real or financial
asset. Example: currency forwards, stock index futures, Stock options etc.

1. FORWARDS

A forward contract or simply a forward is a non-standardized contract between two

parties to buy or sell an asset at a specified future time at a price agreed today.

The party agreeing to buy the underlying asset in the future assumes a long position,
and the party agreeing to sell the asset in the future assumes a short position. The price
agreed upon is called the delivery price, which is equal to the forward price at the time
the contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of the
instrument changes. This is one of the many forms of buy/sell orders where the time
of trade is not the time where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price,
which is the price at which the asset changes hands on the spot date. The difference
between the spot and the forward price is the forward premium or forward discount,
generally considered in the form of a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically
currency or exchange rate risk), as a means of speculation, or to allow a party to take
advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward
contracts are very similar to futures contracts, except they are not exchange-traded, or
defined on standardized assets.

Suppose that Bob wants to buy a house a year from now. At the same time, suppose
that Andy currently owns a $100,000 house that he wishes to sell a year from now.
Both parties could enter into a forward contract with each other. Suppose that they
both agree on the sale price in one year's time of $104,000 (more below on why the
sale price should be this amount). Andy and Bob have entered into a forward contract.
Bob, because he is buying the underlying, is said to have entered a long forward
contract. Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy's house is
$110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will
make a profit of $6,000. To see why this is so, one needs only to recognize that Bob
can buy from Andy for $104,000 and immediately sell to the market for $110,000.
Bob has made the difference in profit. In contrast, Andy has made a potential loss of
$6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a
forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to
expire/settle at a future date, as they do not wish to be exposed to exchange
rate/currency risk over a period of time. As the exchange rate between U.S. dollars
and Canadian dollars fluctuates between the trade date and the earlier of the date at
which the contract is closed or the expiration date, one party gains and the
counterparty loses as one currency strengthens against the other. Sometimes, the buy
forward is opened because the investor will actually need Canadian dollars at a future
date such as to pay a debt owed that is denominated in Canadian dollars. Other times,
the party opening a forward does so, not because they need Canadian dollars nor
because they are hedging currency risk, but because they are speculating on the
currency, expecting the exchange rate to move favourably to generate a gain on
closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract
to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the
current rate—these two amounts are called the notional amount(s)). While the notional
amount or reference amount may be a large number, the cost or margin requirement to
command or open such a contract is considerably less than that amount, which refers
to the leverage created, which is typical in derivative contracts.

2. FUTURES

A futures contract is a standardized contract between two parties to buy or sell a

specified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a
specified future date at a price agreed today (the futures price or the strike price). The
contracts are traded on a futures exchange. Futures contracts are not "direct" securities
like stocks, bonds, rights or warrants. They are still securities, however, though they
are a type of derivative contract. The party agreeing to buy the underlying asset in the
future assumes a long position, and the party agreeing to sell the asset in the future
assumes a short position.

The price is determined by the instantaneous equilibrium between the forces of supply
and demand among competing buy and sell orders on the exchange at the time of the
purchase or sale of the contract. In many cases, the underlying asset to a futures
contract may not be traditional "commodities" at all – that is, for financial futures, the
underlying asset or item can be currencies, securities or financial instruments and
intangible assets or referenced items such as stock indexes and interest rates.

The future date is called the delivery date or final settlement date. The official price of
the futures contract at the end of a day's trading session on the exchange is called the
settlement price for that day of business on the exchange.

A closely related contract is a forward contract; they differ in certain respects. Futures
contracts are very similar to forward contracts, except they are exchange-traded and
defined on standardized assets. Unlike forwards, futures typically have interim partial
settlements or "true-ups" in margin requirements. For typical forwards, the net gain or
loss accrued over the life of the contract is realized on the delivery date.

A futures contract gives the holder the obligation to make or take delivery under the
terms of the contract, whereas an option grants the buyer the right, but not the
obligation, to establish a position previously held by the seller of the option. In other
words, the owner of an options contract may exercise the contract, but both parties of
a "futures contract" must fulfill the contract on the settlement date. The seller delivers
the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is
transferred from the futures trader who sustained a loss to the one who made a profit.
To exit the commitment prior to the settlement date, the holder of a futures position
has to offset his/her position by either selling a long position or buying back
(covering) a short position, effectively closing out the futures position and its contract
obligations.

Futures contracts, or simply futures, (but not future or future contract) are exchange-
traded derivatives. The exchange's clearing house acts as counterparty on all contracts,
sets margin requirements, and crucially also provides a mechanism for settlement.

3.OPTIONS

An option is a derivative financial instrument that establishes a contract between two

parties concerning the buying or selling of an asset at a reference price. The buyer of
the option gains the right, but not the obligation, to engage in some specific
transaction on the asset, while the seller incurs the obligation to fulfill the transaction
if so requested by the buyer. The price of an option derives from the difference
between the reference price and the value of the underlying asset (commonly a stock,
a bond, a currency or a futures contract) plus a premium based on the time remaining
until the expiration of the option. Other types of options exist, and options can in
principle be created for any type of valuable asset.

An option which conveys the right to buy something is called a call; an option which
conveys the right to sell is called a put. The reference price at which the underlying
may be traded is called the strike price or exercise price. The process of activating an
option and thereby trading the underlying at the agreed-upon price is referred to as
exercising it. Most options have an expiration date. If the option is not exercised by
the expiration date, it becomes void and worthless.

In return for granting the option, called writing the option, the originator of the option
collects a payment, the premium, from the buyer. The writer of an option must make
good on delivering (or receiving) the underlying asset or its cash equivalent, if the
option is exercised. An option can usually be sold by its original buyer to another
party. Many options are created in standardized form and traded on an anonymous
options exchange among the general public, while other over-the-counter options are
customized ad hoc to the desires of the buyer, usually by an investment bank.