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FOREIGN EXCHANGE RISKS

Meaning
Foreign exchange risk is a financial risk, that exists when a
financial transaction is denominated in a currency other than
that of the base currency of the company. Foreign exchange
risk also exists when the foreign subsidiary of a firm maintains
financial statements in a currency other than the reporting
currency of the consolidated entity. The risk is that there may
be an adverse movement in the exchange rate of the
denomination currency in relation to the base currency before
the date when the transaction is completed. Investors and
businesses exporting or importing goods and services or
making foreign investments have an exchange rate risk which
can have severe financial consequences; but steps can be taken
to manage (i.e., reduce) the risk.

VARIOUS FOREIGN EXCHANGE RISKS


A firm dealing with foreign exchange may be exposed to foreign currency
exposures. The exposure is the outcome of possession of assets and
liabilities and transactions denominated in foreign currency.

Various foreign exchange

ECONOMIC EXPOSURE:Economic exposure measures the probability fluctuations in foreign exchange


rate which affects the firms value. The intrinsic value of a firm is planned by
discounting the expected future cash flows with suitable discounting rate. The risk
concerned in economic exposure requires measurement of the outcome of fluctuations
in exchange rate on different future cash flows.

TRANSACTION EXPOSURE:A firm may have some contractually fixed payments and receipts in foreign currency,
such as, export receivables, import payables, interest payable on foreign currency
loans etc. all such items are to be settled in a foreign currency.

TRANSLATION EXPOSURE:The translation exposure is also known as accounting exposure or balance sheet
exposure. It is in essence the exposure on the assets and liabilities exposed in the
balance sheet and which are not going to be liquidated in the near future. It refers to
the probability of loss that the firm may have to challenge because of decrease in value
of assets due to devaluation of a foreign currency despite the fact that there was no
foreign exchange transaction during the year.

MEASURE TO MITIGATE FOREIGN EXCHANGE RISK


Meaning:Exchange rate risk is simply the risk to which businesses and investors
are exposed to because changes in exchange rates may have an adverse effect on
them. An exporter is likely to find its sales falling or its gross margin shrinking, or
both when an appreciation occurs in its domestic currency. Therefore, fluctuation
in exchange rate can impact a business.
Foreign exchange risk management is the process through which the
treasurers try to reduces/ eliminate the loss that may results from an adverse
movement of foreign exchange rates. There are five important techniques of
foreign exchange risk management.
Forwards Contracts:
Forwards exchange contract is a contract wherein two parties are
involved. In India one party compulsorily being a bank, one agrees to deliver a
certain amount of foreign exchange at an agreed rate at a fixed future date to the
other party.

Futures Contracts:Currency futures contract is a contract to buy or sell on the exchange a


standard quantity of foreign currency at a future date at the price agreed to
between the parties to the contract. These are standardized contract that are
traded on organized future markets.
Futures contracts are traded for three maturity dates
o Last working day of current calendar quarter.
o Last working day of next calendar quarter.
o Last working day of next to next calendar quarter.

Option Contracts:Forward and future provide protection against adverse movements in


exchange-rats. However, they have one common disadvantages that the buyer
cannot benefit from favourable movements in exchange rates, since he is
obligated to sell/ buy currencies at a predetermined rate.
A currency option is a financial instruments that gives the buyer of the
option the right but not the obligation to sell or to buy fixed amount of a
currency at a fixed price on a fixed future date.

At-the-money option:If the option holder does not lose or gain whether he exercises his option or
not, the option is said to be at the money. While solving question in the
examination, it is assumed that if the option is at the money, it is not exercised by its
owner.

Currency Swaps:
In a currency swap, two parties agree to pay each others debt obligation
denominated in different currencies.
A currency swap involves:
o An exchanges of principal amounts today.
o An exchanges of interest payments during the currency of loan.
o A re-exchange of principal amounts at the time of maturity.

COUNTRY RISK ANALYSIS


When a business transaction occurs across international border,
they bring additional risks compared to those in domestic transactions.
The additional risks are called country risks .

RISKS ASSESSMENT REQUIRES ANALYSIS OF MANY


FACTORS,INCLUDING THE DECISION process in the
government ,relation of various groups in country.
Country risks are unpredicted event in a foreign country affect in
the value of international assets ,investment projects and the cash flow
The country risks distinguish between the ability to pay and willingness
to pay .it is sustainable amount of funds a country can borrow. Country
risks is determined by the costs and country risks has benefit for
repayment and default strategies.
The ways of evaluating country risks by different firms and
financial institution differ from each other. CRA represent the
potentially adverse impact of a country of a country s environment on
the multinational corporation of cash flow and is probability of loss due
to exposure to the political and social upheavals in a foreign country all
business dealing involve risks.

CRA IN FOREX TRADING


If the party is unable to receive an expected amount of payment because
of payment because of government interference in matters of insolvency of an
individual bank or institution . The country foreign exchange trading risks are
linked with interference of government in forex markets. The government
control on foreign exchange activities is still present and implemented actively.
When business transactions occur across international borders, they bring
additional risks compared to those in domestic transactions. These additional
risks are called country risks which include risks arising from national differences
in socio-political institutions, economic structures, policies, currencies, and
geography. The CRA monitors the potential for these risks to decrease the
expected return of a cross-border investment.

SOVEREIGN RISKS
The risk that a foreign central bank will alter its foreign-exchange
regulations thereby significantly reducing or completely nulling the value of
foreign-exchange contracts.
Probability that the government of a country (or an agency backed by
the government) will refuse to comply with the terms of a loan agreement
during economically difficult or politically volatile times. Although
sovereign nations don't "go broke," they can assert their independence in
any manner they choose, and cannot be sued without their assent. Sovereign
risk was a significant factor during 1970s after the oil shock when
Argentina and Mexico almost defaulted on their loans which had to be
rescheduled.

Political risks
This is the risks of loss that is caused due to changes in the political
structure or in the politics of country where investment bank is
made . The main historical data provides a good understanding of
the key factor such as behavior of the society ,the government the
private sector, political and relation with neighbor country. there are
2 types of aspects
1.Political forces which act in the country their representative and
the main national issue must be focused.
2.Social aspects their key indicator like population growth rate,
unemployment ratio, composition of the population.
3.Critical aspects the geographic positioning and its related strength
and weakness are also critical aspects.

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