What is Foreign Exchange Risk Mangement?

The financial risk associated with foreign exchange is called Foreign exchange risk or currency risk. It is also called FX risk or exchange rate risk. The value of investment changes with the change in currency rate. The exposure to forex risk can affect organizations, big or small as it affects the assets and liabilities and hence the overall profitability. This also includes risk an investor would face while trading in the forex market, if there are open positions – long or short due to adverse exchange rate movement. With the forex market being a global one and functioning 24 hours – 5 days a week, this is likely to continue due to the socio-economic uncertainty.

The different types of risk associated with foreign exchange can be divided into transactional, translational or economic risk. These broadly refer to

Transactional risk – when a corporate deals with a foreign entity there is a forex risk arising due to difference in date of transaction and the final settlement date. On day of conversion, there can be a profit or loss which the corporate would have to bear.

Translational risk – if the corporate has assets and liabilities (A&L) denominated in a foreign currency, with the fluctuating exchange rates there will be a change in the value of A&L. This gives rise to translational risk.

Economic risk – If there are future cash flows of a company from foreign operations, the operating expenses and revenues tend to change too. This unanticipated change in forex rates causes the economic risk. 

A well managed Foreign Exchange Risk Management policy would help the organization to mitigate such risks and not hurt the company’s revenue numbers. This is done by adopting hedging strategies to reduce the effect on the corporate cash flows. The spot, forward and options contracts aid in understanding the hedging tool which would be best for the corporate.

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