Foreign Exchange and Risk Management

The term Foreign exchange implies two things; they are foreign currency and exchange rate. Foreign currency is any foreign nation’s currency which is authorized medium of circulation and the basis for record keeping in that country. An exchange rate is the value of a nation’s currency in terms of another currency.

The strengthening of the globalization process has led to a rise in foreign exchange transactions in international financial markets. This has set on higher volatility of exchange rates and has absolutely increased foreign exchange risk. There are numerous types of risks involved, however only a few can bring losses as massive as foreign exchange risk. In these conditions, the demand for new modern and effective methods for managing foreign exchange risk becomes a great necessity for the parties in international foreign exchange activity.

Foreign Exchange Risk Management is crucial for firms frequently trading in the international market. Coping with risk has therefore continuously been a vital managerial function. In recent years, however, risk management has received increasing attention in both corporate practice and the literature.

To manage the exchange rate risk inherent in international firms operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy, and the available instruments to deal with these currency risks. Exchange rate Risks are majorly divided into:

Translation Risk: is the extent to which a firms financial reporting is affected by exchange rate movements.

Transaction Risk: is the risk faced by companies involved in international trade, that currency exchange rates will change after the companies have already entered into financial obligations.

Economic Risk: is an effect caused on firms cash flows as a result of unexpected currency rate fluctuations. It is long term in nature as it has a substantial impact on a company’s market value

The first step to managing risks is through regular internal financial management by using techniques such as leads and lags, cross-hedging, currency diversification, Risk sharing, parallel loans etc. The development of markets for derivative financial instruments such as, Forward contracts, futures, options, swaps, and other, more complicated instruments today permit corporations to transfer risks to forex agents who are better able to manage.

Foreign exchange risk management is the base of trading in the currency market today. The problem arises from the lack of fundamental foundation with no proper planning, lack of knowledge, not using the right strategy at the right time, and not being able to analyze the market properly.

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