Management of Foreign Exchange Risk Exposure - Free paper Sample

Introduction

Also regarded as exchange rate risk, foreign exchange risk is part of the primary dangers that businesses suffer when they decide to engage in international finance. It involves fluctuation of domestic and foreign currency, relative to each other. It majorly affects companies that are involved in the export and import of goods. There are three forms of foreign exchange rate risks. They include transactional, economic uncertainties, and translational risks (OFX, 2019). To manage these risks, companies use forward contracts, currency futures, currency options, and currency swaps. In retrospect, this discussion describes the forms of risks associated with foreign exchange, ways of managing these risks, and advice on the ideal technique for non-financial firms.

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Types of Foreign Exchange Risks

Transactional Risks

It is faced by companies that sell and buy goods from each other in different countries. If the exchange rate varies after signing in the contract, transactional risks result. One of the parties is likely to lose more compared to the other one. The longer the period between entering into a contract and performance, the more likely it is for the exchange rates to vary.

Economic Risks

Variations in exchange rates affect the market value of a company and lead to economic or operating risk. Further, macroeconomic environment variations such as government rules and regulations, and political stability influence operating risks. Operating uncertainties are long term, and may either be positive, stable, or negative.

Translation Risk

The risk is faced by large organizations that have auxiliaries in other countries. Therefore, when ancillary companies make profits, they have to convert to a common currency. If the rate is of a lower value, the stock prices also vary, and it is not easy to project the profit levels. In essence, the higher the assets and liabilities in the auxiliary companies, the more the translation risk.

Management of Foreign Exchange Rate Risks

Forward Contracts

These types of contracts aim at protecting the buyer from exchange rate fluctuations (Chen, 2019). The parties involved in the selling and buying of goods enter into a contract and agree to make payments in the future. In this regard, the exchange rate is capped at a fixed rate, and therefore both parties are aware of whether they shall lose and gain by the time they are entering into the contract. Further, it cannot be terminated unless the two parties agree. The agreement also has a high liquidity level, given that the buyer and seller are known, and the maturity date is predetermined. However, neither of the parties can predict what will happen in the future. Moreover, the price of the asset is likely to reduce as the maturity date approaches.

Currency Futures

It is an external technique for protecting parties in a contract involving foreign exchange. In this type of agreement, the parties deliver a specific currency at a particular time at the agreed price rate. It similar to forwarding contracts save for the fact that they are traded in structured markets, and the parties do not have to wait for the maturity date. Further, the costs of the contract are relatively low. However, these types of agreements are only limited to professionals in the industry.

Currency Options

The options give the parties to a transaction the right to transact at an agreed date in the future, but they are not obligated. It enables the business to benefit from positive exchange rates while protecting it from unfavorable exchange rate risks. They are also affordable. Further, the risk to the buyer is limited compared to that of the seller. The higher the risk, the more likely it is to make high returns. However, some costs should be paid to earn protection. They are also less liquid since the terms are not obligatory.

Currency Swaps

They entail an agreement that involves the exchange of currency to another. It consists of changing the interest and principal of a loan agreed in one currency to the interest and principal of another currency but of equal value. The existence of a principal amount is hypothetical. Its work is to enable the parties to calculate the interest rates. It is cheap and ideal for extended-term contracts. It is less liquid and is more likely for parties to breach the contract

Comparison

Forward contracts involve an agreement between parties to make payments at a future date, and the interest rates remain constant. Besides, currency futures are similar to forwarding contracts, but they operate in structured markets. Currency options give the mandate to parties to transact at a future date, but there is no obligation. Lastly, currency swaps involve the exchange of interest rates and principal with another currency at an equal value.

Several factors determine the management technique to be adopted. They include the size of the firm, leverage, liquidity, profitability, and growth of sales (Goel & Kumar, 2014). The book value determines the firm's size. According to Goel and Kumar (2014), large firms should adopt forward or swap management techniques. Also, the higher the leverage level of a firm, the more likely it is to hedge itself. Further, firms with a high profitability and liquidity ratio are less likely to hedge because they have easy access to finances. Lastly, a company that is willing to tap growth opportunities is more likely to hedge compared to a stable company.

The characteristics of the product determine the price of goods in non-financial institutions. Therefore the ideal technique to manage this type of risk is currency futures. In this approach, the market is regulated and is fair to both the seller and buyer. Further, the costs are favorable. Forward contracts are not ideal since they give power to the buyers, who may pay a lower price. On the contrary, currency options give power to sellers who may raise the prices.

Conclusion

In conclusion, foreign exchange risks, ways of managing these risks, and ideal techniques for non-financial firms are essential financial lessons. Transactional, economic risks and translational uncertainties are the major forms of foreign exchange risks. Forward contracts, currency futures, currency options, and currency swaps are used for managing risks. Currency futures are ideal for non-financial institutions to manage risk exposures.

References

Chen, J. (2019). Forward Exchange Contract. Retrieved from Investopedia: https://www.investopedia.com/terms/f/forward-exchange-contract.asp

Goel, N., & Kumar, R. (2014). Foreign Exchange Risk Management Practices: A study of Ludhiana Textile Exporters. Global Journal of Commerce and Management Perspective, 3(5)69-77.

OFX. (2019). Understanding the types of foreign exchange risk. Retrieved from OFX: Https://www.ofx.com/en-au/blog/2019/8/types-of-foreign-exchange-risk/