Foreign Exchange Risk and Management

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INDEX

SL.NO.| CONTENTS|
1.2.3.4.5.| INTRODUCTIONFOREIGN EXCHANGE RISKS-TYPES OF FOREIGN EXCHANGE EXPOSURE1. Transaction exposure2. Translation exposure3. Real operating exposureMANAGING FOREIGN EXCHANGE RISKS1.Managing transaction exposure2.Managing translation exposure3. Managing real operating exposureCONCLUSION|

FOREIGN
EXCHANGE RISKS

-MEANING AND TYPES

INTRODUCTION

Foreign exchange risk refers to the risk of an investment's value changing due to changes in currency exchange rates. It is the risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Foreign Exchange Risk is also known as "currency risk" or "exchange-rate risk”. This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. It is the risk that the exchange rate on a foreign currency will move against the position held by an investor such that the value of the investment is reduced. For example, if an investor residing in the United States purchases a bond denominated in Japanese yen, deterioration in the rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or she must eventually exchange the yen for dollars. In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favor of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation and the oil shock. Corporate struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivatives – foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. However derivative use is still a highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only. The risks related to foreign exchange are many and are mainly on account of the fluctuations in foreign currency.

CAUSES OF FLUCTUATIONS IN FOREIGN EXCHANGE RATES
1. Foreign exchange rates are influenced by domestic as well as international factors and happenings. 2. Foreign exchange dealings cross national boundaries and rates move on the basis of governmental regulations, fiscal policies, political instabilities and a variety of other causes. 3. Foreign exchange rate movements, like the stock market, are influenced by sentiments that may not always be logical. 4. Foreign exchange is traded hours a day at different markets and dealers cannot be in control at all times. 5. The ratings of credit agencies can affect the exchange rate. For instance, when Indian’s foreign exchange rating was downgraded by Moody’s in the mid—1990s, the value of rupee fell.

TYPES OF FOREIGN EXCHANGE EXPOSURE

An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose magnitude is not certain at the moment. The magnitude depends on the value of variables such as Foreign Exchange rates and Interest rates. Foreign exchange exposure can be broadly divided into 2 classes: * Accounting or translation exposure

* Economic exposure
Economic exposure can further be...
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