The foreign exchange market is an over the counter market that trades foreign currencies. Based on the supply and demand for a countries currency, the value of that currency changes, which causes the price to shift. If a business is doing a transaction in a foreign currency, they will need to exchange it back to their home currency after the transaction is complete. The fluctuation in exchange rates creates a foreign exchange risk on businesses doing international business. Accounts Receivable
Companies expecting to be paid in a foreign currency at some point in the future face an accounts receivable exposure. For example, if a company sells a product to a British firm for 1,000 pounds with payment due in two months, they will receive dollars based on the spot rate in two months. As a result, if the exchange rate is $1.5 per pound, the company expects to receive $1,500. However, if the dollar appreciates in value relative to the pound to $1.20 per pound in two months, the company will only earn $1,200 dollars on the transaction.
Accounts payable exposures can significantly increase the cost of doing a transaction. Account payable exposure occurs when a firm takes out a loan in another currency or imports products in a foreign currency. Agreeing to pay in your home currency does not eliminate the exposure, but simply transfers it from the paying firm to the receiving firm. Payable exposure works similarly to receivable exposure. If a firm owes 1,000 pounds in two months and the exchange rate goes from $1.20 to $1.50 per pound, the paying firm will have to pay $1,500 instead of $1,200. Managing Exposure
Mangers use hedging strategies to reduce the risk they face in a foreign exchange transaction. However, by hedging they also reduce the potential additional profits they may gain from a favorable movement in the exchange rate. Mangers use forward contracts, money...