Foreign Exchange Risk Management

Topics: Exchange rate, Foreign exchange market, Inflation Pages: 18 (5402 words) Published: June 25, 2013
1.0 Introduction1
1.1 How do we identify exposure2
1.2 Company’s activities that causes exposure3

2.0 The Effect of Exchange Rate Changes on 8
Operational Cash Flow

3.0 Guidelines for corporate forecasting of foreign exchange rates10 - Fundamental forecasting11
- Technically forecasting14

4.0 Tools and instrument for managing foreign exchange risk17

5.0 Non-derivative hedge of foreign exchange risk management20

6.0 Conclusion25

7.0 Reference26

1.0 Introduction
We have chosen Foreign Exchange Risk Management as the topic of our report. We chose this topic as it is closely related to our field of study, which is in the Finance and Investment sector. In this field, we are most likely required to analysis the risk involved in certain prospects of a company’s objective to increase its value and expand to a greater market, before pursuing to any projects, major or minor, by the firm. Moreover, it is vital for us, as investors, financial analyst and such profession to be aware of not only the risk involved but also how to hedge against it, avoiding losses. In this report, we will discuss about the foreign exchange risk and its impact to a firm. Exchange rate risk is the changes in investment’s value due to the changes or fluctuation of the currency exchange rate. This will affect firms who are doing export or import business and international investment. It is because currencies have to be converted when doing these business. If the exchange rate is uncertain, it will cost the firm. There are a few factors that cause the exchange rate to fluctuate, such as the differential in interest rate, differential in inflation rate, current account deficit and etc. In our report, we will explain about the relationship of interest rate, inflation rate and the movement of exchange rate by using economic theory such as Purchasing Power Parity (PPP) and the International Fisher Effect (IFE). There are several types of foreign exchange exposure, for example: transaction exposure, translation exposure, economic exposure and etc. Each kind of exposure will bring different level of impact to the firm. It will affect the accounting of a firm, non contractual return and also the operational cash flow of a firm. The impact of foreign exchange rate risk can be positive or negative depends on how wisely the firm manages it. Foreign exchange risk can be managed by implementing a hedging strategy. The strategy should match with the true financial instrument in order to hedge the risk effectively. The common financial instrument used to manage the risk is derivatives such as forward, future and options contract. By using these tools, the firm can make profit from the fluctuation of the exchange rate and diversified the risk.

Our focus is the exposure of non-financial corporations and the value of their assets. Unlike financial institutions where bulk of assets consists of (paper) assets with contractually fixed return, Non-financial business firms have only a relatively small proportion of their total assets in the form of receivables and other financial claims. Their core assets consist of inventories, equipments, buildings and other tangible assets, closely related to technological capabilities that provide earning power and value. The location of an asset in a country is an indicator of their foreign exchange exposure. What is Foreign Exchange Exposure? It is the risk associated with activities that involve a global firm in currencies other that its home currency. Companies must assess and manage their foreign exchange exposures as they will face certain situations that have a direct impact on the firm’s hedging decisions. risk of change in value of a company’s equities when a company denominates a portion of its equities, assets, liabilities or income in foreign currency which will be affected due to exchange rate changes....

References: * UKessays, 2011. Foreign Exchange Risk Management. Viewed on 10 March 2013. Available from : <http://www.ukessays.co.uk/essays/strategic-management/foreign-exchange-risk-management.php>
* Financial Times, 2012
* Lan H.Giddy, 2011. The Management Of Foreign Exchange Risk. Viewed on 9 March 2013. Available from : <http://people.stern.nyu.edu/igiddy/fxrisk.htm>
* Investopedia, 2013
* Wikipedia, 2013.Currency swaps. Viewed on 12 March 2013. Available from: <http://en.wikipedia.org/wiki/Currency_swap>
* Wikipedia, 2013
* Forex-exchange-rates.com, 2012, Technical Analysis in Exchange Rates, viewed on 14 March 2013. Available from : <http://forex-exchange-rates.com/importance-technical-analysis-exchange.html>
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