This is Part 3 to further explore and inform us about Foreign Exchange Risks and how to Mitigate - Minimize & Manage them - Links to Part 1 & Part 2 are at the bottom of the page
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What Is Meant by Foreign Exchange Risk? By Eric Bank
When a company begins to export its products to other countries, it encounters foreign exchange risk, which is the risk of loss due to unfavorable changes in foreign exchange rates.
The risk comes about because importers typically pay in their own local currency, and the exporter must convert the payment back into the home currency. Should the importer's currency decrease in value, then the exporter will receive a smaller payment in home currency terms.
There are several techniques an exporter can exploit to mitigate foreign exchange risk.
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Sell in Foreign Currency
The simplest way to circumvent foreign currency risk is for the exporter to price a transaction in the importer's currency and demand payment in advance. The payment in advance is crucial -- with it, the exporter can immediately exchange the payment amount into the exporter's home currency.
Of course in very volatile markets, the timing of the payment and exchange can be tricky, as a delay of even a few minutes can have negative effects upon the exporter's revenue.
Net Receipts With Expenditures
If a company does business in the foreign country to which it exports its products, then it is likely that the exporter makes expenditures in the foreign country's currency.
By netting the income and outgoing foreign cash flows, the exporter can minimize the foreign currency risk, as the netted cash is never exchanged for the home currency. This strategy works best when the value of goods exported is roughly equal to the amount of expenditures made in the foreign country by the exporter.
Hedge with Forward Contracts
A foreign exchange forward contract is an agreement that allows the exporter to sell at a future date an agreed amount of foreign currency (the currency of the importer's country) at a rate agreed to in advance. For example, a U.S. exporter sells 125 million yen in merchandise to a Japanese firm with payment due in 60 days.
If the current exchange rate is 125 yen to the dollar, the exporter can eliminate currency fluctuations by agreeing with a bank to deliver 125 million yen in 60 days in return for $1 million. When the importer makes payment in yen, the exporter immediately converts it at the agreed forward rate. Foreign exchange forward contracts require no initial purchase price (premium).
Hedge with Options Contracts
A foreign exchange put contract provides the exporter with the right, but not the obligation, to deliver a specified amount of foreign currency on or before the option's expiration date in return for a specified amount of home currency. In our example, the exporter would purchase put options that controlled 125 million yen for 60 days and that paid $1 million when exercised.
This transaction establishes a floor for the exchange rate -- by exercising the option, the worst case scenario is the same exchange terms as those for the foreign exchange forward contract, except that options are purchased for an up-front non-recoverable premium.
If the yen strengthens over the 60-day period, the exporter could let the option expire and instead exchange the 125 million yen payment for more than $1 million dollars in the spot (current) market.
Read more: What Is Meant by Foreign Exchange Risk? | LINK
What Are Three Foreign Exchange Risks? By Edriaan Koening,
If you have business dealings with companies or governments outside of the USA, you expose yourself to foreign exchange risks. These risks arise from having to use foreign currencies because you may suffer losses if currency exchange rates fluctuate. There are three general foreign exchange risks that arise from translation, transaction and economic exposures.
Transaction risk comes from having to conduct commercial transactions in foreign currencies. You usually have to convert the foreign currencies into your own currency for the purposes of reporting and consolidation eventually. You may gain profits if your currency becomes stronger and suffer losses if your currency becomes weaker. For example, if you have CA$5,000 profits from your Canadian operations and your currency drops in value, you may end up with less than US$5,000.
Translation risk comes from transactions in foreign currencies that you have already entered into. For example. if you have subsidiaries and assets in another country, their values are expressed in a foreign currency. In your financial statements, you need to express the values of your foreign assets in your currency so you can combine it with your local assets. Translation risk is often known as accounting risk because it affects your financial statements, but not real money.
Also known as operating risk, economic risk is associated with the revenue, demand and costs for your products in a foreign country when the exchange rates fluctuate. For example, if the foreign currency drops in value, your products would become more expensive and less attractive to the residents of the foreign country. This could result in lower sales revenue and lower profits.
You may also face tax risks due to your international dealings, depending on the particular country where you do business. Generally, you only have to pay taxes on realized foreign exchange gains and you can only claim tax deductions on realized foreign exchange losses. You can use various methods to limit your exposure to foreign exchange risks. For example, you can use currency derivatives such as futures, options and forward contracts to reduce your transaction risk.
Read more: What Are Three Foreign Exchange Risks? |LINK
What Are the Major Types of Foreign Exchange Risks?
With an average daily volume of over $1 trillion, the foreign exchange system is the largest market in the world. It is used by central banks, commercial financial institutions, multinational corporations, and individual speculators, each of which have their own specific types of risk.
Today's international foreign exchange system has its roots in the global currency exchange regime created by the 1944 Bretton Woods Agreement.
The largest players in the foreign exchange system are central banks like the European Central Bank, Bank of Japan, and U.S. Federal Reserve. They are followed by commercial and investment banks, global companies like Coke and McDonald's, and many different kinds of investors and traders.
Sovereign Currency Risk
The largest risk in Forex is that a country's currency will significantly depreciate or possibly even devalue. This may happen in response to political turmoil, social unrest, war, or may be a long-term consequence of the country pursuing unsustainable budget and trade deficits.
Multi-National Company Risk
Major multinational companies like Coke, Pepsi, and McDonald's derive a considerable share of their revenue from overseas markets. McDonald's, in particular, earns of 65 percent of its income outside the U.S. As a result, these companies would be very badly affected if the currency values in one or more of their major foreign markets would significantly depreciate--this would cheapen the value of their revenues, while bolstering the value of their expenses.
As a result, many of these billion-dollar firms employ complex hedging strategies designed to significantly minimize bottom-line risk in the event of adverse currency swings.
Investment risk is the more classic kind of risk faced by almost every foreign exchange investor, from billion-dollar macro hedge funds to individuals trading miniscule accounts. A currency investor typically buys and sells two currencies simultaneously, hoping the one he buys appreciates in value relative to the one he sold. If this doesn't happen, he'll have a loss.
Given the very high borrowing limits availed to Forex investors, sometimes in excess of $200 for every $1 on deposit, losses of even a few percent on the underlying currencies can rapidly lead to ruinous losses in a brokerage account.
Read more: What Are the Major Types of Foreign Exchange Risks? | LINK
How to Mitigate Foreign Exchange Rate Risk By Carmelo Montalbano,
Mitigating foreign exchange risk means to reduce the effect of currency translation or currency effect on a financial instrument. Thus, the true financial return can be measured on the basis of capital gains and dividends. There are many ways to mitigate or hedge financial risk in currencies.
1 Open a futures account at a brokerage firm that trades foreign currencies. Opening an account includes opening a margin account so that the trader can use leverage. Understand that you are personally responsible for any failure to meet initial margin or maintenance margin. Choose a broker with a trading platform you understand and can manipulate easily. Make certain you know how to place orders and limit losses online.
2 Consider the risk you wish to mitigate. If it is fluctuating value, calculate a minimum value (as you would with an insurance policy) and the currency at which the asset is valued. Short the currency in the amount of the minimum value. Then, subtract the minimum value from the current value and short that amount. This latter amount should be checked periodically and the short recalibrated as necessary.
3 Buy put or call options, depending on whether you believe the security to be hedged is rising or declining in value. If you believe the currency underlying the security is rising, then purchase a call. Use puts or don't hedge at all if you believe the currency is declining. Options limit your market risk, but you may pay a stiff price for the protection they provide. Understand that most options have multiple expiration dates within six months of the current date.
4 Mitigate risk of a company by demanding payment in the home currency. Lower risk for a foreign company reporting in U.S. dollars by making the payment terms in dollars. Know that this is common practice in the international oil business, for example.
5 Buy stock of foreign companies denominated in U.S. dollars. Diversify your stock portfolio by buying U.S.-based international companies rather than buying the stocks of competing local foreign businesses. U.S. companies must report earnings in dollars and do their own hedging internally.
Tips & Warnings
Always practice-trade before employing real money.
Understand the technical aspects of futures trading before undertaking real trades.
Read more: How to Mitigate Foreign Exchange Rate Risk |LINK
How to Minimize Foreign Exchange Risks By Eliah Sekirin
Foreign exchange risk refers to the risk of cash flows suffering from adverse currency exchange rate movements. Because foreign exchange transactions are rising together with cross-border trade and capital flows, which have increased tremendously over the past decades, the question of minimizing foreign exchange risk has become increasingly important. The strategy of minimizing foreign exchange risk is called FX or Forex hedging.
1 Identify your foreign exchange exposure. What cash flows do you need to convert into other currencies? What are those currencies? Also net out the incoming and outgoing cash flows denominated in the same currency--for example, if both your revenues and costs are denominated in Canadian dollars, your foreign exchange exposure is limited only to profits, which you may want to expatriate.
2 Analyze the possibilities of exchange rate movements and their possible effects on the cash flows of your business. Are the exchange rates that you are exposed to likely to move? In what ways? Are they volatile (often go up and down) or stable? Consult expert opinions and forecasts to help you answer these questions.
3 Plan your hedging strategy. Review different hedging options. The most popular and effective hedging instrument is an FX option. An FX option is a contract that gives the buyer the right, but not the obligation, to buy or sell a given amount of currency at a certain price (strike price) by a certain date.
4 Buy hedging instruments that will help you minimize your foreign exchange risks. Continue monitoring the foreign exchange market on a continuous basis and adjust your hedging accordingly. If the volatility in currency markets rises, buy more FX options; if it falls, feel free to sell some.
Read more: How to Minimize Foreign Exchange Risks | LINK
How To Manage Foreign Exchange Risks By Joseph Nicholson
The profits of corporations that do business in more than one country are influenced each quarter by foreign exchange rates. Naturally, it receives revenue from operations in foreign countries in the local currency, but when it states its earnings and publishes financial statements, it will do some in the currency of its home country.
If a U.S. company operates overseas and the value of their foreign currency revenues decreases during the reporting period, those funds will translate into fewer dollars. To manage foreign exchange risks, multinational companies usually hedge their expected foreign currency revenues with foreign exchange derivatives.
1 Hedge with futures or forwards contracts. The predominant way to manage foreign exchange risk is to offset foreign currency holdings or expected revenue with futures or forwards. For example, a company expected to take in a million euros might can sell short a million euros worth of contracts or buy long the equivalent amount in dollars. The net result is that affect on exchange of revenue caused by fluctuation in the currency are canceled out by an opposite position in derivative contracts.
2 Trade options. Just as stocks have puts and calls that trade against their underlying value, currencies also have options. The strategy for hedging a foreign currency position with options is similar to using futures or forwards, but is usually less expensive.
3 Buy swaps. A currency swap is a relatively complex transaction, but an effective method for managing foreign exchange risk. Essentially, it is an exchange of future income streams in different currencies. A company might swap a certain value in a foreign currency to a foreign company who want to sell revenue in dollars.
Unlike hedging, though, swaps create a directional bet on the movement of currencies. At the maturation date, the company receiving the currency that has appreciated relative to the other has improved their situation. Thus, a company might use swaps sparingly for portions of their foreign holdings.
4 Open a foreign bank account. Depositing foreign currency in foreign banks and not repatriating it to the home country will not mitigate the effects of currency fluctuations on revenues, the impact of which will appear on financial statements. It will, however, allow the currency to gain a modest interest rate, and in the meantime, if the exchange rate moves and makes the foreign currency more valuable, a future windfall can be realized when the money actually is repatriated.
Tips & Warnings
The difference between futures and forwards is that futures only trade in fixed contract sizes and expiration dates. Forwards allow much more flexibility and can therefore create a much more precise hedge.
Read more: How To Manage Foreign Exchange Risks | LINK
Part One Foreign Currency
Part 2 Foreign Currency
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