Sequel to the introduction to the foreign exchange market, this article explains the respective potential risks that foreign exchange rate, foreign currency and foreign transactions may pose to the participants of the transactions.
There are certain companies, individuals, traders, etc., who engage and deal with foreign buyers, sellers, partners, customers, etc. In this setting, there will be an arrangement to settle or receive the consideration for the transaction in foreign currency. As far as there is an exchange of foreign currency, there are probable risks inherent in the transaction. Such risks are referred to as the foreign exchange or foreign currency risks. With the increasing need for globalization and international trade, it is pertinent to understand the potential risks that one may face in foreign transactions. The foreign currency or exchange rate risks are almost always present unless if the exchange rates are fixed with respect to one another. In this light, foreign exchange risk refers to the losses that an international or a foreign financial transaction may incur due to currency or exchange rates fluctuations.
There are three main types of currency risks. These risks are: economic risk, translation risk and transaction risk.
Economic risk is the form of risk that arises as a result of a change in the competitive strength of imports and exports. In simpler terms, economic risk is the risk that comes with the effect of exchange rate changes on the revenues of a company and its operating expenses. This risk is also known as forecast risk. In this form of risk, the market value of an entity is impacted as a result of an inevitable exposure to exchange rate fluctuations.
Translation risk is the potential risk that a company’s assets, liabilities, income and equity will decrease in value as a result of changes in foreign exchange rate. This risk is mostly attributed to companies who have a portion of their equity, income, assets or liabilities denominated in a foreign currency. Companies who also have foreign subsidiaries are inclined to face this form of risk as it will be a loss in the consolidated accounts if the subsidiary is in a foreign country with a weakened currency (as the subsidiary’s assets will be less valuable).
Transaction risk refers to the effect that foreign exchange rate fluctuations can have on a completed transaction prior to settlement. In simpler terms, this form of risk is associated with the time gap between when the foreign transaction is completed and when the payment is made. That means, there may be a pre-determined amount to be paid prior to the completion of the contract; however, due to the volatility of the market and its nature, the foreign exchange rate may change, hence, allowing the settlement amount to reduce compared to the amount previously computed. In this form of risk, if the exchange rate moves between agreeing the contract in a foreign currency and paying or receiving cash, the value of the domestic currency paid or received will change; making the future cash flows uncertain.
The aforementioned risks are inherent and are faced by businesses, individuals, traders, buyers, sellers, etc. that engage in transactions that involve the use of foreign currencies. It is therefore important that these respective parties have fundamental and relevant knowledge about these risks that may be encountered while trading and how these risks can be properly managed in order to preserve their funds and minimize their losses while trading.
In the coming weeks, we will discuss the possible measures that can be taken by the market participants to properly manage these risks.
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