Why is Exchange risk management needed in international trade (forex trade)?
Multinational companies, import-export businesses, investors, and individuals making international transactions face foreign exchange rate risk. Exchange rate fluctuations are a daily occurrence.
As the value of major currencies fluctuate against each other, it creates income uncertainties for anyone doing cross-border transactions Thus, there is a need to mitigate this risk through efficient exchange rate risk management strategies.
Understanding financial terms
Risk – In finance, refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision
Exposure risk- Exposure refers to the degree to which a company is affected by exchange rate changes.
Exchange rate risk– is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.
EXPOSURE RISK TYPES
HEDGING– the method of mitigating exchange risk in forex (international ) trade is called hedging
Exchange risk management, centers around the concept of hedging.
Entering into an offsetting currency position, so whatever is lost/gained on the original currency exposure, is exactly offset by a corresponding currency gain/loss on the currency hedge. This coordinated buying or selling of a currency to minimize exchange rate risk is called Hedging
forex risk management is done by Internal and external hedging tools
Internal Hedging Techniques( internal hedging tools)
Netting,
Matching
Leading and lagging
Price Variation
Invoicing in foreign currency
Asset Liability Management.
Companies having subsidiaries in different countries can practice internal techniques to minimize foreign exchange exposure and the eventual need for its active hedging.
External Hedging Techniques(external hedging tools)
forward contract,
future contract,
options,
swaps, Money Market.