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WHAT IS FOREIGN EXCHANGE?

Foreign exchange refers to the financial transaction where currency value of one country is traded into another countrys currency. The whole process gets done by a network of various financial institutions like banks, investors and

governments. The exchange rate varies according to the value of each countrys currency which is based on the health of that particular countrys economy.

FOREIGN EXCHANGE RISK EXPOSURE


Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately. Pros
Enhances export sales terms to help exporters remain competitive Reduces non-payment risk because of local currency devaluation

Cons
Cost of using some FX risk management techniques Burden of FX risk management

TYPES OF RISK
Transaction exposure
A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. Firms generally become exposed as a direct result of activities such as importing and exporting or borrowing and investing. Exchange rates may move by up to 10% within any single year, which can significantly affect a firm's cash flows, meaning a 10% decline in the value of a receivable or a 10% rise in the value of a payable. Such outcomes could be troublesome as export profits could be negated entirely or import costs could rise substantially.

Economic exposure
A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure can affect the present value of future cash flows. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good.

Translation exposure
A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. Translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price. Translation gives special consideration to assets and liabilities with regards to foreign exchange risk, whereas exposures to revenues and expenses can often be managed ex ante by managing transactional exposures when cash flows take place.

Contingent exposure
A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.

OTHER RISKS
Market Risk:
This is when stock or bond prices drop and you appear to lose money on your investment. However, most losses are sustained over the short term of a year or less. As long as you don't sell, your investment will have the chance to recover from price declines and earn you a greater profit.

Inflation Risk:
The risk that the rising costs of inflation will outpace the growth of your investment over time.

Company Risk:
This is the risk that the individual company in which you invest will fail to perform as expected.

Credit Risk:
Specific to bonds, credit risk refers to the company or government's inability to repay principal plus interest to the bondholder.

Maturity Risk:
Also specific to bonds, this is the risk that the value of a bond may change from the time it is issued to when it matures. The longer the period to maturity, the greater the potential for price fluctuation. That is why long-term bonds generally offer a higher interest rate--to compensate for this greater risk.

Legislative Risk:
Whatever laws the government passes today may be extinct tomorrow. For example, the long-term capital gains tax rate has been changed five times in the last 20 years, with the most recent cut at 20%. Factors such as tax deduction and deferral should never be your sole reason for selecting an investment. These perks are at the mercy of Congress.

Timing Risk:
Timing risk works two ways. First, you run the risk of investing a large sum of money when share prices hit their peak. Second, there's the risk that you'll need to access your money to pay for retirement or college expenses during a temporary market setback-causing you to lose money on your investment.

Risk Management Process

Identify Risks Identify risks that affect the project (positively or negatively) and documenting their characteristics.
Assess & Analyze Risks - Assess the risk impact, Analyze the probability of risk occurrence and prioritize the risks, numerically analyze the effect of identified risks on project objectives (usually on cost, schedule and scope targets) Plan Actions Explore all the possible ways to reduce the impact of threats (or exploit opportunities). Plan actions to eliminate the risks (or enhance the opportunities). Action plans should be appropriate, cost effective and realistic. Monitor & Implement the Action Track the risks throughout the project. If risks occur then implement the risk strategy based on action plan. Ex. If mitigation strategy is selected, execute the contingency plan based on risk triggers. In case contingency plan fails, execute fallback plan.

Measure the effectiveness & Control the risk impact - Measure the effectiveness of the planned action and controlling the risk impact by understanding risk triggers & timely implementation of planned actions.

HEDGING
A hedge is used to reduce any substantial losses/gains suffered by an individual or an organization. Ex:-

Agricultural commodity price hedging


A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.

SWAPS
A swap is a foreign currency contract whereby the buyer and seller exchange

equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchanger ate so that the parties end up with their original currencies. Ex:
Consider an export oriented company that has entered into a swap for a

notional principal of USD 1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement

FUTURES
In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short".

OPTIONS
An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.

TYPES OF DERIVATIVES
Derivatives are products whose value is derived from one or more basic variables called underlying assets or base . In simpler form, derivatives are financial security such as an option or future whose value is derived in part from the value and characteristics of another an underlying asset. The primary objectives of any investor are to bring an element of certainty to returns and minimize risks. Derivatives are contracts that originated from the need to limit risk.

Advantages of Derivatives:
They help in transferring risks from risk adverse people to risk oriented people. They help in the discovery of future as well as current prices. They increase the volume traded in markets because of participation of risk adverse people in greater numbers. They increase savings and investment in the long run.

Forward Contracts A forward contract is an agreement between two parties a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Future Contracts A futures contract is an agreement between two parties a buyer and a seller to buy or sell something at a future date. Options Contracts Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Swaps Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.