Thursday, 15 December 2016

Risk & Exposure In The Forex Market

Exchange rate risk can  be categorized into three types based on the nature of exposure and the whole trading process involved. These risks are: (1) Transaction Exposure, (2) Translation Exposure, (3) Operating Exposure. These are the risks that are faced by all the financial institutions, MNCs or the individuals is almost same. So, lets have a discuss about these:

  • Transaction Exposure:

 Transaction exposure measures the risk involved due to the change the foreign exchange rate between the time the transaction is executed and the time it is settled. For instance; Radge Ltd. An Russian Company enter into a trade for purchasing from a US based company and the transaction will be invoiced in US Dollar for 5 USD. The terms of contract provide for payment after two months. At the time of transaction if the Russian Rubble depreciates then it will loss significant more Rubble over it’s actual expenses of 5 USD it could have been at the time of entering the contract. Thus, transaction exposure leads to a risk of loss while fluctuation of currency become unfavorable and conversion of currency occur. In the same way a gain will be also possible if there is the movement of exchange rate gone favorable.

For a financial institution, this type of a risk does not normally occur in its routine business operations. manufacturing/trading units are more exposed to such risk. If Radge Ltd. Buys US Dollar from a bank either on the spot or in the forward market, then the bank will become short having sold the US Dollar. However, the bank takes up a long position immediately to square up the transaction so as to eliminate the exposure. Thus banks, in general, hold a square or near square positions at the end of each day by going long (short) corresponding to every transaction with the customer (Merchant Transaction) which is short (long). Hence the transaction exposure to the banks mostly remain an intra-day exposure. The bank helps the customers to hedge their exposure while ensuring that it also hedges its exposure.

  • Translation Exposure:

 Differentiating itself from the transaction exposure is the translation exposure which refers to the risk arising on account of changes in exchange rates at the time off inalizing/consolidating the financial statements which has assets/liabilities denominated in foreign currencies. When a company has to finalize/consolidate its account, it has to convert its foreign currency denominated assets/liabilities at the applicable exchange rates as against the rates at which they are initially recorded. The rates at which the existing liabilities/assets are to be converted are governed by the guidelines issued by Foreign Exchange Dealers Association or the designated body that are governing the exchange rate for their respective country. The financial institution is directly affected by this translation risk.

  •  Operating Exposure:

 Operating exposure arises because of the impact of change in the foreign currency rates on the profit of a corporate house. Even this impact affect the corporate which also not deal in foreign currency. The future cash flow of a firm mainly depends on the two factor that is the exchange rate and the prevailing inflation rate of the different countries. 

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