Fund managers, traders, market makers, and regular individuals use FX risk management to protect their profits and limit their losses. But how is risk managed? What are the most important things a trader needs to know about Forex risk management? Read on to discover the answers.
What Is FX?
Foreign exchange (FX or Forex) is a part of the global market where currencies are traded for profit or loss. They are primarily traded in pairs that include one currency and other currencies like USD/JPY, EUR/GBP, or CAD/USD. While the foreign exchange is typically associated with traders and international markets, many people now have to consider the inherent risks associated with exchanging currencies. In the global market, many people are typically paid in USD. However, to use this currency in their home country, they must exchange it for their local currency. But what exactly are the main risks associated with foreign currency exchange?
What Risks Are Involved With FX?
Foreign exchange risk is an unavoidable component of conducting international business. The prices of major currencies change continuously against one another, generating income unpredictability for your company. Many organizations choose to remove this risk by securing future exchange rates. However, some firms see currency fluctuations as a profit opportunity which further exacerbates the situation. There are three primary risks associated with FX including:
A corporation’s risk while performing money transfers between countries is transaction risk. The danger is that the currency rate will change before the transaction is completed.
Economic risk is the concern that exchange rate movements will impact a company’s market value, also called forecast risk. This type of risk is often triggered by macroeconomic variables.
A company with a domestic headquarters but operating in a foreign jurisdiction and reporting its financial performance in the native currency is deemed at risk when dealing with translation. Translation risks are more significant for corporations whose assets, liabilities, or stocks are significantly denominated in foreign currencies. For instance, an Australian company with a Chinese subsidiary is exposed to translation risk.
What Can Be Done To Manage Risk?
The first step to managing FX risk is understanding your company’s FX strategy and the risks it entails. If you don’t know your company’s FX strategy, you may need help from an advisor or get in touch with their internal legal and compliance team, who will help find out what they need. A few additional steps should be taken before transferring money internationally, depending on how risky the transfer is. You can also consider moving money through banks or other financial institutions that offer lower rates than wire transfers, such as international bank transfers or domestic bank transfers with a high exchange rate between the two countries.
Hedge The Risk
One of the best ways to overcome these risks is to hedge. Hedging is an effective way to protect against currency risk. It protects against unexpected changes in the value of your portfolio or investments. Foreign exchange hedging is a strategy that involves the purchase of foreign currency denominated assets to offset the potential losses caused by fluctuations in currency values. According to FX specialists at https://www.shiftconnect.com/oanda/, a service like that provided by OANDA will provide you with a customized strategy that lets you make use of hedging in a way that fits your business model. This is ideal since all businesses or individuals who deal with foreign exchange will have different requirements. If you use tools that let you hedge the risks, you will drastically lower your risk exposure.
Use Derivative Instruments
Foreign exchange derivative instruments are a type of financial contract used to protect against changes in foreign exchange rates. In the simplest sense, a derivative instrument is an agreement that gives the right to someone else to buy or sell some underlying asset from you at a specific price on a certain date. If the value of the underlying asset increases, you will have made money from this transaction. In contrast, if it decreases, you will have lost money. Foreign exchange derivatives are one type of derivatives that are traded in international markets. Some of the more common instruments used in this industry included:
- Basis swap
- Currency future
- Currency swap
- Forward exchange rate
- Power reverse dual-currency note
- Foreign exchange binary option
- Foreign exchange forward
- Foreign exchange option
- Foreign exchange swap
- Non-deliverable forward
Hopefully, this post will help you understand your FX risk management better. From hedging to specific derivative instruments, there are some things that you can do to offset the risk involved with foreign exchange successfully.