Question

Management of Forex Exposures. Explain the differences among them (namely translation, transaction, and economic exposures) and how do corporations manage these forex risks? Identify and illustrate the methods used.

PC. This if for 3-unit BA-343 International Banking special study, I need deeper explanation. Thanks

Answer 1

Foreign exchange or Forex:

• Foreign exchange is the exchange of one currency for another or the conversion of one currency into another currency.Foreign currency transactions take place between two parties of different countries, but invoice can be made in any one currency only.
• The party to whom invoice currency is a foreign currency has to convort foreign currency into home currency and at the time of conversion currency may flactuate adversely.

Management of forex expose is means to minimize the risk associated with currency flactuation.Foreign exchange risk typically affects businesses that export and/or import their products, services and supplies.

Translation exposure/risk: Firms generally prepare financial statements. These statements are created for reporting purposes. They are provided for multinational partners, thus the need for the translation of important figures from the domestic currency to another currency. These translations face foreign exchange risks, as there can be flactuation in foreign exchange rates when the translation from the domestic currency to another currency is performed. It doesn't effect cash flows of the firm.

Transaction exposure/risk:  A firm is exposed to foreign exchange risks if it has receivables and payables whose values are directly affected by currency exchange rates. Contracts between two different firms with different domestic currencies set contracts with specific rules. This contract provides exact prices for services and exact delivery dates. However, this contract faces the risk of exchange rates between the involved currencies changing before the services are delivered or before the transaction is settled.

Economic exposure/risk: It is also called forecast risk - if its market value of firm is impacted by unexpected currency rate volatility. Currency rate fluctuations may affect the company's position compared to its competitors, its value and its future cash flow. These currency rate changes may also have good effects on firms.

Management of forex risk through

• Currency options: A currency option gives the buyer of the option the right, but not the obligation, to exchange a quantity of one currency for an agreed quantity of another on or before (depending on the terms of the option agreement) a given date in the future.
• Forward contract: It is a over the counter (OTC) instrument. Simply we can say that it is a present transaction for future sattlement. Under this we can fix buying/selling rate of a currency today for future date. Ex: An oil dealer has 200 barrel crude oil & is concerned about a potential decline in the price of crude oil. It therefore enters into a forward contract with its financial institution to sell 200 barrels of oil at a price of $50 per barrel in six months, with settlement on a cash basis.
• Hedging: A hedge is an investment strategy to reduce the risk of adverse price movements in an currency. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.