Question

What are the different strategies you can apply to mitigate the Foreign Exchange risk? Explain briefly each one.

Answer 1

Foreign exchange risk also known as currency risk is the risk which is arised due to unanticipated changes in the exchange rates between two countries. The three types of foreign exchange risks are transactional, translational and economic risks.

There are certain operational risk mitigation techniques such as :

• Shifting of risk
• Sharing of Risk
• Leading and lagging

However the financial risk mitigation strategies are more common.They are:

• Forward contract hedging
• Money market hedge
• Futures
• Currency swaps
• Currency options
• Payments and netting arrangement

We will discuss the forward contract hedging technique in this solution:

Forward contract hedging :

Let us consider a businees wishes to buy or sell a certain amount of foreign currency at a certain date in future.So they will buy a forward exchange contract so that they can lock in the forward exchange currency rate and save themselves from the currency fluctuations. They will get into a contract with a third party , typically a bank or other financial institutions and subsequently buy a forward contract. These contracts will require a certain deposit with the currency broker.

Suppose Mr X is an investor in India and has an exposure to Indian assets. Currently the Exchange rate is 1usd = 76INR. He plans on converting the INR to USD in six months as he has to make payment in US assets. However due to current pandemic he is unsure whether the INR will fall further with respect to USD or it will recover. So he intends to buy a forward contract hedge and lock in the price at 76.5 INR. Now suppose at the end of six months, INR falls further to 78 INR/ USD .At this situation Mr X will benefit from the hedging. However if the INR recovers to 74 INR/USD , then it will be his loss. In this way Forwards contract hedging eliminates forex risk.