Forex risk, also called currency or exchange rate risk, refers to a financial risk caused by being exposed to sudden and unexpected changes in foreign exchange rates affecting two currencies. Investors, forex traders, brokers and multinational companies that export and import goods and services, or perform foreign exchange transactions globally often deal with these risks. The risk can have a significant effect in one’s finances if it is not correctly managed. It is possible to measure foreign exchange risks using domestic variance or the actual currency value of assets, operating income and liabilities that are traceable to the unexpected changes in forex rates. Exposure to this risk also comes in various types including the following:
1. Transaction Exposure / Risk
This form of risk exposure takes place when traders encounter risks involving adverse exchange rate movements, or changes that occur in a typical global trading transaction. It also usually occurs in the event that the forex market becomes volatile, and the exchange rate continues to fluctuate. Traders who negotiate contracts with delivery dates and set prices might deal with changes in forex rate between domestic and foreign currency. An example of this is when there are movements in forex rates between the date different parties agree on the value, and the date when there is a payment in cash even when the original contract involves fixed forex terms.
2. Economic Exposure / Risk
Economic exposure covers a forex risk involving the effects of relative short-term cash flows, and long-term effects of forex rate changes affecting the market value of a firm. Economic exposure also emphasizes exposure on anticipated future cash flows (meaning cash flows that are not yet contracted) with values that might move or change due to the changes in forex rates that also tend to alter international competitiveness.
3. Translation Exposure / Risk
This refers to the extent of the effects of exchange rate movements in the financial reporting activities of a firm or forex trader. All firms need to create consolidated financial statements for the purpose of reporting. The process of consolidating financial reports and statements also encompasses the translation of foreign liabilities and assets and foreign subsidiary statements from foreign into local or domestic currency. Translation exposure might not have a significant impact on the cash flows of a trader or company, but it can greatly affect their reported earnings and stock price.
Effective Forex Risk Management Solutions
Managing forex risk is not that difficult for traders who are already fully aware of how the market and the rates move. One efficient way to manage or avoid foreign exchange risk is to match receipts and payments. A firm or trader who anticipates making payments or receiving currency should develop a plan to offset payments against receipts using the currency in question. Another way to manage risks is through netting. The primary goal of this strategy is to save a substantial amount on transaction costs by trying to net off inter-company balances prior to any payment arrangements.
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