A firm may be able to reduce or eliminate currency exposure by means of internal and external hedging strategies. Internal Hedging Strategies 1. Invoicing A firm may be able to shift the entire risk to another party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency, but in the presence of well functioning forwards markets this will not yield any added benefit compared to a forward hedge. At times, it may diminish the firm’s competitive advantage if it refuses to invoice its cross-border sales in the buyer’s currency. In the following cases invoicing is used as a means of hedging: Trade between developed countries in manufactured products is generally invoiced in the exporter’s currency. Trade in primary products and capital assets are generally invoiced in a major vehicle currency such as the US dollar. Trade between a developed and Continue reading
Forex Trading
Influence of Interest Rate on Exchange Rates
Traditional macroeconomic exchange-rate models are based on fundamental analyses. In these models, the basic force that drives currency’s rate comes from the balance between supply and demand of currency, for example if the demand for the U.S. dollar exceeds its supply at the current exchange-rate against the euro the price of US dollar in terms of the euro will rise. Conversely, if supply exceeds demand, the price will fall. Demand and supply factors that govern currency’s rate’s become much more complex than that because people don’t use currencies just to purchase foreign goods and services, but also for activities like cross-border investment and speculation. This opens up many other variables that must be considered when addressing exchange-rate movements, as underscored in the Federal Reserve Bank of New York’s commentary cited previously. One of the most important factors, for example, is how investors ride interest-rate differentials between countries. We know that Continue reading
Economic Exposure of Foreign Exchange Risk
Economic exposure is concerned with the present value of future operating cash flows to be generated by a company’s activities and how this present value, expressed in parent currency, changes following the foreign exchange rate movements. The concept of economic exposure of foreign exchange risk is most frequently applied to a company’s expected operating cash flows from foreign operations, but it can equally well be applied to a firm’s home territory operations and the extent to which the present value of those operations alters resultant upon changed exchange rates. For the purpose of convenience, the exposition that follows is based on a firm’s foreign operations. Some experts classify transaction exposure as a subset of economic exposure. They take this view arguing that the present value of an uncovered foreign currency denominated receivable or payable will vary as exchange rates vary. Whilst we accept the logic of this view, in this Continue reading
Internal Strategies for Managing Forex Transaction Risk
Transaction risk arises from executed contracts resulting in Forex payables or receivables in the future. The domestic currency value of these payables or receivables at current exchange rate and at future exchange rate is expected to be at variance, resulting in transaction risk. The forex transaction risk can be hedged using internal strategies. Internal strategies refer to strategies that are internal to the firm and its affiliates. These are “home’ arrangements. The counter party to the transactions may be involved. But third parties are never involved. The different internal strategies used for managing forex transaction risk are: Risk Netting: This strategy involves matching forex receivables in a currency with forex payables in that currency. Both currency and time matching are needed. Suppose an US firm has Yen 10 mn receivable from and Yen 7 mn payable to same counter party, both having 90 days to mature. These two transactions can Continue reading
Translation Exposure in Terms of Foreign Exchange Risk
Consolidation of financial statements, which involve foreign currency denominated assets and liabilities automatically, gives rise to translation exposure, sometimes termed as accounting exposure. Consolidation of foreign subsidiaries account into group financial statements denominated in home currency requires the application of a rate or rates of exchange to foreign subsidiaries accounts, in order that they may be translated into the parent currency. Both balance sheets and income statements must be consolidated and they both give rise to translation exposure. Translating foreign currency profit and loss accounts at either the average exchange rate during the accounting year or at the exchange rate at the end of the accounting year (both methods are currently permissible as per British accounting procedures) will mean that expected consolidated profit will vary as the average or that the expected closing rate changes. So the whole amount of profit earned in the foreign currency is exposed to translation Continue reading
Forward Exchange Contracts
A forward exchange contract is a mechanism by which one can ensure the value of one currency against another by fixing the rate of exchange in advance for a transaction expected to take place at a future date. It is a tool to protect the exporters and importers against exchange risks. The uncertainty about the rate which would prevail on a future date is known as exchange risk. From the point of an exporter the exchange risk is that the foreign currency in which the transaction takes place may depreciate in future and thus the expected realization will be less in terms of local currency. The importer also faces exchange risks when the transaction is designated in a foreign currency. In this case the foreign currency may appreciate and the importer may be compelled to pay an amount more than that was originally agreed upon in terms of domestic currency. Continue reading