Risk Analysis in Foreign Exchange - Assignment Example

Running Head: RISK ANALYSIS IN FOREIGN EXCHANGE Name Course Lecturer Date Introduction A forex market is an electronically connected network of foreign money brokers, banks and dealers where trading involves use of phones, Society for Worldwide Interbank Financial Telecommunications network or telex. The market mainly involves transfers of buying power denominated in certain currency to another. Foreign exchange risk is the exposure of an organization to impacts of variations in foreign exchange rates. Since the abolition of the initial fixed rate system, the now used floating rates system means the price of buying and selling currencies is dictated by the available supply and demand of money in the market. The risk being the unfavorable fluctuation of exchange rates consequences to losses in terms of money (Popov & Stutzmann, 2003). The risks in a foreign exchange institution crops up from two main factors namely; the mismatches in currency cash flow, and mismatches in organizations assets and liabilities which are not subjected to a fixed rate of exchange. This kind of risk may result from areas such as foreign exchange retail accounts, retail cash transactions, foreign exchange trading, foreign currencies denominated investments and ventures in foreign companies. The quantity at risk is attributed to the magnitude of change, size duration of exposure of foreign currency. Despite the engaged prevention techniques, probable threats that may arise inside or outside the organization must be assessed to ensure survival of the business. This paper explores the objectives of risk analysis and the main techniques used in risk analysis in foreign exchange business (Chen, 2009). Objectives of risk analysis  Risk analysis can be referred to as a process involving the identification of the most probable threats to an institution and analyzing the correlated vulnerabilities of the institution to these pressures. After identifying foreign exchange exposures, the institution ought to clearly know the impact of exchange rate on all facets of it operation. Therefore, objectives sets must reflect management’s indulgence and approach toward exchange rate risks, and must be plainly affirmed in the policy. Objectives in regard to foreign exchange institutions revolves around two categories namely; financial and protection objectives. The financial objectives are further divided into two categories; primary and secondary objectives (BMO Capital Markets, 2012). Financial objectives Primary objectives involve taking all rational steps in to curtail losses arising from consolidated earnings exposure. Fluctuation in foreign exchange rates shapes cost competitiveness, productivity as well as valuation of an organization`s international functioning. This calls for policies that minimize the effects resulting from adverse exchange rate variations on the company`s financial position. Absence of a policy to handle the same, results to unpreparedness of a corporation to control or handle the unpleasant impacts of currency movements (BMO Capital Markets, 2012). Secondary objectives: A major secondary objective for risk analysis is the need to finance the universal operations at the lowest after-tax cost. As such, a foreign exchange institution ought to responsibly make sure that whichever action engaged to lessen exposure is economically acceptable on an after-tax basis. Moreover, the objective of risk analysis in foreign exchange business aims to make the most of the US dollar profits from international operations. Most currencies are quoted against the US dollar. Therefore, working out the cross rates for other currencies other than the dollar in an efficient way is necessary. This is vital as quoting currencies in terms higher than the one base currency, will probably cause inconsistent quotes from different quotes (Popov & Stutzmann, 2003). Protection Objectives: The institution ought to avoid hedging its position in a currency in case any of the below conditions prevail; When there is minimal risk of loss The cost of casing the position is too expensive The ways to cover the position are not readily or not available at all in the market. In other words, protection objectives in general states when not to or when to hedge, and that can be expressed in qualitative or quantative terms. For instance, ‘prohibitive cost’ might be specified in terms of dollars, or be left open for appropriate manager interpretation of what is designated in the policy. Thus, the main point is to avoid decisions on hedging if they are done so without regard to cost and efficiency (Wang, 2009). Risk analysis techniques Even though the exact natures of a potential risk or their resultant impacts are hard to verify, it is beneficial to conduct a comprehensive risk analysis of all threats that faces any aspect of the company. As such, risk analysis techniques aims at analyzing the identified risks to ensure the institution survives in the marketplace. The major risk analysis techniques employed in foreign exchange institutions includes; sensitivity analysis, scenario analysis, probability analysis, Delphi method and Monte Carlo simulation (Jagerson & Hansen, 2006). To begin with, sensitivity analysis is the simplest type of risk analysis. This form of analysis tries to place value on the effect of change of a single variable within a venture by scrutinizing that effect on the venture plan. To start on the sensitivity analysis, a base case scenario must be arrived at first which is typically the NPV. Improbability and risk are mirrored by defining a likely variation range for every element of the original base case estimate. In practice this kind of analysis is only engaged for those variables with a high effect on cost, economic return, and time as well as to those that the project is highest sensitive to. The main advantages of sensitivity analysis are that decision making becomes more rational, and the impressing management that renders possibility of a range of outcomes. Additionally, the virtual significance of every variable checked is readily noticeable (Mazin, 2006). Secondly, scenario moves the sensitivity analysis a step further. This technique looks at the probability allotment of the variables. The method begins with creation of a base case scenario. From this point many other scenarios are analyzed, referred to as “best case scenario” and also the “worst case scenario”. Then probabilities are allotted to the scenarios and calculated to get to an anticipated value. Due to its unfussiness, scenario analysis is among the most frequently engaged risk analysis techniques (BMO Capital Markets, 2012). Thirdly, Monte Carlo Simulation is termed the best method of sensitivity analysis as it brings forth the infinite calculations, or rather provides the expected values given a number of constraints. Constrictions are added and the system generates random variables of inputs. From this NPV is then calculated. Instead of generating minimal iterations, the simulation repeats the procedure several times from which the projected value is computed (BMO Capital Markets, 2012). Fourthly, Delphi method of risk analysis main idea of is to get a consensus by engaging a panel of experts to derive a convergent solution to a particular problem. This is specifically beneficial in getting at probability assessments linking to future dealings where the impact of risks is huge and serious. First and foremost a panel of experts in the field is to be selected. For excellent and reliable results, company should avoid the panel members knowing each other’s identity. The process may as well be conducted in for each panel member at their own location. The members answers, plus their opinions and validations, are assessed and statistical feedback is given to every panel member in the next iteration. The procedures are repeated until the members responses congregate to a particular solution (Ritter, 2008). Finally, probability analysis is also a major technique used in risk analysis in foreign exchange business. This method overcomes the limits of sensitivity analysis by spelling out a probability distribution for every variable. This is then followed by reflecting the situations that can allow changing of any or all of these variables at the same time. Though, defining the probability of occurrence of any particular variable may be tricky, especially due to the fact that commercial and political environments changes fast. Just like in sensitivity analysis, the range of variation is subjective, except that it ranges more with its cost elements estimate skewed toward overrun, for the sake of natural optimism and omission of estimator (Ritter, 2008). Conclusion Therefore, in conclusion, risk analysis process is an imperative aspect of foreign exchange transactions business. The probability of a risk occurring in an institution is highly uncertain. Companies should employ comprehensive risk analysis methods that tackle all the significant operation and role of the business. An effective foreign exchange risk analysis is a financial tool for ensuring the business` profitability. Companies involved in international market must establish and know the importance of risk analysis. This ensures liquidity for international operations and upholds access to local credit markets as well as it role in protecting the organizations assets worldwide. Being aware of the exchange rate impact on all facets of a foreign exchange business, then risk analysis and proper method of doing so will be employed broadly. Both financial and protection objectives established should be unmistakably affirmed in the policy. Furthermore, employing the right risk analysis is a key ingredient to survival of foreign exchange business. This enables a business to set the right measures in handling risks. References BMO Capital Markets. (2012). Management policy Objectives and Controls. Retrieved 11 28, 2012, from bmocm.com: http://www.bmocm.com/products/marketrisk/fx/images%5Cpolicy.pdf Chen, J. (2009). Essentials of Foreign Exchange Trading Epub Edition. Hoboken, NJ: John Wiley & Sons Inc. Jagerson, J. &. (2006). Profiting with Forex : the most effective tools and techniques for trading currencies. New York: McGraw-Hill. Mazin, A. M. (2006). Foreign-exchange trading risk management with value at risk . The Journal of Risk Finance Vol 7, Issue 3 , 272-274. Popov, V. &. (2003). How is Foreign Exchange Risk Manged? An Empirical Study applied to Two Swiss Companies. Lausanne, SW: University of Lausanne. Ritter, D. (2008). Risk Analysis Techniques. Retrieved 11 28, 2012, from certifedpmp.wordpress.com: http://certifedpmp.wordpress.com/2008/09/17/risk-analysis-techniques/ Wang, P. (2009). The economics of foreign exchange and global finance. Berlin: Springer. Read More