The Use of Currency Ortions in Risk Options - Literature review Example

INТЕRNАТIОNАL RISK МАNАGЕМЕNТ Thе Usе Оf Сurrеnсy Орtiоns In Risk Mаnаgеmеnt Name. Class. Date Executive summary Many companies in the world today have been struggling to understand the various roles risk management strategies and products play in their companies. This task has been revealed to be more complex that it was thought before. The adoption of currency option has given these companies flexibilities and protection insurance while engaging in volatile international business practices. Currency option gives these companies both freedom towards benefits from the adverse changes in the business practices and also the protection strategy during the currency adverse moves (Western Union, 2015). As seen in studies, risk management also seeks to exploit the opportunities that can certainly bring or they can allow companies to be aware of the opportunities they can target in their business activities (Nathan, 1999). This is the reason to engage on currency options. These companies have therefore used different technique such as the hedge technique and the study of the foreign exchange risk to ensure there is no risk affecting their practices (Nathan, 1999). On the part of the foreign exchange risk, counteracting this risk can be made successful through the use of currency options in the organization by understanding the three foreign exchange risks, i.e. the translation risk, transaction risk and the economic risk (Buckley, 1999). Lastly the consideration of these risk methods will enable an organization to manage risks that would affect the organizational practices (Buckley, 1999). Table of Contents Executive Summary……………………………………...…………………………………….….1 Introduction 2 Literature Review 3 Risk Management 3 Currency Options Risk Management 4 Application/Case study 5 Hedging Technique 5 Foreign Exchange Risk 7 Types of Foreign Exchange Risks 8 I.Transaction Risk 8 II.Translation Risks 8 III.Economic Risks 9 Managing Foreign Exchange Risks 9 Conclusion 9 References 11 Introduction Numerous business organizations have adopted the use of currency option that gives them flexibility and protection while engaging in volatile international business practices. Currency option gives these companies both freedom towards benefits from the adverse changes in the business practices and also the protection strategy during the currency adverse moves (Western Union, 2015). Therefore, for these companies to continue performing in their goals, risk management is the main goal they put in place to ensure they conduct their businesses. Many other companies have also struggled to understand the various roles, risk management strategies and products play in their companies, this task is more complex that it was thought before. For instance, in order to stabilize companies cash flows and protecting the profits there are a number of risk management strategies that will need to be employed (The Institute of Risk Management, 2015). In regard to the financial instrument, currency options being one of them will provide the companies with a number of possible strategies for risk management. The companies that wish to leave their business financial operations by the chance of being unaware of the strategies and tools that are available in mitigating risks will readily expose their company's operations. Therefore the thesis of this paper is to determine and discuss the use of currency options in risk management companies can use. Literature Review Risk Management Risk management essential occurs anytime when a fund manager or an investor attempts and analyses the potential ability for losses in an investment program and then they take the necessary action subjected to their risk tolerance and investment objectives (The Institute of Risk Management, 2015). Therefore, risk management has been defined as “The combination of probability of a happening event and its achieved consequences. The consequences have been determined to range from negative to positive, hence risk management is the systematic process in addressing, evaluating and understanding the risks to maximize the chances of objectivity that can be achieved while ensuring companies are sustainable” (The Institute of Risk Management, 2015). According to study, risk management also seeks to exploit the opportunities that can certainly bring or they can allow companies to be aware of the opportunities they can target in their business activities. Effective and efficient risk management processes normally require an informed understanding of the risks companies are to meet. An assessment of these risks with relative priority and following a rigorous approach will enable the companies to control and monitor them (The Institute of Risk Management, 2015). Risk management must be proportionate to the nature and the size of the company in order for it to be effective. The proportionate size and nature of a risk management can range to an integrated multi-national from a community event. Therefore, it is wise for organization to embed risk management in general management of an organization to fully integrate it with other business functions such as the finance, strategy and planning (The Institute of Risk Management, 2015). Currency Options Risk Management In currency risk management, there are a range of risk management services, products and structured risk management solutions geared to meet the customers needs of which they include currency options, foreign exchange swaps, forward exchange contracts and the use of foreign exchange and currency risk management (Western Union, 2015). In relation to research, currency options should be employed in organization since they are financial instruments that ensures organizations gain both freedom towards benefits from the adverse changes in the business practices and also the protection strategy during the currency adverse moves (Western Union, 2015). The use of currency options has gained acceptance as invaluable tools that assists in managing the foreign exchange risks companies are likely to accrue from (Western Union, 2015). Currency options are extensively used to in many organizational companies and they bring a wider range of alternatives tending their nature of occurrence. The different they posses form the other forward contracts as methods used in risk management is that the holder of the contract do not have an obligation, but only a right after completing a transaction in the future (Western Union, 2015). Current options have been seen as attractive financial instruments to organizational managers and also the corporate treasuries due to their flexibility character. Application/Case study Hedging Technique According to the article, “The choice of hedging techniques and the characteristics of UK industrial firms” by Nathan provided a way out in understanding the currency options in risk management (Nathan, 1999). This study used a sample hedge foreign exchange (FX) exposure to focus on the narrow set of hedging techniques to use (Nathan, 1999). The adoption of this process sought to provide the solution behind the industrial firm's hedge exposure to focus on the differences in financial risks that are likely to be met (Nathan, 1999). While applying the currency options through the use of foreign exposure, there will be needed to provide more additional insights into the hedging behaviour of the UK firms by ensuring focus on the degree of utilization of the hedging techniques, the sources of exposure to be hedged in the organization and lastly the maturity structures of the hedged techniques (Nathan, 1999). These considerations have impact in choosing the effective hedging techniques in the industrial firms in the UK. Therefore, this risk of choosing the effective and efficient choice of hedging techniques for the firm needs a financial instrument that will focus on the available probabilistic risk to eliminate before engaging on the risks (Nathan, 1999). Despite the fact that financial innovations have a higher rate in reducing the demand for traditional types of hedging techniques and studies, it has depicted that organizations are not very receptive to newer and complex types of derivatives (Nathan, 1999). This is because financial institutions are concerned about the products and their ability to provide real solutions to the exposed problems. An organization degree of internationalization has been said it can be affected by the extent to which it uses the hedging techniques. Since these organizations appear to be on the internal techniques to hedge exposure, there will be an expectation of positive degree of utilization of the internal hedging techniques (Nathan, 1999). According to the article by Nathan, hedging technology is likely to reduce the potential for financial distress through reducing the variability of certain financial measures (Nathan, 1999). Also the selection choice had been said to contribute to the increase in the variability of the organization's cash flow. The organizations can make greater use of the available foreign currency lending and borrowing, cross currency interest rates swaps and the foreign currency swaps that are expected to show greater variability on leverage, cash flow and liquidity (Nathan, 1999). Hedging as one measure to counteract the risks encountered in the organizations play a crucial role through mitigating the investment practices being faced up with problems by ensuring there is a reduction in both the organizational dependence on external finance and the cost of external funds (Nathan, 1999). More so in terms of an exporter, the exporter normally acquires the right to sell their fixed quantity without any obligations at any specified date. This process provides a protection against the adverse movements while introducing flexibility (Nathan, 1999). Hedging techniques offer the expectations that the spot rate will be above the forward rate at maturity. This provides a strategy on the part of the exporter to protect them against any appreciating exchange rates while at the same point trying to allow for unlimited participation (Nathan, 1999). Therefore, in order to avoid adverse impacts of asymmetry in taxation, organizations will tend to adapt to the use of internal techniques when hedging transaction exposure (Nathan, 1999). Foreign Exchange Risk In the case study in the article “Foreign exchange risk management in the UK, USA and Asia Pacific multinational companies” by Andrew it shows how the currency options are used to minimise the risk that are met through foreign exchange (Marshall, 1999). The objective of the study was to survey the foreing exchange risk practices of the mentioned larger countries. Foreign exchange risk being one of the many risks business risks numerous organization companies face up each day, its management has a crucial role to play in offering effective financial management practices (Marshall, 1999). The objectives of the management as to whether it should maximise exchange gains or minimise foreign exchange losses they need to stand up and manage the attitudes towards foreign exchange risks in the organizations (Marshall, 1999). In relation to the foreign exchange risk that is likely to be accrued in businesses, the importer side has a right to enforce contracts and to exchange currency to one another, but they do not exercise the option if it is more beneficial to the in the spot market (Marshall, 1999). To counteract foreign exchange risk through the use of currency options in the organization leads us to specify the exact type of foreign exchange risk the organization are being faced up to. These risks in foreign exchange risks include transaction risk, translation risk and economic risk (Marshall, 1999). Types of Foreign Exchange Risks I. Transaction Risk Transaction risk or exposure normally arises when the cost of the settlement of a future receipt or payment that is detonated in another currency type rather than the home currency will vary due to the differences in exchange rates (Buckley, 1999). The transaction risk has also been determined as the cash flow exposure, which is associated with trading flow and dividend flows. The emphasis that is placed over transaction risk is in understanding the impact towards profitability and cash flow, hence currency options are to be adopted to correct transaction exposures in business practices (Buckley, 1999). II. Translation Risks Translation exposure is achieved through consolidation of financial statements that the organizations produce to involve the denomination of the foreign currency liabilities and assets which this process is also termed as the accounting exposure (Buckley, 1999). Translation risk is therefore a reflection of the possibility that the foreign currency being dominated are items that are consolidated into financial statements to depict a translation gain or loss (Buckley, 1999). Organization therefore can use the currency options method as one of the financial instruments able to offer guidance in managing the translation risks likely to be accrued in the long run of the business venture (Buckley, 1999). III. Economic Risks Economic exposure in the business organization is normally concerned with the present value of the future cash flows being operated by the organizational activities towards the changes in the movement of the exchange rates (Buckley, 1999). The concept that is behind economic risk is largely being adopted in many organizations to show the future operating cash flows from the foreign operations and the sales in foreign currency (Buckley, 1999). Despite managing the economic risks of having a major challenge through the impact on the fluctuation of exchange rates on net cash flow, economic risk is considered very important(Buckley, 1999). Managing Foreign Exchange Risks The main aim toward managing of the foreign exchange risks is to protect an organization against the adverse impacts of exchange rate fluctuations likely to be encountered in the long run of the business processes (Buckley, 1999). According to the article Marshall claimed that the lack of comprehensive guideline towards hedging and managing currency risks would imply that organizations would be ready to adopt a number of new methods to counteract the risks being met (Buckley, 1999). Therefore the consideration of both transaction risk, translation risk and economic exposures will enable an organization to manage these risks that would affect the organizational practices through engaging on currency options (Buckley, 1999). Conclusion Risk is one element that is needed to be considered while engaging in activities that can either bring you back a profit or a loss in the long run. Therefore, it is evident in business practices for organizational leaders to set up some measures that will control and compel the rise of any risks in their business (The Institute of Risk Management, 2015). Risk management has been revealed to occur anytime when a fund manager or an investor attempts and analyses the potential ability for losses in an investment program and then they take the necessary action subjected to their risk tolerance and investment objectives (The Institute of Risk Management, 2015). As seen in this research it is true that the use of risk management component in an organization will help combat risks affecting the existence of a business venture. The use of currency options has been seen as an effective and efficient method in controlling various risks such as the translation risks, transaction risks and economic risks from affection the business practices. Also the use of hedging technique that engage foreign exchange (FX) exposure help to provide the solution behind organizational hedge exposure in order to focus on the differences in financial risks that are likely to be met (The Institute of Risk Management, 2015). Therefore the use of currency options in risk management for companies play a major role through eradicating and controlling risks likely to affect the companies. References Buckley, A. (1999). Multinational Finance, United States; US, financial times prentice hall Marshall, P. A. (1999). Foreign exchange risk management in the UK, USA and Asia Pacific multinational companies, journal of multinational financial management, 10(2000)185-211. Nathan, L. J. (1999). The choice of hedging techniques and the characteristics of UK industrial firms, journal of multinational financial management, 10 (2000), 161-184 The Institute of Risk Management, (2015). Risk Management, Building excellence in risk management. Available on Western Union, 2015. Currency options for the busy professional, Business Solutions. Available on Read More