The Risk Management of the Foreign Exchange within the Financial Industry and Institutions - Literature review Example

The Risk Management of the Foreign Exchange within the Financial Industry and Institutions in the UK Name: Course: Institution: Tutor: Literature Review Introduction Foreign exchange risk refers to the exposure of a financial institution to the adverse movements in foreign exchange rates. This risk has it that adverse changes in exchange and rates may result in loss of money and profitability to the financial institutions engaged in foreign exchange transactions. Foreign exchange risks are caused by two main factors: mismatches in a financial institution’s liabilities and assets that are not subject to fixed exchange rate and mismatches in currency cash flow (Horcher, 2011). Further, the risks arise from different sources such as retail cash transactions, investment in foreign companies, investments denominated in foreign currencies and foreign currency retail accounts. In developed economies such as Britain, the amount of risk available in financial service industry are a function of the magnitude of possible exchange rate changes and the duration as well as size of foreign currency exposure. Foreign Exchange Risk Management Practices Management of foreign exchange risks forms a fundamental component of sound and safe management of all financial institutions that have exposure to foreign currencies (Kavaliova, 2007). The practice of risk management in these financial institutions involves prudent monitoring of foreign currency positions in order to control the impact of exchange rate changes of the financial institutions. The direction and frequency of exchange rate changes and the extent of foreign currency exposure, as well as, the ability of institutions to honor their financial obligations is a significant consideration in the management of foreign exchange rate risks (Lakshman, 2009). Although the particulars of foreign exchange risk will generally differ among individual financial institutions depending on the complexity and nature of their involvement in foreign exchange activities, adequate management of foreign risk management requires: i. Establishment and implementation of sound risk management policies. ii. Well articulated policies setting the principles and objectives of risk management strategies and the limits within which the strategies should be applied. iii. Development of appropriate and cost-effective risk control procedures. According to Horcher, (2011) it is necessary for financial institutions to decide the objectives of foreign exchange risk management and their willingness to assume the risk before implementing risk management programs. This is because the level of tolerance of an institution to assume foreign exchange risks will generally vary with the extent of other risks such as credit risks, liquidity risks, investment risks and interest rate risks (Malz, 2011). As is the case with other aspects of financial management, a clear trade-off exists between risk and return as regards the management of foreign exchange risks. Accordingly, the principal objectives of foreign exchange risk do not necessarily have to be focused on complete elimination of adverse exposure to changes in exchange rates. Instead, it should be to reasonably manage the potential adverse impact of exchange rate changes within an institution’s self-imposed limits after a careful evaluation of a range of possible parameters (McGuigan, 2010). Horcher (2011) has explained in his book that financial institutions need to establish prudent and reasonable foreign exchange rate limits, which ensure that the level of exposure to foreign exchange rate risks does not exceed the set limits. Where possible, the limits should at a minimum cover the currencies to which an institution can incur exposure and the level of risk exposure that the institution can reasonably assume. Nidhi (2007) concurs with this argument and states that foreign exchange risk limits should be set in accordance with individual institution’s overall risk profiles as reflected by such factors as credit quality, capital adequacy and investment and interest rate risks. Therefore, foreign exchange rate risk should be managed within an individual financial institution’s ability to quickly recover its financial positions if necessary. In addition, potential foreign exchange risks should be assessed regularly to identify potential changes in interest rate volatility and the institutions’ risk management philosophy. In his analysis of foreign exchange risk management strategies, Christoffersen (2011) provides that there should be clearly-defined levels of delegated authority. This, he says, helps ensure that institutions' foreign exchange positions do not exceed their set limits established under their national risk management policies. It is important, however, to take into consideration that the delegation of authorities is documented clearly and that it outlines the restrictions placed on the delegated authority. In fact, financial institutions in the United Kingdom have consolidated their external reserve holdings, and this has foisted the financial challenges of adoptive management skills. This initiative ensures that the right amounts of reserves are not only conserved but also that they are deployed optimally to serve essential needs. Ngai and Hoi (2006) have explained that this measure has over the years entailed designing effective ways of monitoring the use of foreign exchange resources. In his book, Nidhi (2007) explains that the fear of risk and the possibility that the actual outcome of a transaction will not be the same as the anticipated result are inevitable in financial operations. For this reason, the main focus of financial institutions such as banks continues to be that of taking risks. The kind of risks involved in foreign exchange transactions in a country are not necessarily related to anticipated exchange rate changes. As each financial institution strives to meet its own foreign currency demands, there are liquidity risks and interest rate risks associated with the dealings in forward foreign exchange market. Therefore, management of risks in the financial service industry is a core function of all stakeholders in the industry. In essence, the overriding consideration in management of foreign exchange transaction risks is to maximize returns by minimizing risks. Christoffersen (2011) gives a detailed explanation that a myriad of risks are associated with foreign exchange rate risks. These risks include bank fraud, credit and interest rate risks, economic risks, interest rate risks, counter party risks and money laundering risks. Additionally, functional staffs in the foreign exchange industry are frequently exposed to risks associated with the payment or receipt of foreign exchange. Foreign Exchange Risk Management Procedures Foreign exchange services play a fundamental role in the development and stabilization of a country’s economy (Jain, 2007). As such, management of the country’s foreign exchange resources has evolved broadly in accordance with the liberalization of financial markets and economies. Generally, foreign exchange in developed economies such as the United Kingdom is managed and held to facilitate international transactions. Therefore, some of the objectives which the management of foreign transactions seeks to achieve include: profitability, liquidity, safety and adequacy of reserves. Coyle (2001) has noted that the main aim of foreign exchange risk management is to ensure that reserves are adequately maintained to cushion against temporary shortfalls in exchange receipts. Such an initiative allows the economy to adopt necessary measures in dealing with external shocks. Individual institutions engaged in foreign exchange transactions are responsible for developing, implementing and overseeing procedures for controlling their foreign exchange rate risks. This has to be done in accordance with their country of origin’s foreign exchange management policies (Bessis, 2011). The risk management procedures employed should be able to commensurate well with the frequency, size and complexity of an institution’s foreign exchange activities. To realize this important consideration, foreign exchange risk management procedures should cover the following aspects: i. Management and accounting information systems to help measure and monitor risk exposure and exchange positions. ii. Controls procedures to govern the management of foreign exchange transactions. iii. Routine inspections and audits. Moreover, individual financial institutions need to ensure that the people engaged in conducting foreign exchange activities work on behalf of the institutions and in accordance with the policies governing foreign exchange dealings. Such policies may include guidelines respecting trading with partner institutions. Broyles (2003) has outlined that the use of hedging is an important technique for managing and controlling foreign exchange risks. In this regard, different financial instruments are used to manage risks such as the derivative instrument. An important consideration in the use of hedging as a way of managing foreign exchange risks is that the different instruments for hedging are not distinguishable from the instruments that may be used to take risk positions. It is, therefore, important for institutions to ensure that they understand the hedging technique before using it. In addition, the effectiveness of hedging as a risk management tool should be assessed in the context of an institution’s overall risk exposure resulting from changes in asset/liability mix (Bessis, 2011). Conclusion Management of foreign exchange risks presents an important challenge for a majority of financial institution engaged in foreign exchange transactions. Because of the differences in nature and complexity of business involvements, each institution involved in foreign exchange activities is responsible for managing their exposure to foreign exchange risks. Although the specific procedures and tools employed in managing foreign exchange risks will vary across institutions, the management of institutions is generally responsible for implementing foreign exchange risk management policies. The management is also responsible for ensuring that risks are managed and controlled in line with an institution’s foreign exchange management programs. Foreign exchange risks remain a significant problem in the United Kingdom’s financial institutions. Because of the harmful effects of these risks, many sources of potential growth opportunities for the industry remain untapped. For instance, debt capital is available for a large number of financial institutions but foreign exchange risks are a potential deterrent. References Bessis, J. 201), Risk Management in Banking. New York: John Wiley and Sons. Broyles, J. E., 2003, Financial management and real options. New York: John Wiley & Sons Christoffersen, P., 2011, Elements of Financial Risk Management. Glasgow: Academic Press. Coyle, B., 2001, Foreign Exchange Markets. New York: Taylor & Francis. Horcher, K. A., 2011, Essentials of Financial Risk Management. New York: John Wiley and Sons. Jain, N., 2007, Foreign Exchange Risk Management. Boston: New Century Publications. Kavaliova, M., 2007, Foreign Exchange Risk Management- Which Hedging Techniques Can Be Used by a Mid-Size Company. Boston: VDM Verlag. Lakshman, R., 2009, Introduction To Foreign Exchange & Financial Risk Management. Delhi: Shroff Publishers & Distributors. Malz, A. M., 2011, Financial Risk Management: Models, History, and Institutions. New York: John Wiley & Sons. McGuigan, J, R., 2010, Managerial Economics.Boston: Cengage Learning. Ngai, C. and Hoi, W., 2006, Simulation Techniques in Financial Risk Management. Sydney: John Wiley & Sons. Nidhi, J., 2007, Foreign Exchange Risk Management. Atlanta: New Century Publications. Read More