Foreign Exchange Risks - Coursework Example

• Background of foreign exchange risks

Many small, medium and sometimes large enterprises overlook the financial exchange risks. Most of these small and medium-sized enterprises are those that wish to grow and succeed in the global marketplace. However, the concept of foreign exchange risks is an important concept that all businesses should understand especially those large firms whose business operate globally. In businesses where the main operations revolve around financial services, then they should understand the concept of financial exchange risks and ways to manage this risks. These risks should also be managed in such a way that the operations of the business do not expose the firm to financial risks. Foreign exchange risks revolve around the financial risk existing when financial transactions are denominated in currencies other than of the basis of the currency of the company; they are the risks of investment values that change due to the existing changes in currency exchange rates

Foreign exchange risks began after the introduction of the foreign exchange markets after the world war. Foreign exchange market began with the setting up of the international monetary fund and organization whose function was the monitoring the balance of payments and the exchange rate activities. In 1944, in New Hampshire, 44 countries signed the agreement of the international monitory funds. At the center of the agreement established a worldwide system of fixed exchange rates between these different countries . However during the time the anchor of the fixed exchange rates was the use of gold, later the countries pegged to the United States dollar at a fixed exchange rates. For example at the time, the Japanese yen was set at 360 yens for one dollar while the British pound went for 4 dollars .

The success of this system existed between 1950 and early 1960, later in the late 1960s the foreign exchange system come into a strain that almost collapsed the economic systems of the involved countries. During that time, most economists blamed the United States for the introduction of the "united states microeconomic policy package in 1965 which aimed at financing Vietnamese conflict and all its welfare programs. This crisis in the economy led to a rise in inflation, the worsening of the United States trade position, on the other hand, gave support to the speculation in the foreign exchange market. Foreign exchange markets and the rates involved in the market become more volatile in 1973 and the years that followed. The rates were also unpredictable to an exchange that they exposed countries to dangers of economic crisis

To solve the currency problem in the United States President Nixon in 1971 announces that the dollar could not be converted to gold. Another technique to reduce the issue was that the tax on imports was to remain the same and in effect until the trading partners of the United States agreed to revalue their own currencies against the dollar. However this attempts did not solve the existing problems, the United states balance of payment position deteriorated throughout the following year, The money supply during the time continued to expand inflationary, this problem later forced the foreign exchange markets to close. In March 19, 1972, the foreign exchange market reopened, the currencies of Japan during this time were floating against the United States dollar.

As years passed many businesses in different countries were less concerned and did not manage the risks of foreign exchange under the Bretton Woods system of the international monetary fund. However the introduction of the floating system after the collapse of the Bretton system, firms become exposed to an increased risk of the fluctuations of within the foreign exchange market. With this businesses began to trade an increased volume revolving around the financial derivatives aimed at hedging their exposure. The currency crises between the late 1990s and the early 2000s, for example, the Argentine peso crisis and the Asian currency crisis led to losses from the foreign exchange market forced the business firms to pay closer attention to the risks of foreign exchange

The major currencies currently move independently of other currencies, in that anybody can trade for the currency so inclined. This is a system called the free floating, in this system of currencies the US dollar provided opportunities to investors to judge and trade these currencies. The system of free floating also proves that it is the best market available all over the world with similar kind of exposure and opportunities to trade and make use of the foreign exchange market

• Changes in FX activities and the exposure of FX risks
  • Changes in foreign exchange activities

The activities involved in the process of foreign exchange greatly influence the risks the financial institutions are exposed to. These changes influence the value of the financial instruments and the products and also impact on the investment flows. In most cases these changes in foreign exchange activities include, the value of foreign claims and positions and decrease the volume of currency trading. Some of the foreign exchange activities whose changes expose firms to foreign exchange include the trading activities . Trading in foreign exchange is divided into four main activities which include the purchase and the sale of currencies in order to complete a firm international transaction, the accommodation of hedging activities, speculations and the facilitation of positions in foreign financial and real investments.

When changes occur from changes in foreign exchange activities, the firm or the financial institutions are exposed to credit and market risks. The credit and market risks, on the other hand, extend across the departments, the product lines and the legal entities which in turn challenges both documentation procedures and management information systems. Increased value of foreign claims and foreign positions and the decrease in volume of currency trading increases the presence of trends and volatility in the markets, and also shifts the currencies that were consistently increasing .

At times the domestic, foreign exchange activities can also expose the firm to FX risks, this may be through the fall or the rise in the domestic exchange rates. When domestic FX rates fall, there may be an increase in of costs for the importers which in turn reduces the profitability. This results in a decrease in dividends which in turn result to a fall in the market value of the business. Falling domestic FX rates can also increase the cost of capital expenditure which makes the domestically produced goods become competitive over the imported goods. Another effect of the fall in domestic FX is the increase in the cost of investing overseas.

The rising of the domestic FX rates results in a decrease in the value of investment in monetary assets and foreign subsidiaries and also the fall of the value of the liabilities of foreign currency. When the domestic FX rates rise the export in the region become less competitive which in turn reduced the profit gained by the exporters. This leads to a decrease in dividends also resulting the business to fall in its market values. Also, the rise of domestic FX rates results in a decrease in the foreign income currency that results from investments

• • Exposure to foreign exchange risks

The exposure to financial risks threatens the normal functioning of the financial institution and the business firms. There are four types of exposure that firms and financial institutions face and those that results to foreign exchange risks. These risks include the transaction risk, contingent exposure, the economic exposure, and the transaction exposure. Transactional exposure occurs to firms or financial institutions with contractual cash flows; these contractual cash flows must have values which are subject to the unanticipated changes within the exchange. This happens when the foreign currency denominates the contract in place

Economic exposure occurs when firms and financial institutions market values are influenced by the unexpected fluctuation rates of the foreign currency. These rate adjustments in most cases tend to damage severely the firms or the financial institutions market share position in relation to its competitors, the financial institutions cash flow and the firm's general value. Firms with economic exposure are faced with a challenge of the present value of the future cash flow. All transactions within an organization that exposes the firm to foreign exchange risks also expose the firm to all the economic risks, however, economic exposure can result from activities of partner firms and other firms activities and investment which impact on the international transactions. Economic exposure also results from a shift in the exchange rate, for this shift to result in economic exposure of a firm it must influence the demand for a certain good sold by the firm faced by economic exposure. Economic exposure in firms and financial organizations can be managed through pricing, branding, product differentiation and outsourcing .

Translation exposure occurs when a firm is affected by the existing movements in exchange rates this exposure mostly occurs when a firm is faced by foreign exchange of transactional risks. Translation exposure does not affect the cash flow of the firm or the financial institution; however, the exposure results in significant impacts on the firms reported earnings which in turn affects the firms stock price, the different between translation exposure and transaction exposure is the existence of different treatments relating to accounting

Contingent exposure, on the other hand, occurs mostly in cases of bidding for foreign projects, foreign direct investments and also when negotiating for other contracts. This risk occurs when a firm faces risks in economic and transactional foreign exchange. However for it to occur the firm must be contingent on the outcome of a made negotiation of a signed contract. In most cases when a firm is in this position, there is a higher chance of other risks coming up when this happens the firms prefer to manage the contingent exposure which in turn manages the other existing exposures

• Hedging as a tool for managing FX risks

Managing foreign exchange risks involves the following steps, the identification and the measure of the exposure to FX risks, development of the FIs policy, hedging or the use of other techniques to help manage the risks and finally evaluation and periodic adjustments.

Hedging involves the process of matching the outgoing foreign currencies versus the inflowing foreign currency receives at the same time. For there to exist a perfect hedge, the inflows and the outflows of foreign currency must exist at the same time. Perfect hedges in Foreign exchange aims at eliminating the risks facing the business. Hedges reduce the risks facing a financial institutions through managing the exposure to foreign exchange risks, hedging, however, does not eliminate this risks. Hedging also aims at reducing the foreign exchange risks through the reduction of the volatility of the future returns.

The concept is basically a risk management strategy which helps in the reduction or the offsetting of the probability of loss due to fluctuations in the prices of currencies. When using hedging some techniques are employed, these techniques include the taking of equal and the opposite positions in two different markets. Hedging can also be an investment technique aimed at reducing the existing uncertainty about the future price movements of a commodity, foreign currency, and foreign security. Hedging is an important concept used in financial institutions and firms to help in the management of foreign exchange risk. The process of hedging can be done through

Hedging in the management of foreign exchange risks is divided into four parts, this includes the analysis of the exposure, determining the tolerance, determining the most appropriate hedging strategy, implementation and the monitoring of the strategy. However before employing hedging as a tool for managing the risks companies should understand that the tool may place the firm at a higher risk if not implemented correctly. Also, an important concept in hedging is the options available in relation to foreign currency. These options give the financial institution the rights but not the obligations to trade currencies at a certain exchange rate in the future. Hedging process is, however, a straightforward process, the most important thing to manage foreign exchange risks is to access the amount of exposure to the risks so as to determine the hedge ratio of the number of the "futures" needed in order to offset the risks.

In analyzing the risk, the financial institution should first identify the risks that relate to foreign exchange. Once the risks are identified then the company should identify what the risks will result to if not managed . This helps determine whether the risk is low or high in the foreign exchange market. The institution should then determine the level of tolerance through assessing the company's tolerance levels. This also helps determine the positions risk and the best hedging method to employ. In foreign exchange there is always a chance of risk exposure; hence, the step is important to determine if hedging is necessary. The financial institution should then determine the hedging strategy; this can either be the off balance technique or the on balance technique. The last step is implementing and monitoring the selected hedging strategy; this helps the company check if the is the strategy in place works in an intended way and if there is the reduction in foreign exchange risks

• • Financial hedging

This method involves the use of balance sheet techniques and requires the matching currency durations and position of all the financial institution assets and liabilities. The use of diversification employs the use of derivatives which enable the use of the precise calculation or the current of the future risks. The method, however, requires some measure of sophistication and at times may need the use of capital. For this method to occur the financial institution, need to buy some foreign exchange instruments, which include the foreign exchange forward contracts, currency swaps of other currency options.

Financial contracts help the firm or the FI to set an exchange rate which it will sell or buy a certain quantity of foreign currency in the future. These contracts are efficient due to their flexibility and the fact that they can match the future transaction exposures. The use of financial contracts also enable the exporter to sell certain amounts of FX at a certain pre-agreed exchange rate with a few days to the set date.

• • Non-hedging FX risk management

This technique employs an off-balance sheet techniques and enables the financial institution to reduce the existing foreign exchange risks. The objective of this technique is the reduction of the difference between the payments and the receipts in a given foreign currency. The method is effective in the reduction of FX risks, but it takes time to implement. Also, the solutions revolving around the use of non-hedging technique often revolve around the use of long-term commencements

• Theories in foreign exchange risks
  • Purchasing power parity theory (PPP)

Purchasing power parity theorem states that exchange rates between different currencies are only in equilibrium when their purchasing power is the same in the involved countries. This theory implies that the exchange rate between involved countries (two or more) should equal the ratio of the countries price level of a certain fixed basket of goods and services. In order to return to the purchasing power parity in countries with increasing domestic price levels, then the currency exchange within the country must depreciate. The theory of purchasing power parity revolves around the law of price, in that in the absence of transaction and transportation costs then the competitive markets tend to equalize the prices of identical goods in the involved countries when price is expressed using the same currency.

Relative purchasing power parity is a concept in the theory that refers to the rates of changes of price levels of changes in inflation rates. Relative PPP indeed states that the rate of appreciation of a certain countries currency is equal to the existing difference in inflation between the foreign country and the home country. For example, if the United States have an inflation rate of 3% while Canada has an inflation rate of 1% the United States dollar will appreciate against the Canadian dollar by 2% each year.

PPP does not determine the exchange rate over a short term; this is because the exchange rates in a short-term are "news driven." In that short-term, exchange rates are driven by the announcements about the changes in perception in relation to economies growth path and those about changes in interest's rates. PPP, on the other hand, describes only the behaviors of exchange rates over a long period of time. This is because the economic forces behind the theory end up equalizing the purchasing power of the existing currencies which may even take more than four years.

Purchasing power parity theory in managing foreign exchange risks employs some calculation techniques. Thief simplest way to calculate the PPP between two trading countries is the comparisons between the prices of standard goods identical in the two countries. However, there are more sophisticated versions of calculating the PPP, which look at a large and diverse number of goods and services . The challenge faced in calculating PPP is that the people in different countries have different consumer preferences which make it difficult to compare the purchasing power between the different countries.

This theory is a law of one price applied in the total prices, in that one price of identical; goods should sell at the same price in trading countries. When making these comparisons the values should be converted, this may include the conversion of the GDP (national income) to a common currency. Financial institutions can achieve this through the use of PPP. The strongest form of this theory is the absolute PPP, which revolves around the good multi version of the law. The absolute PPP helps in predicting the exchange rates to adjust intruder to equate the prices in the trading countries as most markets are driven by arbitrage. In this form of PPP, the exchange rates are equal to the ratio of the domestic to that of the foreign price which makes the exchange rate constant

The other form of PPP is the relative PPP, which forces the exchange rates between countries to adjust in order to account for the differences in the existing inflation rates. In these, the countries only follow the policies of the monetary fund policies with different inflation rate objectives, to some extent this helps in showing the movements of the exchange rates

• • Interest rate parity theory (IRP)

The interest rate parity theory states that the interest rate differences between two different currencies reflect the discount or the premium for the forward exchange rate on the foreign currencies in case there is no arbitrage. In that, the interest rate differential between the countries is equal to the existing forward exchange rate and the spot exchange rate. The theory plays an important role in analyzing the existing relationship between the forward rate and the spot rate of currencies. The theory also states that the size of the forward premium on a certain foreign currency must be equal to the interest rate differences between the two countries .

The IRP theory is divided into covered IRP and the uncovered IRP, the covered IRP states that the exchange between the future premiums tends to offset that interest rate differentials between two countries. The uncovered IRP, on the other hand, states that the expected appreciation of a certain currency is the existing offset by a lower interest and vice versa. Studies on these theories have however shown that the Uncovered IRP does not hold and seems to be currency dependent rather than horizon dependent. Covered IRP, on the other hand, is the most used in economies for the short term instruments.

The theory holds when the markets are efficient and in countries where governments do not prevent arbitrage. When these conditions lack the traders in countries tend to make profits through the use of covered interest rate arbitrages. In this covered interest rates mean the investments which are not exposed to the to the transactions that revolve around the risks of foreign exchange .

• Conclusions

Evident from the information above the concept of Foreign exchange risk revolves around the financial risks that exist when currencies denominate the financial transactions rather than the basis of the currency of the company . Also, the management of foreign currency risks plays an important role in the general functioning of the company in relation to the reduction of financial exchange exposure. Managing FX risks in financial institutions help in minimizing the effects resulting from exchange rates on all the nonprofit margins, increasing the predictability of the future cash flows as well as eliminating the need to forecast the future direction of the institutions exchange rates