Managing Your Foreign Exchange Risk

Once you have a clear idea of what your foreign exchange exposure will be and the currencies
involved, you will be in a position to consider how best to manage the risk. The options available
to you fall into three categories:
• Do Nothing: You might choose not to actively manage your risk, which means dealing in the
spot market whenever the cash flow requirement arises. This is a very high-risk and
speculative strategy, as you will never know the rate at which you will deal until the day and
time the transaction takes place. Foreign exchange rates are notoriously volatile and
movements make the difference between making a profit or a loss. It is impossible to properly
budget and plan your business if you are relying on buying or selling your currency in the
spot market.
• Take out a Forward Foreign Exchange Contract: As soon as you know that a foreign
exchange risk will occur, you could decide to book a forward foreign exchange contract with
your bank. This will enable you to fix the exchange rate immediately to give you the certainty
of knowing exactly how much that foreign currency will cost or how much you will receive at
the time of settlement whenever this is due to occur. As a result, you can budget with
complete confidence. However, you will not be able to benefit if the exchange rate then
moves in your favour as you will have entered into a binding contract which you are obliged
to fulfil. You will also need to agree a credit facility with your bank for you to enter into this
kind of transaction.

• Use Currency Options: A currency option will protect you against adverse exchange rate
movements in the same way as a forward contract does, but it will also allow the potential for
gains should the market move in your favour. For this reason, a currency option is often
described as a forward contract that you can rip up and walk away from if you don't need it.
Many banks offer currency options which will give you protection and flexibility, but this type
of product will always involve a premium of some sort. The premium involved might be a
cash amount or it could be factored into the pricing of the transaction.
Finally, you may consider opening a Foreign Currency Account if you regularly trade in a
particular currency and have both revenues and expenses in that currency as this will negate to
need to exchange the currency in the first place.
The method you decide to use to protect your business from foreign exchange risk will depend
on what is right for you but you will probably decide to use a combination of all three methods to
give you maximum protection and flexibility.

Importers, Exporters and Exchange Rates

If you are an Importer or Exporter, on the other hand, you will find yourself exposed to easily
identifiable form of foreign exchange risk known as 'Transactional' exposure. This arises from
your need to either buy or sell currency relating to a trade transaction in return for sterling.
Movements in exchange rates can work in your favour and enhance profitability but, equally, they
can have the opposite effect and seriously erode profit margins or lead to making a loss.

Foreign Exchane Option

In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date; see Foreign Exchange derivative.

The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or theChicago Mercantile Exchange for options on future contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158,300 billion in 2005

Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.

Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.

If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.

Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expectedpounds sterling at a predetermined rate), which will: income for

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  protect the GBP value that the firm will receive in 90 day's time (presuming the cash is received)
  
  
  
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  cost at most the option premium (unlike a forward, which can have unlimited losses)
  
  
  
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  yield a profit if the expected cash is not received but FX rates move in its favor
  
  
  

Trading Opportunities

In Three Ways to Identify a Trend, GFT¹s Directors of Currency Research, Kathy Lien and
Boris Schlossberg, demonstrate how to use:

• ADX (Average Directional Index): to gauge the intensity of a trend¹s strength.
• Moving Averages: to track the average price of a currency pair over a specified period of time.
• Bollinger Bands: to forecast when a currency pair may enter or exit a trend.

Basic Facts Of Foreign Exchange

Currency exchange is the name given to the foreign exchange market. This market exchanges currency between countries allowing companies in one country to pay for products and services in another. This facilitates global trade and investments. If you are traveling to Europe, you go to your bank and exchange greenbacks for Euro dollars so that you have money to spend on your trip. Your bank bundles this exchange with others and then exchanges the bucks for Euros through currency exchange.

The foreign exchange market has no physical location and is open for business 24 hours per day between Monday morning in New Zealand through Friday night in the East. The average trading volume is over 3 trillion dollars a day. Profit margins are relatively low.

The majority of the traders are central and world banks, and international business firms.

In contrast, about 80% of the trading is done by the ten most active traders, which are huge international banks. These traders make up the top tier of the market. The difference between the bid and ask prices at these levels are extremely narrow and unavailable to the rest of the traders. These top tier traders account for 53% of total trading volume. Below the top tier are smaller invesment banks, big multi-national corporations and large hedge funds.

The market is split into tiers, with the 10 traders who do the most trading in the top tier. These are the huge international banks. The profit margins here are miniscule and the rate between the bid and ask costs are available only to this elite group. This accounts for approximately 53% of the trade volume. The following tier of investors includes large hedge funds, investment banks and global corporations.

There\’s no fixed exchange rate on currency exchange and it is feasible to get several different rates depending on what huge trader is trading. Rates also fluctuate based mostly on macroeconomic conditions and other considerations. Political conditions can have an extreme effect on rates of exchange.

Foreign exchange is a hopeful market. Although it might be less risky than high risk stock trading, as with any investment there is a potential for both gain and loss. When shake ups in the market occur, most traders head for the safest, or most stable currencies, like the Swiss franc. This drives the rate of exchange up on those currencies.

different types of trading instruments include the futures contract which is mostly for 3 months, and the spot exchange which is similar to a futures contract, but is routinely a two day exchange. The forward contract boundaries risk somewhat, because money doesn\’t change hands till a fixed upon date in the future. One type of forward contract involves a swap, where two parties exchange currencies for an agreed upon time period. The currency exchange option gives the holder the right, but not the requirement to exchange one currency for another an at a formerly agreed on rate of exchange on a pre set date. The option is equivalent to a stock option.

The foreign exchange market is intensely complex and with much less regulation than the exchange, more subject to abuses. It\’s advantages are its liquidity and the incontrovertible fact that it trades twenty four hours per day. This is a reasonably speculative investment and is going to be approached with caution by small investors. Before considering an investment in foreign exchange, you\’ll need to learn about the market and the best investment methods.

Introduction

The Foreign Exchange Market is vast in size and scope and exists to fulfil a number of purposes
ranging from the finance of cross-border investment, loans, trade in goods and services and of
course, currency speculation. Trading may be for "spot" or "forward" delivery. A spot contract is a
binding obligation to buy or sell a certain amount of foreign currency at the current market rate. A
forward contract is a binding obligation to buy or sell a certain amount of foreign currency at a
pre-agreed rate of exchange, on or before a certain date.

From Wikipedia

The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies.

The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S.dollers.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floting exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Wood System.

The foreign exchange market is unique because of

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  its trading volumes,
  
  
  
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  the extreme liquidity of the market,
  
  
  
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  its geographical dispersion,
  
  
  
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  its long trading hours: 24 hours a day except on weekends (from 20:15 UTC on Sunday until 22:00 UTC Friday),
  
  
  
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  the variety of factors that affect exchange rates .
  
  
  
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  the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
  
  
  
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  the use of leverage