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Currency risk in modern conditions

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Currency risk in modern conditions

Today, everyone who deals with foreign exchange should understand what currency risk is and how to take it into account. This issue is of particular importance due to the fact that in modern conditions, currency risks are exposed not only to business organizations, but also to individuals. First of all, these are:

  • importers;
  • exporters;
  • banks;
  • creditors;
  • borrowers;
  • currency speculators, etc.

 On the tradernew.pro website, we have already considered many issues related to foreign exchange transactions, so it would be quite logical to talk about the risks involved in working with foreign exchange.

Content:

  1. Foreign exchange risk is the probability of a loss.
  2. Types of foreign exchange risks.
  3. Bank exchange rate risk.
  4. Exchange rate risk and methods of its regulation

Currency risk is the probability of a loss.

 

Currency risk in modern conditions

If we talk about risk, the uncertainty of the final result is already implicit from the beginning. When trading currencies, the risk component increases many times. Therefore, a concept such as foreign exchange risk was introduced. This concept means that there is a possibility of a loss as a result of a change in the exchange rate. In this case, it does not matter in which direction the course will change:

  • The exporter’s financial loss may occur as a result of a depreciation of the currency of payment.
  • The importer runs the risk of losing part of the profits or making a loss if the rate of the currency of payment increases.
  • As a result of foreign exchange transactions, a trader can suffer losses, both when the exchange rate rises and when it falls.   

The probability of such losses is an objective reality that must be taken into account. Therefore, it is generally accepted that currency risk is one of the most important indicators in the work of business organizations and individuals.

Types of currency risks

 

 

In modern economic theory, currency risks are conditionally divided into the following types:

  1. Exchange rate operational risk. This type of exchange rate risk may arise in commercial and financial transactions associated with the investment (long-term loans). The possible lost profit or loss is formed as a result of a time lapse between the date of an operation and the date of transfer of money in foreign currency. If at the time of the money transfer an unfavorable exchange rate gap is formed, the amount of income will be significantly less than what was supposed to be received according to the initial calculations.
  2. Translational risk. Sometimes this type of currency risk is called balance risk. This is because in this case we are talking about recalculating the amount of the balance of an organization or business company from one currency to another. For example, this recalculation can be done to determine the borrower’s foreign currency debt. If the foreign currency exchange rate has changed, the result may not be in favor of the company that borrowed the currency.
  3. Economic risk. This type of currency risk manifests itself if fluctuations in the foreign currency exchange rate affect the economic condition of a business entity. For example, a company uses imported raw materials to manufacture its products. If the price of this raw material begins to rise, it will cause an increase in the price of the final product, a decrease in the competitiveness of the company and a deterioration in its economic performance.

It should be noted that this classification is valid for companies whose main activity is not foreign exchange transactions. Commercial banks engage in these operations. Therefore, the bank’s currency risks must be analyzed separately.  

Bank exchange rate risk

 

 

Commercial banks are active participants in the foreign exchange market. The purchase and sale of currencies is carried out by them on a regular basis:

  • If a bank enters the market with the intention of buying foreign currency, then it has requirements for a transaction to acquire the required amount of currency.
  • When selling foreign currency, the bank undertakes to provide a certain amount of foreign currency to the counterparty within the specified period.

If there is parity between the bank’s requirements and obligations, your foreign exchange position will be considered closed. If there is an imbalance in the requirements and obligations of a participant in the foreign exchange market, the bank’s foreign exchange position will be open. Understanding this becomes especially important due to the fact that currency risk and currency position are interrelated concepts.

With an open position, the bank’s foreign exchange risk becomes higher, as it can be influenced by various market and non-market factors. There are several types of currency risks associated with a currency position:

  • Exchange rate risk. The negative dynamics of the foreign currency exchange rate before the closing of the foreign exchange position can lead to significant losses for the bank.
  • Interest rate risk. This type of risk is associated with a possible change in the interest rates of open foreign currency positions.
  • Credit risk. This risk of financial loss arises in the event that one of the parties to the transaction does not redeem an open position.
  • sovereign risk. This is the risk of the government regulator interfering with the foreign exchange market. The possibility of such interference exists and may have negative consequences on the work of any commercial bank.

The exchange rate risk in international agreements also falls on commercial banks. Therefore, for their part, they are doing everything possible to reduce the risk component in dealing with currencies. This issue should receive more attention from all commercial entities that carry out operations with foreign currency and depend on its exchange rate.

Exchange rate risk and methods of its regulation

 

Currency risk in modern conditions

In a free market, the exchange risk will be present in all transactions involving a particular currency, since its rate is not constant. What should be done to minimize this risk and what methods exist for its regulation?

Currently, there are many techniques, the use of which can significantly reduce the level of currency risk. They are conventionally divided into two large groups:

  1. Internal. Risk management practices within a single company or company will be considered internal. They may consist of the following organizational actions:
    • Close a foreign exchange position in the purchase of the desired currency in the amount that allows to conclude long-term export and import contracts.
    • Carry out a proactive price correction (in national currency) of manufactured products, taking into account exchange rate fluctuations in the foreign exchange market.
    • Diversify in the stage of signing long-term contracts. That is, the contracts must be signed with the possibility of their execution in different currencies with a multidirectional trend of exchange rate variations.
    • Use a foreign exchange clause when entering into a contract. In practice, a currency clause can be of two types and contain the following information:
    • In all agreements between the parties, use only “hard” currency.
    • When making payments, review the value of the contract taking into account changes in the exchange rate of the currency agreed by the parties. 
    • External. External risk management methods include the following:
    • Urgent currency exchange operations in the interbank markets or on stock exchanges. These can be forwards, futures or options contracts.
    • Sure. This method of risk management is the most widely used in practice. For its implementation, financial transactions are carried out to compensate for possible losses due to an unfavorable change in the exchange rate. Such operations include:
    • Hedging operations, which in most cases are reduced to the opening of forward currency transactions.
    • Forex currency swap or two identical but oppositely directed transactions with different maturities.
    • Network. This is a method to minimize the number of foreign exchange transactions due to its consolidation.
    • Acceleration or deceleration of payments in foreign currency during periods of high volatility in the foreign exchange market.

There are other methods to regulate foreign exchange risks. It does not matter which of these methods you use in practice. The main thing is that the effect of such regulation is greater.

Answers to popular questions about currency risk

What is currency risk? Foreign exchange risk is the possibility of financial loss associated with fluctuations in the exchange rate. Exporters and importers, banks, lenders and their clients are more exposed to foreign exchange risks. The essence of this risk lies in the loss of real capital, which subsequently jumps in the foreign exchange market, and is divided into operational, translational and economic. How to avoid currency risk? It is impossible to completely avoid currency risk. But you can minimize losses by dividing financial assets into many currency baskets. Thus, with the loss of part of the funds associated with a ticket, the entrepreneur keeps the other part of the finances safe.Traders and brokers are recommended to use hedging to reduce financial risks. How to reduce currency risk? To reduce currency risks, it is necessary to go back to the basics of trading. Analysis of the foreign exchange market by fundamental and technical analysis, allows you to predict the level of risk of the transaction and / or its delay. If it is impossible to carry out the analysis yourself, it is recommended that you contact experts, financial companies or professional traders. How to calculate currency risk? The foreign exchange risk is calculated using two methods: VaR test and through the stress index.Each of the types of calculation has a significantly long settlement chain, but has its own advantages and disadvantages. Var: The tests do not take into account many factors associated with the influence of physical buyers, and the stress tests do not take into account financial and exchange assets. Who is exposed to currency risks? In the modern world, everyone is exposed to currency risks, from financial corporations to individuals. Importers and exporters bear the greatest risk facing currency conversions everywhere.In second place are banks and credit organizations, followed by foreign exchange agents and other categories of people whose work is related to foreign exchange transactions.

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