Instructor: David Juliao Show bio
David has a bachelors degree in architecture, has done research in architecture, arts and design and has worked in the field for several years.
In this lesson, learn what hedging is, examine the different risks involved in the foreign exchange market and explore the strategies for reducing their potential impact. Also, identify some of the methods used in foreign exchange hedging. Updated: 08/19/2021
Risks and Exposure in the Foreign Exchange Market
We often try to reduce our exposure to certain risks. When you drive your car, you put on the seat-belt (or at least, you should). You probably have home insurance, so if something bad happens, you dont lose money.
The foreign exchange market, or Forex, consists of many international transactions of currency exchange that take place between different countries, moving billions of dollars each day. The fluctuations in the exchange rate of the different currencies have become a form of investment, and currencies often make part of the portfolio of commercial banks and many other investors.
However, people and investors in the Forex market are exposed to risks as well. Exposure is the sensitivity to fluctuations in the value of an asset, while risks refer to how much exposure can affect the asset or operation. For example, an importer firm has a big exposure to fluctuations in the currency exchange rate, but if that rate has remained steady for the last few years, the risk is low.
Currencies tend to rise and fall constantly, so they can pose important risks for investors, for importers, exporters and for local industries that use foreign products or services in their processes.
International operators are exposed to sudden movements of the currency exchange rate
The main risks in the foreign exchange are market are transaction risks and translation risk.
Transaction risks are the impact of exchange rate fluctuations on cash flows. Imagine you own U.S.-based company selling to a Japanese firm, and you send products for 1,150 million yen (10 million dollars at the current exchange rate of 115 yen per dollar), payable in 30 days. However, during that month, the yen loses value and the rate changes to 120 yen per dollar. Suddenly, your payment becomes 9.58 million, reducing your profit.
Translation risks involve an asset losing value because of currency exchange variations. If your company also owns real estate in Russia and the ruble devaluates, your property will worth less U.S. dollars, so your asset loses value.