Risk In Foreign Exchange Rate

Possibility of loss ensuing from an adverse movement in foreign exchange rates is termed as risk. When someone conducts business overseas, he will have to change currencies involved at some ongoing exchange rate. The price of one country's currency in terms of another country is termed the exchange rate. When the currency of one country drops in value, there will be a corresponding appreciation of value in another country's currency. Depreciation takes place when it takes more currency to purchase the currency of another country. Appreciation is just the opposite; the currency is capable of purchasing more units of the other country's currency. Since most currencies are valued according to the marketplace, there are constant changes to exchange rates. This gives rise to exchange rate risk.

There are some ways to bring down exchange rate risk. Two popular approaches are hedging and netting. Hedging is where someone buys or sells a forward exchange contract to cover liabilities or receivables that are denominated in a foreign currency. Forward exchange shrinks offset the gains or losses associated with foreign receivables or payables. A very popular norm of hedging is the Interest Rate Swap. Interest rate swaps are arrangements by which two companies located in different countries agree to exchange or swap debt-servicing obligations. This swap assists each company to avoid the risks of changes in the foreign currency exchange rates. Due to the popularity of interest rate swaps, most major international banks offer interest rate swaps for organizations concerned about foreign exchange rate risks when taking interest payments. The costs charged by banks for interest rate swaps are comparatively low.

Another way to meet to foreign exchange rate risk is the use of netting. The practice of maintaining an equal level of foreign receivables against foreign payables is called netting. The net position is zero and thus exchange rate risk is discarded. If someone expects the currency to depreciate in value, than he should hold a net liability position since it will take fewer units of currency to pay the foreign currency debt. If he expects the currency to appreciate in value, then he would want to have a net receivable position to take advantage of the increased purchasing power of the foreign currency.

There are other vehicles for dealing with exchange rate risk, such as option hedges and other forms of derivatives. However, the costs and risks associated with these forms of arrangements can be much higher than a simple approach such as the interest rate swap. If he has exchange rate exposure, then take a look at simple hedges and netting as ways of avoiding foreign exchange rate risk.

Risk aversion in the forex is a kind of trading behavior demonstrated by the foreign exchange market when a potentially adverse event takes place which may hinder market conditions. This behavior is caused when risk averses traders liquidate their positions in risky assets and transfer the funds to less risky assets due to uncertainty. In the context of the forex market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US Dollar Sometimes, the choice of a safe haven currency is more of a choice based on ongoing sentiments rather than one of economic statistics. The value of equities across world fell while the US Dollar strengthened .This occurred despite the strong focus of the crisis in the USA.