Foreign Exchange (Forex) Risk

FX risk is the possibility of financial loss caused by unfavorable changes in exchange rates.

FX risk arises when a transaction or exposure is denominated in a foreign currency and exchange rates may change before settlement or reporting.

At ₹80, the cost is ₹800,000; at ₹85, it becomes ₹850,000, an increase of ₹50,000.

Transaction risk concerns outstanding foreign-currency receivables or payables whose domestic-currency value can change before settlement.

Importers and exporters with foreign-currency receivables or payables are directly exposed to transaction risk.

If the yen weakens against the euro, the yen receipt converts into fewer euros.

Translation risk occurs when foreign subsidiary financial statements are converted into the parent company‘s reporting currency.

A weaker GBP means the same pound earnings translate into fewer U.S. dollars.

Economic risk is the long-term effect of exchange rate changes on competitiveness, market position, and future cash flows.

A weaker euro can make Indian goods more expensive for European buyers when prices are maintained, potentially reducing demand.

Contingent risk arises when a possible future foreign-currency transaction depends on an uncertain event, such as winning a bid.

Because the foreign-currency cash flow depends on whether the bid is successful, it is contingent risk.

The four types covered are economic, contingent, transaction, and translation risk.

Under the gold standard, currencies were linked to gold, providing relatively stable exchange rates.

Under Bretton Woods, currencies were pegged to the U.S. dollar, while the dollar was linked to gold.

The Bretton Woods fixed exchange-rate system was established in 1944 and effectively ended in the early 1970s.

Exchange rates were relatively stable under the fixed-rate framework, reducing day-to-day currency uncertainty.

In 1971, the United States suspended the dollar‘s convertibility into gold, undermining the Bretton Woods arrangement.

Most major economies had moved toward floating exchange rates, with currency values increasingly determined by market forces.

Greater exchange-rate volatility increased the need for tools that could hedge currency exposures.

A forward contract fixes an exchange rate today for a specified foreign-currency transaction at a future date.

The forward fixes the rupee cost at ₹83 million, reducing uncertainty from future exchange-rate movements.

Futures are standardized contracts traded on organized exchanges, while forwards are typically privately negotiated.

An option gives the holder the right, but not the obligation, to buy or sell currency at a specified rate under the contract terms.

A currency call option provides the right to buy the underlying currency at the specified exercise rate.

A currency put option provides the right to sell the underlying currency at the specified exercise rate.

A currency swap involves exchanging cash flows or principal and interest obligations denominated in different currencies.

Natural hedging reduces exposure by matching foreign-currency inflows with foreign-currency outflows.

Netting offsets foreign-currency receivables against payables in the same currency.

Home-currency invoicing can shift some exchange-rate exposure from the seller to the foreign buyer.

Leading means accelerating a payment when management believes doing so can reduce expected currency exposure or cost.

Lagging means delaying a foreign-currency payment or receipt when the timing is expected to be beneficial.

Operating across multiple markets can reduce dependence on a single currency and economic environment.

Using suppliers across different currency regions reduces dependence on one currency and can diversify cost exposure.

Producing closer to the market can reduce the need to import goods or inputs in a foreign currency.

USD liabilities, such as appropriately matched USD debt, can offset some USD asset exposure when translated into yen.

A higher standard deviation indicates greater variability around the mean and therefore greater observed volatility.

Variance measures the average squared deviation from the mean and is a common measure of dispersion.

Semivariance can focus on unfavorable or downside deviations rather than treating positive and negative movements equally.

AAD calculates the average absolute distance of observations from the mean, providing a direct measure of dispersion.

VaR estimates a potential loss over a specified time horizon at a specified confidence level.

The statement means that, under the model and assumptions, there is a 95% probability the loss will be no more than $1 million over one month.

VaR must be interpreted with both a time horizon and a confidence level.

PPP links exchange rates to relative price levels or inflation across countries.

Interest Rate Parity connects exchange rates, forward rates, and interest-rate differentials between currencies.

IFE relates expected currency movements to differences in nominal interest rates between countries.

A weaker USD means each dollar converts into fewer rupees, reducing the investment‘s INR value if the share price is unchanged.

A weaker domestic currency generally makes foreign-currency imports more expensive in domestic-currency terms.

An appreciating domestic currency can make exports more expensive for foreign buyers and reduce competitiveness.

Rupee depreciation raises the domestic-currency cost of imported commodities such as crude oil, which can feed into prices.