Risk is basically defined as threats which creates hurdles for the communities or organizations to achieve its mission. Risk can be any unpredictable event such as losing your files in computer or destruction of building etc. In the financial world, risk is associated almost with every financial transaction.
Types of Risk:
Risk is of two types
- Systematic risk
- Unsystematic risk.
Systematic risk is the one which lies within the firm and are easily avoidable.
Unsystematic risk is the one which occur due to external factors for instance, political or economical factors and these types of risks cannot be easily avoidable.
Now the question comes that what is risk management? Risk management is basically a process of identifying and analyzing all systematic risks before actually happening and setting procedures and techniques to avoid minimize or completely mitigate it. For starting or developing any business, it always requires risk taking hence it is for sure that risk cannot be ignored therefore in today’s world it is necessary by the firms to practice risk management. For example, if you have ever noticed the fact that stock prices, exchange rates and interest rates are more volatile now a days as compare to past. So the firms which do not practice effective risk management techniques would definitely faced significant losses.
Foreign Exchange Risk Management:
Foreign exchange risk is the risk associated with the investments value which gets affected by change in currency exchange rate. This is also known as currency risk. This type of risk is usually faced by those firms who are indulging in exports and imports and mainly to the foreign investors.
For-ex Risk Management Techniques
1. Hedging with derivatives
2. Forward and futures contracts
3. Currency options
4. Currency swaps
Hedging with derivatives:
Hedging embrace all acts aimed to reduce risk associated with price moments of commodities, financial security or foreign currency. Hedging is usually done in over the counter (OTC) forward or in the organized future markets. It is a substitute to speculation. Many financial managers are adopting hedging strategies and using derivatives in order to reduce foreign currency risk.
Forward and futures contracts:
A forward contract is a commitment of trade about a specified item at a specified time at a future date. This contract allows the parties to agree at a price today but delivery will be made in future. A system of margin requirements is designed to protect both parties against default. On the other hand, future contracts are executed by securities brokerage houses on an organized exchange. Moreover, futures contracts are traded for only seven major currencies versus the dollar (the Japanese yen, the German mark, the Canadian dollar, the Mexican peso, the British pound, the Swiss franc, and the Australian dollar) while forward contracts can be established for any currency.
Currency option usually offers the right to buy and sell the currency. It is not an obligation to make trade at any specified price or date. Options are beneficial in a way that it hedge against foreign exchange rate risk happens from import or export of goods. It is also useful to hedge foreign investment.
Basically it is a commitment between two parties to exchange two currencies at a spot or current exchange rate. It is closely related to interest rate swaps. Currency swaps oblige the party to receive the currency with a higher interest rate in that country’s currency to pay the interest to the counter party at a rate that represents the interest rate differential between the two countries.