Exchange Risks Trough Different Instruments Finance Essay - Free Essay Example

Sample details Pages: 7 Words: 2036 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? Foreign Currency Risk is very important source of managing risk for the banking industry and different research have been done in different parts of the world in that topic. (Papaioannou M. G., 2006). Don’t waste time! Our writers will create an original "Exchange Risks Trough Different Instruments Finance Essay" essay for you Create order Foreign currency exposure and risk management is very important for the firm to avoid any liability from exchange rates instability which can affect the profits and assets values in a negative way. Also different way and strategies for managing foreign currency risk were analysed along with advantage and disadvantages of each strategy and technique. Additionally, best practice widely spread was outlined along with data on financial derivatives and hedging practice by US Firms. A study that is said to USA forty eight largest business banks (Choi, Elyasiani, amp; Kopecky, amp; Kopecky, 1992) for the amount 1975-1987 showed that effects of charge per unit rely on cyber web position of the bank in foreign currencies. in step with them, once banks had positive internet position, depreciation of foreign currencies negatively affected the stock costs of banks before year 1979 and when 1979 banks stock returns responded completely with the depreciation of foreign currencies as banks had modified from positive to negative internet open positions. during a similar study on Canadian banks (Atindehou amp; Gueyie, 2001), its observed for the Canadian Banks that stock costs responded completely with depreciation of foreign currencies. Selecting the appropriate hedging strategy is usually a troublesome task because of the difficulties concerned in mensuration exactly current risk exposure and selecting the appropriate degree of risk exposure that got to be secure. the ne cessity for interchange risk management began to arise when the autumn of the Bretton Woods system and at the top of us greenback peg to gold in 1973 (Papaioannou M. , 2001) the problem of interchange risk management for corporations in non-financial sector is freelance type their principal business and is typically severally handled with by their company treasuries. In most of the corporations there square measure freelance committees WHO operate to manage the treasurys strategy in managing the interchange risk (and rate risk) (Lam, 2003). It clearly shows the importance of the very fact that corporations provide a vital attention to risk management problems and techniques. Contrariwise, international investors sometimes use their underlying assets and liabilities to manage interchange risk. Since the currency exposure of international capitalist is majorly associated with translation risks on assets and liabilities command in foreign currencies, they have an inclination to think a bout foreign currencies as a separate quality category, all break free different assets, requiring a currency overlay mandate (Allen, 2003). Functions of Foreign Exchange Market The foreign exchange market is a market where foreign exchange transactions take place. In other words, it is market in which national currencies are bought and sold against one another. The main functions of foreign Exchange Market:- Transfer of purchasing Power: Foreign exchange market is the primary role to transfer of buying power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very significant role in facilitating capital drives and international trade. Provision of credit: this provision of credit function performed by foreign exchange markets also shows a very important role in the growth of foreign trade and international trade depends to a great extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit facilities are available also for importers. The Eurodollar market has emerged as a major international credit market. Provision of Hedging Facilities: The other important function of the foreign exchange market is to provide hedging facilities in the hedger. Hedging refers to covering of unexpected risks, and it provides a mechanism to exporters to protect themselves against losses arising from fluctuations in exchange rates coming in the market. Derivative Market Derivative is the form of financial instrument that is represent from some index, other asset, event, value or condition. Derivative traders enter into an agreement to exchange cash or asset over time based on the underlying asset. Derivative market used for two purposes one is hedging and other is speculation and hedger, speculation take the advantage from the derivative market. Hedging is where a financial risk is eliminated or reduced by passing the risk on to someone else and this is the activity that is usually used by corporate treasurers in managing their IRR. Hedging is a safety net an insurance policy against any open position of a trader. It is an underlying cover. Consider an investor who converts his $15,000,000 at the cash market (where $1.50 = ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬1) for the British pound, and puts his ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬10,000,000 at the British bank for a year at 9.5 percent to get ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬10,950,000. But when he gets that British amount, if the exchange rate becomes $1 = ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬1, he is turning his $15,000,000 into $10,950,000, which is a total loss of $4,050,000 (27 percent). To prevent such potential economic loss, many financial instruments have been created and are in existence for the investor. If at the time the investor exchanges his $15,000,000 and puts his conv erted amount at the rate $1.72 = ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬1 a year later, he can then turn his ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬10,950,000 into $18,834,000. This is the total gain of $3,834,000 (25.56 percent). Selling the future British amount at the available rate of $1.72 = ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬1 is an example of hedging. (Clark Ghosh, 2004). Speculation is the opposite of hedging; it involves trading in established markets on the basis of informed judgments about how market prices will change. A speculator has the intention of making a profit from favourable exchange rate movements but could lose if exchange rate move the other way. Speculation is a form of short term investment activities. Foreign exchange speculators buy currencies with the intention of re-selling them at a profit in the near future, or sell currencies with the intention of buying them back at a profit. Large returns can be made on a fairly small investment within a short period of time (lane Kent, 2000). There are the two different derivative markets where the different financial instrument buying and selling take place to manage the foreign exchange currencies that is Over-the-counter (OTC) and Exchange-traded-derivatives. Over the counter (OTC) derivatives are contracts takes place when there are two person, without going through any exchange market or any mediator. It means if two party is there, they want buy and sell they can do the trade anywhere in this market. The Products of the ETD market such as forward rate agreements, swaps and exotic options are always traded in this derivative market. The size of the OTC derivative market is bigger market ETD market. This market is highly unstandardized and unregulated. The price of the derivative product is not flash in this market; price of the derivative product depends on negotiation. The OTC market is made for that person who does not want to take a risk or want to earn some profit from the foreign exchange market. This market is private trading so reporting this OTC amounts are difficult. Under this market derivative price wont be visible in the OTC derivative market. The OTC market is the primary platform for the trading of interest rate and fore ign exchange derivatives (Spence, 1999). The most widely traded OTC foreign exchange derivatives are foreign exchange swaps, and lesser extent, currency forwards, while currency swaps and options are rarely traded (Iorgova Ong, 2008). Exchange traded derivatives are characterized by standard contract terms, meaning that all participants trade the same underlying instruments. This helps to generate a greater critical mass of liquidity, leading to tighter bid offer spreads and more cost -effective risk management solutions. The worlds most liquid-listed contracts reference various important financial indicators, such as short-term and long-term interest rates, exchange rates, equity indexes and select commodities. ETD is derivative products in which are traded via specialized derivatives exchanges. This derivative market price is publically visible that is why speculator cannot earn abnormal profit. The example of this market product is future and options on futures contract (Banks, 2004). Dealing on the foreign exchange Market There are some of the important types of transactions which is conducted in the foreign exchange market are given below. Spot and forward Exchanges The term spot exchange refers to the category of exchange dealing which needs the exchange of currencies on the spot or immediate delivery. In practically most of the settlement delivery takes place 2 days in markets. The rate of exchange effective for the spot dealing is thought because the spot rate and also the marketplace for such transactions is known because the spot market. The agreement between two parties is generally called forward transaction. It is requiring the delivery at some specific future date of a specified amount of foreign currency one of the parties and the other party will pay in domestic currency, at the price agreed upon the contract time. The exchange rate which is quoted in forward contract that is called forward exchange rate and the market where the forward contract take place that is called forward market. Forward exchange services, obviously, are of immense help to importers and exporter. They can imitate the risks which are arising out of exchange rate fluctuations by taking into a suitable forward exchange contract. Forward Exchange Rate Forward exchange rate has a relationship with the forward rate; the spot rate might be at premium, discount and par. At Par: if the forward exchange rate price is exactly same to spot rate at the making of the contract that forward exchange rate is called to be a par. At Premium: If the forward rate for the currency is more than spot rate, is said to be the premium. It means this forward exchange contract was issued in premium for example you buy forward exchange contract in 2 dollar but the spot price is 1.5 dollar so 0.5 is the premium. At Discount: When the forward rate for a currency buys less than the spot rate that is called discount with spot rate. The discount is usually expressed in a percentage from the spot rate on a per annual basis. There are the different factor effect the forward exchange rate such as demand and supply for the currency, macroeconomics factor et but mostly demand and supply of the currency effect the price changes in currencies. If the demand is high on that particular date then the forward rate issued in premium, if the demand is low that particular date then issue in discount and if the speculator thinks that there is no changes then they will issue the forward in par. Futures The contract which has standardised features, the contract maturity dates is standardised. This contract can be traded in exchange traded derivatives (ETD) market only. This contract price is publically visible so speculator cannot earn abnormal profit. If you want to do this contract you need to pay deposit some margin amount to the counter. Option The option contract is the form of financial instrument that gives the contract holder right but not full obligation. This contract has certain kind of facility like after the maturity period of time if you want exercise this contract you can. I you dont then you can terminate the contract so in this contract investor has an option where should continue this contract or not. According to their exercise features, there are two kinds of options with different maturity period. One is A European option this can be exercised only after the maturity period and another one is an American option can be take place for trading at any time during the contract.( (Cherunilam, 2011). Swap The meaning of Swap is the form of derivative which shows the facilities to buy the curries and other side you can sell that contract to other person. Commercial banks  who  conduct forward exchange business  might  resort to a swap operation  to regulate  their fund position. The term swap  means that  concurrent  sale of spot currency for the forward purchase of  an equivalent currency or  the purchase  of spot for the forward sale of  an equivalent  currency. The spot is swapped against forward. Operations consisting of a  concurrent  sale or purchase of spot currency  in the middle of  a purchase  or sale, respectively, of  an equivalent  currency for forward delivery,  are  technically  referred to as  swaps or double deals, because the  spot currency is swapped against forward. (Cherunilam, 2011).