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Risk management when dealing with foreign exchange (forex)

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  1. Introduction
  2. What is risk management?
    1. How to manage risks?
  3. Introduction to foreign exchange
    1. A brief history of foreign exchange
    2. Fixed and floating exchange rates
  4. Exchange rate systems in various countries
  5. Overview of foreign exchage market
    1. Need and importance of foreign exchange market
    2. Consolidation & fragmentation of foreign exchange market
    3. Advantages and disadvantages of foreign exchange market
  6. The role of global economy in foreign exchange market
  7. The four levels of participants in the foreign exchange market
  8. Methods of quoting exchage rates
  9. Foreign exchange market vs other markets
  10. Five foreign exchange risks
  11. Key terms in foreign currency exposure
  12. Foreign exchange risk management strategies
  13. What is spot exchange market?
  14. What is forward exchange market?
  15. A study on currency futures
  16. Differences between forward contracts & future contracts
  17. A study on currency swaps
  18. Interview with Mr.Sanjay Podar, Forex Dept. Standard Chartered
  19. Conclusion
  20. Bibliography

Risk can be explained as an uncertainty and is usually associated with the unpredictability of an investment performance. All investments are subject to risk, but some have a greater degree of risk than others. Risk is often viewed as the potential for an investment to decrease in value. Though quantitative analysis plays a significant role, experience, market knowledge and judgment play a key role in proper risk management. As complexity of financial products increase, so do the sophistication of the risk manager's tools. We understand risk as a potential future loss. When we take an insurance cover, what we are hedging is the uncertainty associated with the future events. Financial risk can be easily stated as the potential for future cash flows (returns) to deviate from expected cash flows (returns).There are various factors that give raise to this risk. Return is measured as Wealth at T+1- Wealth at T divided by Wealth at T. Mathematically it can be denoted as (WT+1-WT)/WT. Every aspect of management impacting profitability and therefore cash flow or return, is a source of risk. Financial risk management Risk management is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management. This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of creating, or enhancing, firm value. All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.

[...] It is important for treasury personnel to know what benchmarks they are aiming for and it's important for senior management or the board to be confident that the risk of the business are being managed consistently and in accordance with overall corporate strategy Scenario Planning Making Rational Decisions The recognition of the financial risks associated with foreign exchange mean some decision needs to be made. The key to any good management is a rational approach to decision making. The most desirable method of management is the pre-planning of responses to movements in what are generally volatile markets so that emotions are dispensed with and previous careful planning is relied upon. [...]

[...] Examples are illustrations of bullish and bearish put spreads respectively Covering Exchange Risk with Options A currency option enables an enterprise to secure a desired exchange rate while retaining the possibility of benefiting from a favorable evolution of exchange rate. Effective exchange rate guaranteed through the use of options is a certain minimum rate for exporters and a certain maximum rate for importers. Exchange rates can be more profitable in case of their favorable evolution. Apart from covering exchange rate risk, Options are also used for speculation on the currency market Covering Receivables Denominated in Foreign Currency In order to cover receivables, generated from exports and denominated in foreign currency, the enterprise may buy put option as illustrated in Examples Example: The exporter Vikrayee knows that he would receive US $ 5,00,000 in three months. [...]

[...] The foreign exchange regulations of various countries, generally, regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions. Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract Forward Exchange Rate With reference to its relationship with the spot rate, the forward rate may be at par, discount or premium. [...]

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