Every investment involves taking risks to garner returns. A good understanding of the market’s structure and the products involved are key to understanding the costs and tradeoffs one must take on. Forex transactions and trading are no exception, and managing the risk involved is key to protecting one’s capital and increasing the likelihood of returns in the long run.
What is Forex?
Foreign exchange (forex) entails the conversion of one country’s currency into another country’s currency. This happens for a variety of reasons ranging from commercial to governmental.
What is the Foreign Exchange market?
The foreign exchange (forex) market is essentially a market that facilitates the exchange of currencies.
Commercial entities like businesses and individuals need foreign currency for business or travel purposes and tend to source different foreign currencies from commercial banks.
Commercial banks then facilitate the flow and supply of currencies to meet the demands of their individual and corporate clients by trading in the interbank market with other banks and liquidity providers.
National central banks, whose foreign exchange activities involve the buying and selling of the home currency or foreign currencies to ensure that exchange rates move in line with established targets set by respective governments, are also key players in the market.
Besides day to day uses, forex is also traded by traders and investors, with brokerage platforms facilitating these transactions between individuals and other counterparties.
The four main types of transactions undertaken in forex markets are:
- Spot transactions
- Forward deals
- Futures transactions
- Currency options
Forex exchange rate systems adopted by countries
There are three major types of exchange rate systems adopted by central banks to manage their countries’ domestic currencies:
- Floating exchange rate: For economies adopting this In this exchange rate system, the domestic currency’s exchange rate is determined by forces of demand and supply of dissimilar currencies in the forex market, and the currency’s fluctuation is left to market forces.
As such, the exchange rate is essentially determined by the market through interactions of thousands of banks, firms and other institutions aiming to buy and sell currency to make transactions in foreign exchange.
- Managed floating rate: In this exchange rate system, the forces of demand and supply are still the primary factors driving the exchange rate, but central banks influence the exchange rate through intervention in the forex market to restrict the fluctuations in the exchange rate within specified limits.
For such systems, central banks need to maintain reserves of foreign exchange in order to participate in the market and ensure that the exchange rate stays within the desired target range.
- Fixed exchange rate: This system entails governments determining the exchange rate for a specified period of time, based on the value of another country’s currency like the US dollar.
The principal reason for adopting such a system is to ensure stability in foreign trade and capital movements. To achieve this, the governments of countries following this exchange rate system have to sustain large reserves of different foreign currencies to maintain the exchange rate at the level fixed by it.
What is foreign exchange risk?
For the most part, foreign exchange risk involves exposure to the potential impact of movements in foreign exchange rates. A majority of forex risk comes from adverse fluctuations in exchange rates that manifest when a financial transaction is denominated in a currency other than that of the base currency.
As such, the exchange risk appears when there is a risk of appreciation of the base currency in correspondence to the denominated currency, or depreciation of the denominated currency in correspondence to the base currency.
Types of Forex risks
Generally, there are three key types of foreign exchange risk:
Transaction risk arises when a transaction is made, as its name suggests. When this happens, the delay between the agreement and settlement exposes the parties to different prices as the value of the currencies involved could differ at different points in time. Forex transactions are especially sensitive due to the high volatility involved.
Also known as operating risk, this forex risk type reflects the uncertainty of a financial firm’s forecasted value of future operating cash flows from exchange rate movements. Macroeconomic factors such as governmental policies and foreign regulations are difficult to account for at the initial reference point with exposure increasing over time.
Translation risk occurs when foreign subsidiaries under a group or parent company have their performances denoted in the local currency, excluding the exposure that comes from the foreign currencies involved. This increases the greater the proportion of assets held in foreign currencies.
Effective forex risk management strategies
Generally speaking, forex risk is typically managed in two ways:
- Using tools and mechanisms like netting, hedging, matching, etc.
- Using contractual means like forwarding contracts, futures, options to insure against potential exchange losses.
Hedging is an internal technique used by financial firms and organisations. Hedging principally entails a bit of speculation and intelligent work at the beginning of any foreign exchange transaction to ensure that at least there is no loss incurred, especially if there are no profits earned.
In practice, hedging gives the forex traders the opportunity to ‘hedge off’ even future and forward contracts as per the contract entered into on a specific date. Additionally, aside from savings on managerial costs pertaining to managing price volatility, hedging substantially reduces the distress in the event that adverse circumstances arise.
As such, forex hedging is often used by banks to enter into contracts without letting the fear of fluctuating foreign exchange rates tamper with their trading operations.
For businesses, tactical or strategic hedging is usually employed to mitigate transaction risk, to preserve cash flows and earnings, depending on the financial firm’s treasury view on the future movements of the currencies involved.
In practice, tactical hedging is utilised to hedge transaction currency risk relating to short-term receivable and payable transactions, while strategic hedging is employed for long-term transactions.
However, some organisations also employ passive hedging, which entails the maintenance of the same hedging structure and execution over regular hedging periods, irrespective of currency expectations.
Generally, choosing an appropriate hedging strategy is an important task because of the complexities involved in accurately measuring current risk exposure and determining the appropriate degree of risk exposure that should be covered.
Best practices for foreign exchange rate risk management
How can firms effectively handle risk in forex trading?
- Create an independent centralised entity in a firm’s treasury to deal with the practical elements of the execution of foreign exchange rate hedging. This entity should be responsible for forex rate forecasting, the hedging approach mechanisms, the accounting procedures that relate to forex risk, costs of currency hedging, and the establishment of benchmarks to measure the performance of currency hedging.
- Develop an effective exchange rate risk management strategy to deal with the firm’s risk exposure. Particularly, this strategy should specify a firm’s currency hedging objectives, for example, whether and why a firm should fully or partially hedge its currency exposures.
- Develop a tailored set of controls to monitor a firm’s exchange rate risk to ensure appropriate position-taking. This entails setting position limits for each hedging instrument through mark-to-market valuations of all currency positions daily (or intraday), and establishing currency hedging benchmarks for periodic monitoring of hedging performance (typically monthly).
How can individual traders effectively handle risk in forex trading?
- Be aware of the amount of capital you are willing to put at risk while trading. This amount should be a specific proportion of your capital under management based on your risk management and not all of it.
- Whenever you enter a trade, set it and forget it. Try to avoid continuously meddling with the trade. Eventually, the market will hit one of the two or three levels you set. In some instances, you may hit your profit target, or it might hit stop loss. Either way, these are scenarios that you have planned out for and should be comfortable with. Even if you have sustained a loss, trust your strategy and move on to the next trade.
- Ensure to always utilise a stop loss when you open a trade. However, do not make it too tight as the position may get closed out prematurely. Similarly, do not place it too far away as well, as this could reduce the risk-reward ratio of your trades. Where you place your stop loss depends on the type of strategy that you are utilising.
- Set a risk-reward ratio. This is so that you can understand how much you are risking in relation to how much you are expecting to profit from the trade. Though risk-reward ratios will differ from strategy to strategy, do stick to your risk-reward ratio as it is also part of your trading plan.
- Manage your emotions carefully. No matter what, you should always try to avoid letting your emotions meddle with your trading. Over time, you will be able to build up the discipline and mental resilience to stick to your strategy even in times when the markets swing against your favour.
- Always keep a keen eye on news and events. This news and events are movers and shakers in the forex markets, and you should keep an eye on your open positions when such events take place. Do note that the market can swing wildly during such periods, and you should make appropriate adjustments if necessary to avoid being whipsawed out of your trade.
In summary, risks and their management are inseparably associated with all forms of financial activity and no trade can ever be fully characterised as risk-free or “safe”. When dealing with forex transactions and investments, it is imperative to recall the risks involved and keep risk exposure on par with your risk appetite through mitigation of the factors involved with diligent preparation and constant vigilance.
Also read our article on “What Is Forex Trading: A Complete Guide”
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