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You have seen in the newspaper, when India currency's value decrease just 0.50 from US $, it was the first page news. Because there is big effect of foreign exchange risk in all type of business. So, it is very important to understand the meaning and management of forex risk and its management.
Meaning of Foreign Exchange Risk
Foreign exchange risk is the risk of loss of assets or incomes of business due to change in the foreign exchange rate. With changing in foreign exchange rate, there will change in the value of assets and liabilities of any company. Due to this, any company may face big loss in a single day. We can also say foreign exchange risk as currency risk, FX risk or forex risk.
1. A company is working both in India and in USA. It has Rs. 1000 value of asset in India if the value of 1 $ is equal to RS. 65.21, its also means that its asset is $ 15.34 in India but if the value of dollar will become equal to RS. 100, it means now asset's value has decreased and it is only $ 10. So, this is big loss of business due to change in the foreign exchange rate. So, such risk will be called foreign exchange risk or exposure.
2. For example, a student will go to study to USA with RS. 5,00,000 when the currency rate was 1 $ = Rs. 60 but now, USA dollar has appreciate, so the study in USA will become costly for him.
3. If any USA Company sells the goods in Dollar, it will be costly for importers if USA dollar value will increase than Indian currency.
4. If an Indian went to USA for travelling, it will be costly if value of Indian currency will lower than current value of same currency with comparison with USA Dollar.
5. For example, a company's asset in India is Rs. 10 Crores but if Indian currency's value will decrease 50%, value of same company asset will decrease in US market.
Types of Foreign Exchange Risks
There are main 2 types of foreign exchange risks.
1. Operating Risk
If there is the foreign exchange risk which we can not estimate and it will effect our cash flows, then it will be operating forex risk.
2. Currency Translation Risk
If we will show the effect of changing in the forex rate with changing in financial statement, then it will be currency translation risk.
Management of Forex Risk
In the management of forex risk, we include all the techniques and methods which are used to decrease the level of risk and loss due to this risk. We can try to best to control the risk in the management of forex risk.
Methods or Techniques of Forex Risk Management
(A) Internal Methods
1. Flexible Selling Price Method
In this method, company's all product's selling price will be flexible. It will change if there is any change in the currency's value. It will be helpful to cover the loss due to changing in currency value. If currency's value is decreasing, price of product may increase. If currency's value is increasing, price of product will increase.
2. Assets and Liabilities Management
As per this method of controlling the risk of forex, we will start to show our balance sheet in strong currency before happening any risk.
1. Forward Contract of Foreign Currency
This method will decrease the forex risk because two parties will contract to buy or sell the asset in future date on the current currency value.
2. Short Term Loan in Foreign Currency Loan
If local currency value has decreased due to this, there is more liability, for this, company can take loan in foreign currency for short period for payment of such liabilities in local currency.
With option contract, forex risk can be decreased. In option contract, we do not deliver the asset current time, we deliver it in future for exchange of other asset. So, we can come out of current bad situations.
With swap contract, company can better manage its asset and liability in case of forex risk. It can exchange of its one liability with the other liability in international market. Company can also exchange one type of asset with other type of asset in international market.
Reference of Book