Foreign Exchange Market

6 Pages   |   1,624 Words

Foreign Exchange Markets

Foreign exchange markets are the markets where different currencies from different countries are traded. It is the world's largest market with least liquidity problems. The volume of trade in foreign exchange market is over 1 trillion USD per day. These markets are not the usual market place of buying and selling of goods, but the transfer of currencies and financial products took place through 'over-the-counter' trading. In this market, one currency is traded for another currency, which determines the value of the currencies as compared to other currencies in the market (GoCurrency.com, n.d.). In this market, similar to other markets, supply and demand determines the value of the currency. A currency with a demand greater than its supply will tend to have an increase in its value thus creating an appreciation. However, an opposite situation happened if supply of a currency is greater than the demand. This situation is termed as the depreciation of the currency. This also determines the strength of the currency. If one currency is cheaper than any other currency, then it is termed as weak currency in comparison to that currency and vice versa. An economy with weaker currency has the advantage in exports because her products would be cheaper thus increasing the export of the country. However, imports of a weak currency are expensive thus putting extra pressure on the fiscal side of the economy. The situation is opposite in case of strong currency with cheap imports and expensive exports.

This is the only market exists on earth which perform 24 hours a day. All dealers and organizations work in their respective time zones. Though, it has made the international transactions extremely efficient and easy, but it has also raised some risks in the foreign exchange market. This risk is termed as settlement risk, which will be discussed later in this essay.
 

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The foreign exchange market is composed of the large number of dealers. These dealers buy and sell foreign currencies and financial products from any place in the world. This market is the best example of "an integrated world economy". Though, every country has its own rules and regulations that govern her financial markets, but still the global financial system manages to perform in tremendous harmony. The chances of arbitrage activity virtually do not exist. The prices of financial products and the exchange rates of different currencies are almost the same in all foreign exchange markets.   
Foreign exchange markets and the trading of currencies play a pivotal role in international investments and trading. Investors, usually companies and banks, buy and sell different currencies in order to meet their requirements of foreign exchange. Moreover, exchange of currencies also happens when commodities and services are produced in a country with a one currency and are sold in another currency (Blue, n.d.).

Foreign Exchange Risks and Role of Foreign Exchange Markets

There are certain risks exist in the foreign exchange market for small local companies. These risks include "market risk, credit risk and liquidity risk" (Cross, 1998).
Market risk consists of exchange rate risk and interest rate risk. An exchange rate is the value of one currency in terms of other currency. In the exchange rate risk, a small company would be exposed to unexpected change of the price of the currency, both local and the desired currency. If the value of one currency drops, depreciation of that currency has occurred, while the other currency experiences the increase in its value, thus it appreciates. This changing of currency value gives rise to the exchange rate risk (Evans, n.d.).
There are two ways; a small local company could avoid exchange rate risk. These ways are "hedging" and "netting".  Hedging is the declining and manipulation of the risk. Small local companies can do hedging by holding futures that are opposite to the commodity or service market. This is done to decrease the risk of price change. If the price of the commodity or service decreases then the futures hold by the company would offset its effects by the increase in the value of the future in the foreign exchange market (Chakrabarty, 2007). It is a process of reverse causality, where the rise of commodities' and services' prices is offset by the decrease in the value of the futures.
Forward contracts can also be used to avoid the unexpected change of the prices. In these contracts, a small local company could fix the price of trading at the time of bargaining. It would help the company in avoiding the unexpected risks on its profit margins. Increase in the price of the commodity or service would negatively impact the "small local company's budget, cash flow and the profits", but decrease in the prices would also cause small company to lose some of its potential profits. This potential profit would be gained through the cost of exchange rate risk that could have long term effects on the company's performance (currencies direct, 2012).
The other way, the small company could avoid the exchange rate risk is netting. In netting, the local company could hold the same value of receivables and payables in its balance sheet. These, foreign currency dominated, payables and receivables would be used to offset each other's effect. If the foreign currency appreciates thus increasing the value of payables, the value of receivables will also increase to offset any losses made by the currency appreciation (Foreign Exchange Risk, n.d.).
Interest rate risk is the risk arise due to changes in the interest rates in different economies thus effecting the both the liability and the asset sides of the balance sheet. Moreover, interest rates are incorporated in the forward exchange rates, therefore, having an impact on the foreign exchange rate. However, the small local company could eliminate this interest rate and exchange rate risk through the use of "interest rate swap". In this method of eliminating the risk, the company could exchange its foreign liabilities with some foreign company. This exchange would help the small local company to avoid the interest rate risks existed due to the difference of interest rates. This method is also termed as a tool of hedging to avoid the exchange rate risks (Foreign Exchange Risk, n.d.).
Besides market risk, mentioned above, the company could also face credit risk, exists in foreign exchange market. This is the risk arise when one party involved in a foreign trade does not meet its obligations. This may be due to unwillingness of the trading partner or may be due to its inability. As small local company is embarking on its first overseas contract, this risk could be very high. There can be many reasons for the existence of this type risk including change in the government policies or event of bankruptcy. Credit risk can be further categorized into settlement risk and sovereign risk.
Settlement risk arises due to the difference in time and location of transecting parties. Trading organizations operate in their own environment, suitable for their economy irrespective of the environment in which other company is operating. The company can reduce and avoid this risk through the use of, one of the efficient hedging tools, netting. Netting, as described above, is the holding of the same value of foreign receivables and payables. As the company is undergoing a transaction with some foreign company, then the risks of time difference and economic liabilities could be reduced by holding receivables or payables. The net impact would be zero and the company's balance sheet would be balanced, thus ensuring a high level of safety against the settlement risk (Cross, 1998).
In addition to settlement risk, sovereign risk can also affect the small company. This risk is the result of government involvement in international trade. Moreover, there can be legal and political issues causing trouble in international trade and financial transactions. A company can reduce sovereign risk by introducing risk premium in its overseas contract. This risk premium should be put into place by initiating a thorough research and monitoring of the economy of its overseas contract (Cross, 1998).
Furthermore, small company could also be exposed to the liquidity risk exists in foreign exchange markets. This risk is caused when one party of the foreign transaction faced liquidity issues. Liquidity issues are the result of selling assets to meet the financial obligations. The local small company could avoid this nature of risk by introducing a liquidity premium in its overseas contract. This premium is similar to risk premium in its operation and execution.

Conclusion

Conclusively, a small local company can be exposed to many different forms of risks, in its first overseas contract. These risks can be market risk including exchange rate risk and interest rate risk, credit risk including settlement risk and sovereign risk, and liquidity risk. However, the company can avoid these risks by using efficient exchange market tools including hedging, netting, interest rate swaps and liquidity premiums. As the company is small, and it is engaging in its first overseas contract, the company has to put flexibility in its engagement. 

Bibliography

Blue, F., n.d. Definition of Foreign Exchange. [Online]
Available at: http://smallbusiness.chron.com/definition-foreign-exchange-13438.html
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Chakrabarty, C., 2007. Rediff. [Online]
Available at: http://www.rediff.com/money/2007/jun/23hedge.htm
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Cross, S. Y., 1998. managing risk in foreign exchange trading. In: The Foreign Exchange Market in the United States. New York: Federal Reserve Bank of New York, pp. 77-84.
currencies direct, 2012. Forward Contracts. [Online]
Available at: http://www.currenciesdirect.com/business/forward-contracts/
[Accessed 11 April 2012].
Evans, M. H., n.d. Foreign Exchange Rate Risk. [Online]
Available at: http://www.exinfm.com/board/foreign_exchange_risk.htm
[Accessed 11 April 2012].
Foreign Exchange Risk, n.d. Foreign Exchange Rate Risk. [Online]
Available at: http://www.exinfm.com/board/foreign_exchange_risk.htm
[Accessed 11 April 2012].
GoCurrency.com, n.d. The Foreign Exchange Market for Beginners. [Online]
Available at: http://www.gocurrency.com/articles/forex-for-beginners.htm
[Accessed 11 April 2012].

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