Foreign Exchange (Market, Operations, Risk Management)

What is the foreign exchange market?

  • Allows market participants to exchange one currency for another
  • The relative amounts of the two currencies is determined by the foreign exchange rate
  • Largest single market in the world

Why does the foreign exchange market exist?

  • Trade and investment
  • Speculation
  • Hedging

Where are the foreign exchange markets?

  • Foreign exchange is traded over the counter, 24 hours
  • Derivatives for foreign exchange are traded on exchanges
  • London is the world’s largest foreign exchange trading center

What factors affect foreign exchange rates?

Economic factors

  • Relative interest rates
  • Purchasing power parity
  • Economic conditions
  • Supply and demand for capital

Political factors

  • Government policies
  • Political situation
  • Central bank policies
  • Central bank intervention

Market sentiments

  • Positive sentiments
  • Negative sentiments

Technical analysis

  • Highlights trends in the market based on historical data

Methods of FX Interventions

Forward Market Intervention

  • Buys or sells currency in the forward market
  • Does not require immediate sale
  • Postphone the delivery of the purchase or sale
  • Spot market intervention takes time to take effect
  • Forward market is smaller than the spot market (greater impact with similar volume)

Spot Market Intervention

  • Most direct and immediate
  • Affects money supply if not sterilized

Effective FX Risk Management

Conservative

  • Defensive in nature
  • Hedge everything

Aggressive

  • Pro-active and aimed at generating trading profits
  • Stop lost strategy
  • Take Profit strategy

Foreign Exchange Risk

Exposure Risks

  • Vulnerability of institutions to changes in its profits and loss (shareholder’s wealth)

Transaction exposure risk

  • Commitment of receivables and payables in foreign currencies

Translation exposure risk

  • Assets and liabilities denominated in foreign currencies

Economic exposure risk

  • Change in exchange rates that effects long term competitiveness

Trading exposure risk

  • Speculating

Counterparty Risk

  • Risk that one of the counterparties to a FX deal fails to honor the contract

Settlement risk

  • Occurs when one of the counterparties default on the delivery date

Pre-settlement risk

  • Occurs when one of the counterparties default on an outstanding FX contract before the delivery date

Corporate Currency Risk Management Strategies

  1. Avoid all exposure
  2. Internal hedging
  3. External hedging

Internal Hedging Techniques

  1. FX Risk Shifting (billing)
  2. Netting of Receivables and Payables
  3. Cross currency monitoring (currency correlation)
  4. Centralized invoicing
  5. Decentralized invoicing
  6. Matching assets and liabilities
  7. Switching currency base
  8. Assets/liabilities adjust (all assets in strong currencies/all liabilities in weak currencies)
  9. Leading and lagging

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