Foreign exchange risk is the possibility of adverse movement in foreign exchange rate which may results in loss.
All countries have their own protocols to manage International business/financial activities. Due to these protocols and mutual agreement between parties, generally there is a time-gap between an "International business/financial activities" and "actual purchase/sale of foreign exchange" in connection with that "International business/financial activities".
Due to increased cross-border transactions foreign exchange rates have become highly volatile and therefore risk on foreign exchange have been increased. Foreign exchange rates are highly volatile and therefore there is always an element of risk on account of adverse movement of exchange rate.
Example
A British firm exports goods when $1 = Euro 0.8500 and when British firm receives payment, exchange rate become
(I) $1 = Euro 0.8000, in this case firm incurrs loss of Euro 0.05/$.
(II) $1 = Euro 0.8500, in this case firm will be in neutral position i.e neither loss nor gain.
(III) $1 = Euro 0.9000, in this case there will be gain of Euro 0.0500/$.
In the given example, we observe that foreign exchange rate movement is not always adverse.
We welcome gain but can't ignore possibility of loss.
To reduce foreign exchange risk, there are some popular techniques of foreign exchange risk management are:-
Forward contract.
Futures.
Option.
Currency swap.
Money Market operation.
Note:- Each technique will be explained in later articles.
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