What are the risks for the operations in foreign exchange market?

 The operations in Foreign exchange markets are exposed to number of risks. Here in this guide, we are going to discuss the operations in foreign exchange markets which are exposed to number of risks. But before understanding the types of risks for the operation in foreign exchange market, first one should understand what are the operations in foreign exchange market.

The foreign exchange operations include buying and selling of different currencies against euro. The operations in foreign exchange market include the foreign exchange interventions, and other operations like sale of interests which are derived from commercial transaction and the foreign reserve assets.

The foreign exchange interventions includes the unilateral or the concerted actions, and centralized or decentralized actions.

Concerted or Unilateral action

In the case when any general guidelines or the formal agreements are absent, in that case, the euro systems will decides where the conduction of the foreign exchange intervention is necessary.

The euro system is allowed either to conduct such of the foreign exchange intervention on its own which is unilateral action or as the part of the coordinated intervention which also involves other central back as well which is known as concerted actions.

Centralized or decentralized action

In the centralized manners, the ECB will carry out the interventions while in the decentralized manners, the NCB on the behalf of ECB will carry out the interventions.

What are the risks for the operations in the foreign exchange market?

The foreign exchange risk exposure can be classified in three broad categories. And, these are:

  1. Transaction exposure
  2. Translation exposure
  3. Economic exposure

Transaction exposure

The transaction exposure risk on the operations in the foreign exchange market can be defines as the exchange rate on the outstanding obligations that existed before exchange rates changed but were settled after the exchange rates changes. This is the result why it deals with cash flow that is generated from the existing contractual obligations.

For example, In the case when any Indian exporter has a receivable of $10,000 due in six months. And, in the case when the value of the dollar depreciates relatively to the rupee, the exporter will need to face the cash loss. While in contrast the exporter can also exjoy benefit in the case when the value of the dollar appreciates in relative to the rupee.

With the above example, we can understand that wherever the company has firm foreign currency denominated receivable or payables, the company is subject to the transaction exposure and their settlements will directly impact on the cahsflow position of the company.

The transaction exposure measures the changes in the value of the outstanding financial obligation which are incurred prior to the changes in the exchange rates but due to be settles until after the change in the exchange rates. This is wy it deasl with the change in the cash flow which is arised from the existing contractual obligations.   

The transaction exposure is one of the most common kind among all the exposures. Another example explaining the transaction exposure in the company that exports to US, and the export receivables are also denominated in USD. While doing the budgeting, the company has assumed USDINR rate of 62 per USD. But by the time of the exchange, inward remittance arrives. USDINR can either move down to 57 which will ead to the wiping off the commercial profit for the exporter or can rise leading to the increase in the profit of the exposure as well.   

 These kind of transaction exposure can occur in the case when the firm is having foreign currency denominated receipts or payments.

Translation exposure

Another name for this exposure is Translation exposure. This kind of exposure refers to the gain or the losses which are caused by the translation of the foreign currencies assets and liabilities into the currency of the parent company for consolidation purposes.

The accounting exposure or we can say the translation exposure is significant for the accounting derived changes in the equity of the owner to occur because of the need for the translation of the foreign currency financial statement of foreign subsidiaries into a single reporting currency to prepare a worldwide consolidated financial statement.

The risk of the translation exposure arises because of the need for the translation of the foreign currency asset and liabilities into the home currency for the purpose of the finalization of the accounts for an given period. The best example to understand the translation exposure is the treatment of the foreign currency loan.

For example, consider a company who has taken a medium term loan in order to finance the import of the capital goods which worth 1 million dollars. And in the case when the import materialized, the exchange rates tat time was USD/ INR – 55. The imported asset was therefore capitalized that time in the books of the company at the rate of 550 lacs rs through the following accounting entry:

Debit Fixed  assets – 550 lacs Rs

Credit dollar loan – 550 lacs rs.

In the ordinary case where it is assumed that there is no change in the exchange rates, the company will have the provided depreciation on the asset valued at Rs 550 lacks for finalizing the account for the year in which the asset was purchased.  

But in the case, if the exchange rates at the time of finalization f theaccounts moved to USD/ INR – 58, now the dollar rate need to be translated at Rs 58which will lead to the translation loss of 30 lacs RS. This is translation loss which will reduce the profit of the company.

Economic exposure

This can be defined as the decline in the economic value of the company because of the change in the exchange rates.

The bottom line

So these are some risk that the Operations in foreign exchange market are exposed to!