IntroductionA forex market is an electronically connected network of foreign money brokers, banks and dealers where trading involves use of phones, Society for Worldwide Interbank Financial Telecommunications network or telex. The market mainly involves transfers of buying power denominated in certain currency to another. Foreign exchange risk is the exposure of an organization to impacts of variations in foreign exchange rates. Since the abolition of the initial fixed rate system, the now used floating rates system means the price of buying and selling currencies is dictated by the available supply and demand of money in the market.
The risk being the unfavorable fluctuation of exchange rates consequences to losses in terms of money (Popov & Stutzmann, 2003). The risks in a foreign exchange institution crops up from two main factors namely; the mismatches in currency cash flow, and mismatches in organizations assets and liabilities which are not subjected to a fixed rate of exchange. This kind of risk may result from areas such as foreign exchange retail accounts, retail cash transactions, foreign exchange trading, foreign currencies denominated investments and ventures in foreign companies.
The quantity at risk is attributed to the magnitude of change, size duration of exposure of foreign currency. Despite the engaged prevention techniques, probable threats that may arise inside or outside the organization must be assessed to ensure survival of the business. This paper explores the objectives of risk analysis and the main techniques used in risk analysis in foreign exchange business (Chen, 2009). Objectives of risk analysis Risk analysis can be referred to as a process involving the identification of the most probable threats to an institution and analyzing the correlated vulnerabilities of the institution to these pressures.
After identifying foreign exchange exposures, the institution ought to clearly know the impact of exchange rate on all facets of it operation. Therefore, objectives sets must reflect management’s indulgence and approach toward exchange rate risks, and must be plainly affirmed in the policy. Objectives in regard to foreign exchange institutions revolves around two categories namely; financial and protection objectives. The financial objectives are further divided into two categories; primary and secondary objectives (BMO Capital Markets, 2012). Financial objectives Primary objectives involve taking all rational steps in to curtail losses arising from consolidated earnings exposure.
Fluctuation in foreign exchange rates shapes cost competitiveness, productivity as well as valuation of an organization`s international functioning. This calls for policies that minimize the effects resulting from adverse exchange rate variations on the company`s financial position. Absence of a policy to handle the same, results to unpreparedness of a corporation to control or handle the unpleasant impacts of currency movements (BMO Capital Markets, 2012). Secondary objectives: A major secondary objective for risk analysis is the need to finance the universal operations at the lowest after-tax cost.
As such, a foreign exchange institution ought to responsibly make sure that whichever action engaged to lessen exposure is economically acceptable on an after-tax basis. Moreover, the objective of risk analysis in foreign exchange business aims to make the most of the US dollar profits from international operations. Most currencies are quoted against the US dollar. Therefore, working out the cross rates for other currencies other than the dollar in an efficient way is necessary. This is vital as quoting currencies in terms higher than the one base currency, will probably cause inconsistent quotes from different quotes (Popov & Stutzmann, 2003).