Economics of Foreign Exchange - Example

Running Header: Risk analysis Name of the Student: Name of the Instructor: Name of the course: Code of the course: Submission date: Introduction Foreign transactions are characterized by uncertainties due to changes in exchange and interest rates. Moreover, these transactions depend on events in the host country which include political conditions, economic, social and financial factors. According to Wang (2009), it is revealed that as firms engage in international operations and transactions they encounter increased risk associated with different languages, laws and currencies. However, currency risk presents the biggest threat in relation to foreign exchange transactions. This is because it affects the value of transactions as well as those of the cash flows. Therefore, evaluating and managing foreign exchange risk is of paramount importance in order to avoid adverse effects that may occur due to changes in exchange rates. This paper is going to explain the objectives of risk analysis as well as the techniques used in analyzing risk. Objectives of Risk Analysis According to Ramirez (2011), the objective of risk analysis in foreign transactions is to safeguard individuals and firms against adverse losses that may occur as a result of fluctuations in exchange rates. Risk analysis enables analysts to identify the amount of risk that a firm may be exposed to in relation to foreign transactions. This assists in identifying strategies for reducing the risks hence mitigate the losses. Popov and Stutzmann (2006) affirm that the main objective of risk analysis is to minimize and eliminate the losses that may occur as a result of foreign transactions. Foreign transactions are exposed to threats related to unexpected variability in exchange rates. Thus, through risk analysis foreign exchange analysts are able to assess the risks underlying foreign exchange transactions hence identify methods of overcoming the losses that may occur (Brimble at el, 2011). CPA Australia (2011) notes that risk analysis provides an opportunity through which analysts can identify a no loss position whereby firms can engage in foreign transactions profitably. The evaluation process helps foreign transactions analysts to identify risk management strategies hence reduce the losses that may occur as a result of the transactions. Risk analysis assists individuals and firms in making decisions regarding foreign transactions (Yoe, 2011). Successful foreign exchange transactions are determined by the ability of firms to make decisions that reduce the uncertainties presented by the risks. Foreign exchange analysts provide firms and individuals with necessary information regarding the risks that they may face in their international operations. This assists them in making decisions that can enable them evade adverse effects that may be presented by the risks. According to Eurasian Group (2010), risk analysis provides information to international firms regarding the magnitude of the risk associated with different foreign exchange transactions. This makes it easy for them to make their decisions regarding the foreign transactions to undertake and those to avoid based on the amount of risk identified. Risk analysis plays an important role in facilitating firms to make suitable decisions regarding foreign transactions hence this enables them to meet their objectives (Brimble at el, 2011). Popov and Stutzmann (2006) assert that through risk analysis foreign exchange analysts are able to provide information regarding the risk associated with different transactions. The information assists the firms in making effective decisions in regard to foreign exchange transactions. According to Yoe (2011), the objective of risk analysis is to assist firms to maximize their returns in relation to foreign exchange transactions. Risk analysis provides an opportunity through which firms can identify transactions with low risks hence enable them to maximize their returns (Brimble at el, 2011). Cowan (2010) emphasizes that risk analysis in foreign transactions assists firms to identify the constraints that may impair their profitability and performance. By identifying the risk, uncertainty is reduced and this helps in maximizing returns. Foreign transactions analysts provide managers with relevant values and opinions regarding the risks that their firms may face while conducting their operations. They gather information and data that allows them to make their opinions about the risks exposed to the multinationals. This in turn assists managers to identify opportunities whereby they can maximize returns and to avoid transactions that create losses (Price water Coopers, 2008). Loosemore at el (2012) states that risk analysis is important as it assists firms to put controls in place in order to maximize returns and minimize potential risks. In addition, it enables managers to evaluate the effectiveness of those controls so as to ensure that the firms achieve their foreign exchange objectives. Risk analysis provides an opportunity for avoiding risk and identifying prospects for maximizing returns in foreign transactions. Therefore, the objective of risk analysis is to assist firms to maximize their returns by avoiding foreign transactions create uncertainties. Techniques used in Risk Analysis Sensitivity analysis can be used in order to determine exchange and interest rate risk in foreign exchange transactions. Loosemore at el (2012) affirms that foreign exchange risk analysis is measured using sensitivity analysis. This method provides a means of determining the impact of foreign currency fluctuations on net position of a firm. According to Wang (2009), sensitivity analysis provides information regarding the interdependence between interest rates and exchange rates and this assists in managing foreign exchange risk. This method involves conducting an analysis for each type of risk the firm is exposed to and determining how profits can be affected by changes in exchange rates. Yucel and Kurt (2010) note that sensitivity analysis assists firms to determine their economic exposure in respect to exchange rate movements. This technique indicates the potential loss in future earnings, cash flows and fair values that a multinational may face due to changes in foreign currency exchange rates. It also indicates the transactions that may be at a risk of declining in value due as a result of fluctuations in exchange rates. The most widely used technique for analyzing risk in foreign exchange transactions is sensitivity analysis (Cowan, 2010). The advantage of sensitivity analysis is that it provides a means through which multinationals can identify transactions that are most sensitive to changes in exchange rates. This assists them to identify strategies for reducing the potential losses that may occur. According to Yoe (2011), value at risk approach is another technique that can be used to asses risk associated with foreign transactions. The method provides information regarding the risk associated with assets owned by multinationals. It measures the impact of foreign exchange fluctuations on the portfolio value of a multinational. Value at risk is calculated by multiplying exchange rate volatilities by a constant value which is determined by a given confidence level. This enables a firm to measure losses that may occur due to changes in exchange rates hence identify means of minimizing the adverse occurrences. Yucel and Kurt (2010) affirm that value at risk represents a measure in regard to the inherent risk in a portfolio of financial instruments that a multinational may possess. The method provides information concerning the maximum expected loss that a firm can incur in a given foreign transaction over a given time horizon and within a given confidence interval. Foreign currency risk can also be measured using a table of projected foreign cash flows analysis. According to CPA Australia (2011) table of projected foreign currency cash flows enables multinationals to measure the net deficit or surplus from foreign transactions. This is done by projecting foreign currency cash flows. The table also assists international firms to determine the timing of currency inflows. Loosemore at el (2012) asserts that projected cash flows technique helps the management of international firms to assess the foreign currency risk their organization maybe exposed to. It enables firms to establish a net cash position that is needed in order to conduct foreign transactions successfully. This is done by identifying the tracks of cash outflows and inflows. Maintaining a register of foreign currency exposures can assist in analyzing risk involved in foreign transactions. According to CPA Australia (2011), this is the simplest method for assessing foreign exchange risk. The method requires firms to maintain a register of the exposures associated with foreign exchange transactions. The firms maintain records that describe strategies of overcoming each risk associated with a given transaction. Therefore, this technique enables firms to identify the type of risks that they may be exposed to in regard to previous records. Yoe (2011) asserts that maintaining a register of foreign currency exposures provides firms with an easy way of determining the type of risk that they may be facing while conducting foreign transactions. This enables them to respond to the risks with ease. Conclusions The aim of risk analysis in foreign exchange transactions is to assist firms to maximize their returns and to reduce losses that may occur due to fluctuations in exchange rates. In addition, risk analysis is focused towards assisting managers to make decisions regarding their foreign exchange operations. Firms can use either sensitivity analysis, table of projected foreign cash flows analysis and value at risk approach in order to analyze foreign exchange risk. Furthermore, maintaining a register of foreign currency exposures can assist in analyzing risk involved in foreign transactions. The register provides a convenient way through which firms can analyze the potential foreign exchange risk that they may be facing. References Brimble, M., Basu, A., Lenten, L., Thompson, D., Kidwell, D., Blackwell, D., Whidbee, D., & Peterson, R.(2011). Financial Markets Institutions & Money (2nd ed). Melbourne: John Wiley & Sons Australia, Ltd. Cowan, N .(2010). Risk Analysis and Evaluation. London: IFS. CPA Australia. (2011). Guide to Managing Foreign Exchange Risk. Melbourne: CPA Austraria Ltd. Eurasian group. (2010). Risk in Foreign Trade. Risk and Analysis, 6(1), 1-28. Loosemore, M., Raftery, G., Reilly, C., & Higgon, D .(2012). Risk Management. London: Taylor & Francis. Popov, V., Stutzmann, Y.(2006). How is Foreign Exchange Risk Managed? Banking and Finance, 1-40. Price Water House Coopers.(2008). A Practical Guide to Risk Assessment. Connected Thinking, 1-40. Ramirez, J.(2011). Advanced Hedging. Hoboken: John Wiley & Sons. Wang, P.(2009). Economics of Foreign Exchange. London: Springer. Wang, P.(2009). The Economics of Foreign Exchange. London: Springer. Yoe, C.(2011). Principles of Risk Analysis. London: Taylor & Francis. Yucel, T., & Kurt, G.(2010). Foreign Exchange Rate Sensitivity. Journal of Economic Studies, 4(1), 1-11. Read More