The paper 'The Risk Management of the Foreign Exchange within the Financial Industry and Institutions ' is a great example of a Management Literature Review. Foreign exchange risk refers to the exposure of a financial institution to the adverse movements in foreign exchange rates. This risk has it that adverse changes in exchange and rates may result in loss of money and profitability to the financial institutions engaged in foreign exchange transactions. Foreign exchange risks are caused by two main factors: mismatches in a financial institution’ s liabilities and assets that are not subject to fixed exchange rates and mismatches in currency cash flow (Horcher, 2011).
Further, the risks arise from different sources such as retail cash transactions, investment in foreign companies, investments denominated in foreign currencies, and foreign currency retail accounts. In developed economies such as Britain, the amount of risk available in the financial service industry are a function of the magnitude of possible exchange rate changes and the duration as well as the size of foreign currency exposure. Foreign Exchange Risk Management Practices Management of foreign exchange risks forms a fundamental component of the sound and safe management of all financial institutions that have exposure to foreign currencies (Kavaliova, 2007).
The practice of risk management in these financial institutions involves prudent monitoring of foreign currency positions in order to control the impact of exchange rate changes of the financial institutions. The direction and frequency of exchange rate changes and the extent of foreign currency exposure, as well as, the ability of institutions to honor their financial obligations is a significant consideration in the management of foreign exchange rate risks (Lakshman, 2009).
Although the particulars of foreign exchange risk will generally differ among individual financial institutions depending on the complexity and nature of their involvement in foreign exchange activities, adequate management of foreign risk management requires: Establishment and implementation of sound risk management policies. Well articulated policies setting the principles and objectives of risk management strategies and the limits within which the strategies should be applied. Development of appropriate and cost-effective risk control procedures. According to Horcher, (2011) it is necessary for financial institutions to decide the objectives of foreign exchange risk management and their willingness to assume the risk before implementing risk management programs.
This is because the level of tolerance of an institution to assume foreign exchange risks will generally vary with the extent of other risks such as credit risks, liquidity risks, investment risks, and interest rate risks (Malz, 2011). As is the case with other aspects of financial management, a clear trade-off exists between risk and return as regards the management of foreign exchange risks. Accordingly, the principal objectives of foreign exchange risk do not necessarily have to be focused on the complete elimination of adverse exposure to changes in exchange rates.
Instead, it should be to reasonably manage the potential adverse impact of exchange rate changes within an institution’ s self-imposed limits after a careful evaluation of a range of possible parameters (McGuigan, 2010). Horcher (2011) has explained in his book that financial institutions need to establish prudent and reasonable foreign exchange rate limits, which ensure that the level of exposure to foreign exchange rate risks does not exceed the set limits. Where possible, the limits should at a minimum cover the currencies to which an institution can incur exposure and the level of risk exposure that the institution can reasonably assume.
Nidhi (2007) concurs with this argument and states that foreign exchange risk limits should be set in accordance with individual institution’ s overall risk profiles as reflected by such factors as credit quality, capital adequacy, and investment and interest rate risks. Therefore, foreign exchange rate risk should be managed within an individual financial institution’ s ability to quickly recover its financial positions if necessary. In addition, potential foreign exchange risks should be assessed regularly to identify potential changes in interest rate volatility and the institutions’ risk management philosophy.
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