Demystifying Risks in FX Markets
Background:
Foreign Exchange (“FX”) as an asset class is a key component of the global financial markets. The size of the FX market is humongous given the level of trading activity witnessed in this market. The interesting part about FX is — it’s a market that is open throughout the trading day. If we take a typical business day, regional markets start trading FX in a sequence of their respective time zones. For instance, on a given day, the FX markets open first in the City of Rising Sun, followed by other key regions including Singapore, Hong Kong, India, EMEA and US in the sequence of their respective time zones. There is a broad variety of market participants who trade FX including: banks, financial institutions, insurance companies, corporations etc.
A well-functioning and a liquid forex market is vital for supporting growth of international trade & finance. Its hard to imagine how countries would buy/sell goods & commodities to each other without the presence of a foreign exchange market.
For the benefit of readers who are not very familiar with the way forex impacts our daily lives, here is a simple illustration. For example, imagine that you are based in India and are browsing through one of the foreign e-retailing websites online, and you really like a pair of sports shoes that are listed with a price denominated in USD. Now you being a buyer based in India, your local currency is INR, and you need to make the purchase denominated in USD. How do you pay in USD when you are holding INR? To support such a foreign currency transaction, banks provide various means including credit cards that permit us to make payments in international currencies. To complete the purchase in USD, the bank allows you to exchange your INR for equivalent USD at today’s spot USDINR exchange rate + bank transaction charge. In this way a buyer based in India can make payments in USD through the FX market. This is a very simple example, which will help in appreciating the relevance of FX market from the point of view of international trade flows, foreign reserves of sovereign governments, banks trading businesses, financial institutions lending etc.
When we talk about any asset we study it from a risk-return standpoint. The FX as an asset class also exposes participants to certain types of risk that we will try to understand.
In this article we will discuss the fundamental types of risks observed in foreign exchange transactions namely:
a. Transaction Risk
b. Translation Risk
c. Economic Risk
But first the basics!
Direct Vs Indirect Quote
To understand the quote convention lets assume the USDCAD currency pair. Imaging on June 20, 2022: USDCAD rate is CAD 1.30 / USD.
The two quote conventions are:
- Direct Quote (i.e., USD equivalent): The direct quote would be USD 0.7692 per one Canadian dollar
- Indirect Quote (Ccy per USD): The indirect quote would be CAD 1.30 per one United States dollar
Bid-Ask spreads
- Bid: It’s the rate at which a Market Maker will buy
- Ask: It’s the rate at which a Market Maker will sell
Spot Rate and Forward Rate
Spot rate is for exchange of currency at the current (present or right now) point of time.
Forward rate is an estimation of what the foreign exchange rate would be at a certain point of time in the future.
Key Products used in FX markets:
a. Outright forward contracts
b. FX Swaps
c. Futures
Risks in foreign exchange transactions
1. Transaction Risk
Transaction Risk arises when there are payables/receivables transactions involved. Lets understand this through simple examples
- Receivables transaction: Consider an Indian software firm that exports products to North America. The firm will be concerned with fluctuations in USDINR FX rates at the time of receipt of USD from their clients in America. They will suffer losses if USD weakens relative to INR when they are about to receive payment from their client.
- Payables transaction: Consider a British textile manufacturing firm that is procuring yarn from Thailand. The firm is expected to make payments in THB to their suppliers based in Thailand. As a result, they are exposed to GBPTHB fluctuation. If THB appreciates then British firm will find it expensive to import the yarn from Thailand.
What’s the most preferred way to hedge Transaction Risk?
Outright forward contracts are frequently used to hedge transaction risk.
Would it make sense to hedge transaction Risk using FX Swaps?
FX swaps may not be the most ideal for hedging transaction risks unless the company owns foreign currency that will be used for purchases at a future point in time and yet wants to earn interest in domestic currency
What does Transaction Risk impact?
It impacts firm’s cash flows
2. Translation Risk
Translation Risk arises when there are assets / liabilities denominated in foreign currency. All foreign currency denominated items must be converted into the firm’s domestic currency for financial and tax reporting purposes. This gives rise to translation risk. To put this in a simple example:
What’s the most preferred way to hedge Translation Risk?
Optimum way to hedge translation risk is to finance the assets in a country with the borrowings in that country’s currency only. This will ensure that the gain(or loss) on assets are offset by the loss (or gain) on liabilities
Would it make sense to hedge Translation Risk at multiple time points?
Hedging of translation risk is advisable to be done only on one single future date. The reason being, hedging translation risk at multiple points may lead to over-hedging
What does Translation Risk impact?
It impacts firm’s reported earnings
3. Economic Risk
Economic Risk is that a company’s future cash flows will be affected by exchange rate movements. For example,
o A car manufacturer in Italy is selling cars in the UK. Assume the car manufacturer is charging price in EUR. As a result, it does not face any transaction risk (as EUR is the reporting currency in Italy).
o However, the manufacturer faces Economic Risk. If the GBP depreciates sharply relative to EUR, then the buyers in Britain may find it expensive to buy cars whose prices are denominated in EUR. This will impact the business of the firm as its sales in Britain will drop. This is the Economic Risk that the Italian firm is carrying
Economic Risk may also potentially impact a firm’s competitive position. Continuing the above example, some other firm (say car manufacturer based in China) may create its own niche within the British market, and they would be successful in doing so if the GBPCNY rate is favorable for British buyers.
How easy is it to analyze Economic Risk?
Economic Risk is very difficult to quantify as compared to transaction and translation risk, but a thorough scenario analysis of foreign exchange rate movements should be made to make any strategic decisions
Managing FX Risks for an Institution:
An entity like a bank has a robust risk framework and a supporting technology infrastructure to manage risk on its books. Various teams in the bank including Risk Management, Finance, Trading, Compliance etc. play a pivotal role in managing the foreign exchange and other types of risks on a day-to-day basis. FX happens to be a very important component of both the trading book & banking book for a banking institution.
This brings us to the end of this article. Hope you enjoyed reading this article. Feel free to let me know your thoughts. Happy Learning!
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