Management of risk is one of the essence of the business of banking. The extent to which risk management is being managed or controlled could either be said to be an art or science.
Indeed a judicious mixture of both could form the subject of an interesting if inconclusive debate (Richard, 2008). These would however surely be little argument as to whether or not risk taking and risk management in banking require the deployment of special skills and judgment for it is in this field that banking ability of the individual or of the organization is most critically tested.
It is therefore in view of the foregoing that bankers actually understand the very nature of foreign exchange risks, the methods of analyzing them. The various types of risks involved and ways of mitigating these risks. These and other aspect of foreign exchange risks form the various subsection of this chapter.
2.2 Foreign Exchange Risk Defined
Before delving into the mechanics of foreign exchange risk management, it is pertinent to attempt a definition of the term. Foreign exchange risk or currency risk exposure as some authors prefers to call risk associated with in fluctuations in currencies, has been defined severally by different authors. One thing that is glaring is the lack of consensus on what the term actually connotes.
Books on this subject used a number of expressions lime economic transaction, accounting transaction, balance sheet exposure but they do not define them in the same way and very few authors have set out vigorous or formal definitions.
Derosa (1991), foreign exchange risk can be defined as the potential transaction, translation gains and losses when foreign investments are valued in terms of the investors home currency”
Shapiro (1996) also advanced a simplistic definition when be defined exchange risk as the variability in the value of the firm that is caused by uncertain exchange rate changes.
Thus, exchange risk is viewed as the possibility that currency fluctuations can alter expected amounts or variability of the firms’ future cash flows.
Walker (2007) says that” an assets liability or income stream is exposed to exchange risk when a currency movement will change, for better of for worse, its parent currency value” he were on to define accounting exposure as “ the possibility that these foreign currency.
Denominated items which are consolidated into a company’s published financial statement will show translation loss (or gain) as a result of currency movement since the previous balance sheet date” he also defines economic exposure as the possibility that the parent currency denominated net present value of foreign subsidiary’s cash flows will be adversely affected by exchange rate movement”
Kenyon (1984) referred to foreign exchange risk as economic currency risk which he defined as the risk that a sustained real use of a currency against the currencies of competitors will adversely affect a company’s competitive costs and therefore its sales, profit margins and market share, which in turn will reduce the return on the capital and revenue investment previously sunk in its present commercial activity and the present value of the investment.
From the foregoing, despite the difference in expressions and language used, it can be established the foreign exchanged risk reference to the uncertainly surrounding variations in the value of other currencies as compared to a local currency and the effect of such risks on both the value of the company and its cash flow.
2.3 Why Do Firms Deal in Foreign exchange?
It has been argued on many occasions that the simplest way to avoid foreign exchange risk is not to have the risk in the first place. This means the company/bank will trade and sell in the currency of cost and by financial all assets by debts in the same currency
However, this is not to be as many organizations today actively in the foreign exchange market. But why do firms engage in foreign exchange? This is addressed below.
According to Mapletoft (1991), there are three main reasons for dealing in foreign exchange.
- To sell receivable or purchase payable, mostly in fulfillment of business commitments opposite customers or suppliers or financial commitment opposite banks and other institutions e.g interest flows.
- To mange currencies as part of a comprehensive ongoing currency management position, where for example maturing forward deals need to be rolled forward to future period.
- To take positions where distinct views have been taken within the company on the desire composition of its future flows of currency payable receivable and these views differ from the company natural or unamended position
While the first reason being common to all companies and the second more attributable to the more sophisticated companies, the third reason is the one that most interests the treasure, the bank and the market.
It is therefore to this third area that most commentators address their attention either to recommend (as bank) or to bear and perceive a means to increasing understanding (as a corporate) or to appraise and evaluate (as an analyst) or simple to comment (as a newspaper). Given the forgoing as reasons to deal in foreign exchange the motivation to act may differ, particularly for the many levels within the corporate organization. The board, the management and the dealer for example may have different views on the corporate decision to act. There are different constraints impacting on the decision making process, these vary between companies with some encouraging disciplined activity inherent in an over risk management strategy.
The above not withstanding the rationale is mostly characterized by a range of requirement is involving one or more of the following objective.
- To increase certainly: for example, the sale forward of a debt at least to ensure a given (say dollar or stealing) equivalent value, for costing or return on sales, or to safeguard budget exchange rate for transaction.
- To provide an element of smoothing some what more sophisticated and recognizing the volatility of exchange rates, this desires is perhaps not to sell or purchase at necessarily the best rates, but to time the transactions in order to even exchange gains and losses over time and between budget periods.
- To improve on market rates: the most difficult task since all market participants would like to achieve this, most difficult task since all market participants would like to achieve this, but nevertheless the final arbiter of the comparative success of the treasury operations.
2.4 What makes currencies fluctuate?
A foreign exchange rate is a price or a numerical expression of value of the currency of one country in terms of that of another country at any given time. Having established the reasons why firms/ banks trade in foreign exchange and the motives for the transaction, it is pertinent to review those factors which make currencies fluctuate.
Most authorities believes that currencies movement are caused by some or all of the following factors which influence the demand and supply of each currency in the market .
- Relative price levels and inflation rate
- Relative economic growths
- Relative interest rates, especially in the freely traded money market like the Euro currency market.
- Relative change in the money supply in the currency areas (countries) concerned
- Investment or portfolio preferences of big international investors like the OPEC countries.
- . Bandwagon affects (if a currency seems to be on the way up, speculators may exaggerate to trend by buying in the hope of a quick profit)
- Intervention by central banks
- Interest rate arbitrage.
Any of the above factors can independently or in conjunction with other factors affect the value of a particular currency. It is also important to stress the various causes take different time spans to operate.
2.5 Definition and Types of Foreign Exchange Exposure (Risk)
Exchange rate risk management is an integral part of every firm’s decision about foreign currency exposure (Weston 2001). Currency risk hedging strategy entail eliminating or reducing this risk, and requires understanding of both the ways that the exchange rate could affect the operations of economic agents and techniques to deal with the consequent risk implication (Barton and walker, 2002). Selecting the appropriate hedging strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered.
The issue of currency risk management for banking firms is dependent from there is business and is usually dealt with by their corporate treasuries.
As mentioned at the beginning of this chapter, when a firm has assets or liabilities denominated in a foreign currency, profitability will be influenced by the changes in the value of that currency.
Foreign exchange Risk therefore refers to the degree to which a company is affected by exchange rate changes.