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Foreign exchange risk
Foreign exchange can be defined as a global financial market for trading currencies which determines the relative values of different currencies. It can also be termed as the conversion of one country’s currency to another. A risk on the other the other hand can be referred to as the likelihood that a particular activity will result in a loss or shall give an outcome that is not desired.
Foreign exchange risk can thus be defined as the risk of an investment’s value changing due to the various changes in currency rates. It can also be referred to as a risk that a particular investor will be forced to close out a long or short position in a foreign currency at a loss as a result of the fluctuation in the exchange rates. (Herring, 1997)
Problems presented by a foreign exchange in an organization.
Due to the various foreign exchange fluctuations, any foreign exchange will definitely affect an organization either positively or negatively. This is some of the problems that a foreign exchange poses in any organization.
The organization is usually put into an exchange risk meaning that for a particular product, when an organization contracts with a distributor for any agreed amount of money, due to the fluctuation in the foreign exchange rates, the organization will be paying more money than the stipulated amount.
As a result of these fluctuations on the foreign exchange rates, the organization tends to strain due to the cash outflow which ends up straining the working capital requirements and may results in hiccups in a particular organization.
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Foreign exchange may also affect an organization when it comes to the custom duty structure where by the organization tends to pay more VAT e.t.c and this may end up in incurring losses in the organization other than the profits it was meant to achieve.
How may an organization that needs Euros in 6 months protect itself from the currency fluctuations?
The organization is supposed to follow particular steps in achieving this. These steps include the following. First it should identify and measure the foreign exchange exposures that it wants to manage. If the organization is exporting, it should measure the exposure by subtracting the Euros it will be expecting to receive over the period of six months against which it will need so as to fulfill its payments in Euros over the same period of six months. The difference will indicate the exposure that is supposed to be hedged. (Jacque, 1997)
The organization is then supposed to develop its foreign exchange policy. This particular policy should be endorsed by the organization’s senor management. The policy alerts the organization; on when to hedge the exposure, the tools and instruments to be used for hedging and the manner that they should be used, the one responsible for managing the foreign exchange exposure, how to measure the performance of the organization’s hedging actions and the regular exporting requirement. The organization should then put in place consistent hedges. They should also put in place some basic financial hedges with a bank or a foreign exchange broker so as to achieve its intended objective.
Lastly, the organization requires determining whether the hedges are reducing the organizations exposure effectively by establishing clear objectives and bench marks. This will in addition alleviate the fear of those responsible for implementing the policy that they have in some case failed if the exchange rates move in the organization’s favour.