Forex glossary of terms
Any company or person that conducts some portion of its business in a different currency is suspect to some currency forex risk (or exchange rate risk or foreign exchange risk, ). This potential risk is only possible if the company's cost currency is not the same as the company's sale currency. Alternately if a company has revenues and expenses in the same currency, there no foreign exchange risk exists.
Two types of currency risk exist: transaction risk and translation risk. Transaction risk is the risk involved with the actual switching of cash flows from different currencies, and how much the exchange rate changes will impact a company's cash flow. Translation risk has more to do with accounting. It involves the impact of exchange rates on earnings and balance sheet items when merging financial statements from foreign subsidiaries. Transaction risk is the more relevant than translation risk from a business viewpoint.
Five general types of risk exist that threaten all businesses: 1) market risk (unanticipated fluctuations in interest rates, stock prices, exchange rates, or commodity prices). 2) Credit risk also known as default risk. 3) Operational risk (this includes both equipment failure and fraud). 4) liquidity risk (an inability to buy or sell goods at quoted prices). 5) Political risk (such as new regulations and expropriation). Any business that operates in industries such as petroleum, natural gas, and electricity are especially prone to market risk-or more specifically, price risk- due to the extreme fickleness of energy commodity prices. Electricity prices are significantly the most of all commodity prices.
What is known as country risk can be further divided into two parts, economic and political risk. Economic risk is put simply the stability of a country's economy. It depends individual industries or markets, the country's ability to maintain a substantial level of activity and its ability to grow, as well as its supply of natural resources and other important inputs.
Political risk is more tied to the stability of the government that operates the economy. It is related to the ability to move capital into and out of the country, the probability of power transferring easily following elections, and the government's overall feelings toward foreign firms. Clearly, these two parts of country risk display significant overlap. A variety of services exist which can provide in-depth assessments of country risk for virtually every country; Multinational firms frequently use these services to better make decisions with regard to international projects.
Ways to pro-actively protect against transaction exposure include:
- clauses of price adjustment
- forward contracts
- borrowing and lending money in a foreign currency
- currency options
- invoice in ones home currency
One problem that frequently comes up in managing currency risk is that it only occurs to companies that they are exposed to risk once the exposure has been spawned. Currency risk management however should commence well before exposure risks have been spawned. If this has not occurred then fundamental decisions have been taken on the basis of incomplete information. The way a company may approach exposure seem to vary significantly, perhaps by the culture of the company or by the character of the business or the competition. On the one hand a company could be willing to accept a large amount of risk and expect corresponding returns or on the other hand it could not like risk and may be prepared to pay a rather high price for certainty and peace of mind. Another option is that it may have no solid stance on currency and may use a take things as they come/roll with the punches approach.
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