Summary- foreign exchange risk

Essay by dolphi_darren December 2004

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Summary - Foreign exchange risk

l Brief statement

The exchange rate stated simply is the price of one currency in terms of another currency. Exchange rate can therefore be expressed in terms of the law of one price which states that "in the presence of a competitive market structure and the absence of transportation cost and other barriers to trade, identical products which are sold in different markets will sell at the same price in terms of a common currency" (Pilbeam, 1992). Importers and exporters are exposed to the fluctuation in foreign currency (FC) exchange therefore undergoing business risks as they operate mainly in international markets. They are, in global market terms, therefore affected by the fluctuation mainly in the value of the US dollar, the Euro and to a lesser extent the British pound, and other foreign currencies. In principle, in the normal course of doing business, importers and exporters employ derivatives financial instruments, including forward contracts and foreign currency options to manage their exposure to fluctuation in foreign currency exchange rates.

To take New Zealand importers and exporters for example, the value of the NZ dollar has raised generally for the past three years against the US dollar and the Euro though there had been periods of fluctuations. Changes in foreign exchange rate affect NZ participants' revenue, gross margins, operating costs, operating income, net income and retained earnings. In addition, there are some other important approaches to contribution to hedge or control foreign exchange risk, including using a value-at-risk analysis ("VAR"), leading and lagging, netting, back to back loans, natural hedging and so on. For either existing or potential participants of international import and export, how to evaluate the foreign currency risk and implement effective risk strategic management to minimize exposure is critical.

l Comments regarding the key...