MANAGING RISK

Managing Forex Trading Risk

Managing Forex Trading Risk

CHAPTER 1: INTRODUCTION

Forex, which is short for “foreign exchange,” is the largest trading market in the world, turning over as much as US$1.5 trillion every day. There is no central marketplace for currency exchange, which is done over the counter. Currencies are traded on a global basis 24 hours a day, five days a week. Financial transactions involve one party purchasing a quantity of one currency in exchange for selling a quantity of another. Trading commonly occurs between large and central banks, currency speculators, corporations, governments, and other institutions. Currency prices depend on many factors, but ultimately the price depends upon supply and demand.

Forex markets react to trade levels and trends. Trade and investment flows indicate the demand for goods and services, in turn indicating demand for a country's currency to conduct trade. Trade deficits can have a negative impact on a nation's currency. A currency loses value when a country experiences rising inflation, which erodes demand for that particular currency. As a generalization, the healthier a country's economy, the better its currency will perform. Factors to look out for include economic factors, political conditions, and market psychology.

An effective and proven plan can help a company to exploit the forex currency trading system to its best potential. Customizing a forex plan in line with specific issues and needs can help to manage foreign exchange in the most cost-effective and efficient way. It is customary—and wise—to begin with a simulated forex trading account, which does not need any investment upfront but is used to train beginners in the strategies and fundamentals of forex trading.

A well-considered forex plan needs to take into account various elements. Decide whether you will hedge recorded or future assets and liabilities and how. Choose a trustworthy and competitive forex supplier. Plan the scope of activity taking into account objectives and time frames in which to achieve set goals. Make sure you schedule regular assessments of your forex business and revise any activities as needed. A forex plan should be sustainable, so aim to negotiate transactions at the most favorable prices. Keep track of your forex exposure by implementing methods for data capture. A good plan also has internal controls—consider your business processes and documentation requirements, ensure that you have strict authorization limits, and keep tasks segregated where necessary. Finally, stay familiar with accounting and reporting requirements.

A forex plan should be reviewed at every stage, from the first planning phase and throughout implementation. Senior management should sign off all decisions to ensure that risks are minimized. If the forex plan is of limited duration (for example for a specific project), then a post-implementation review is wise as it can identify areas for improvement and efficiency gains if you decide to enter the forex markets in the future.

Objectives and the Purpose of Study

While the risk management strategy of non-financial firms has been the subject of intense theoretical and empirical research, very little is known about the actual hedging practices of multinational ...