Transaction risk
This is the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component of treasury risk management.
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on whether the Treasury Department is been established as a cost or profit centre.
Economic risk
Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the longer-term effects of changes in exchange rates on the market value of a company. Basically this means a change in the present value of the future after tax cash flows due to changes in exchange rates.
Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.
Translation risk
The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is the translation not the conversion of real money from one currency to another.
The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement.
If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then the UK parent company will anticipate a balance sheet value of £500,000 for the subsidiary. A depreciation of the US dollar to $/£2.00 would result in only £250,000 being translated.
Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.
Risk and exchange operations
Foreign exchange market is always characterized by its volatility and unpredictability. This is explained by an unusually fast response of the market players on the political and economic changes in the world, as well as to a large extent may be due to speculation.
Currency risk is the risk of loss due to adverse changes in foreign exchange rates during the execution of transactions for their sale. It occurs only in an open position.
Default risk on fixed currency transactions depends on the creditworthiness of the investor and the term of the contract . The higher the duration , the higher the probability of rate changes and non-payment.
Derivative instruments used bank customers as the main methods of insurance (hedging ) their currency (or financial) risks . Banks are forced to use these tools as a service to customers . At the same time the risk of future transactions is serious enough and the bank , in turn, forced himself to insure prisoners customer futures transactions .
So, here are the main derivatives transactions.ar
Forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset (i.e. equity, currency, commodity, etc ) at a specified future time at a price agreed upon today.
The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.
The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged.
The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party2.
A forward contract is used to reduce (hedge) the risk resulting from the movement of a market variable (i.e. currency movements, interest rate movements, equity price movements
Future contract like a forward contract, a future contract is an agreement between two parties to buy or sell an asset in the future for a price agreed upon today (the futures price or strike price). But unlike a forward contract, a future contract is traded on an exchange, which implies that trading is only possible for standardized underlying time to maturity quantities.
The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties—the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease in near future.
Any investor who enters into a future contract with an exchange has to deposit funds on an account at the beginning (initial margin). This account is adjusted (margin call) every day to reject the investor's gains and losses.
Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss3.
An option is a contract between two parties giving the buyer the right, but no obligation, to buy (Call-Option) or to sell (Put-Option) an underlying asset or instrument at a specified strike price on or before a specified date.
An option gives the buyer a right but is no obligation, i.e. the holder does not have to exercise the right. The seller of the option contract is obliged to sell, respectively buy, the underlying asset, if the option buyer wants to, i.e. the option is exercised.
Contrary to a forward contract, an investor needs to make a payment the option premium when purchasing an option4.
There are four types of market participants in option trading:
Buyer of a Call-Option
Seller of a Call-Option
Buyer of a Put-Option
Seller of a Put-Option
Options are often classified with respect to the exercise date:
European Options can be exercised only on the expiration date.
American Options can be exercised any time up to the expiration date.
Bermudan Options can be exercised on the expiration date and several specified dates before expiration.
Arbitrage (or an arbitrage opportunity) exists, if there is a possibility to lock in profit without risk and with no initial endowment.
A simple arbitrage opportunity would for example exist if the same asset is traded at different markets for a different price. In that case, it is possible to buy the asset at the market with the lesser price and sell it on the market with the higher price.
In general, it is almost impossible to detect an arbitrage opportunity in equity, currency or interest rate markets. In transparent markets each arbitrage opportunity will be detected immediately and traded away.
People who engage in arbitrage are called arbitrageurs - such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies5.