The foreign exchange market is the largest and most liquid financial market in the world. It has several participants such as commercial banks, investment banks, central banks, governments, corporations, institutional investors, currency speculators, hedge funds, mutual funds and retail investors.
Along with being the biggest financial market, it also is one of the most rapidly growing markets. According to a survey conducted by the Bank of International Settlements in 2010, the average daily turnover in the FX markets was US$3.98 trillion. For comparison, in 1998 this number had been pegged at $1.7 trillion. [REF1.1].
The $3.98 billion market can be broken down as follows:
Spot market: $1.5 trillion
FX derivatives (outright forwards, FX swaps and other derivatives): $2.5 trillion
FX volatility
As discussed earlier, the breakdown of the Bretton Woods fixed rate system ensued the era of floating exchange rates. The value of a currency is not constant and value of all currencies changes over time with respect to each other. In a free foreign exchange market, the currency rates reflect the value of a currency pair and the extent to which a particular currency fluctuates against another is called volatility.
There are two types of foreign exchange pair relationships.
Fixed-rate currencies: These are currencies whose values are either held constant or allowed to fluctuate within very narrow boundaries [REF1.3]. The countries which follow this system, keep their currencies fixed in value to another currency, a basket of currencies or to some other commodity such as gold.
Not many major economic players follow this model any more. The People's Republic of China did so before July 2005. On July 21st 2005, China took an important step in moving towards a market economy by declaring that it would increase the value of the Yuan, abandon its decade-old fixed exchange rate to the US dollar and would instead peg the Yuan to a basket of global currencies [REF1.2].
Freely floating currency: These are currencies whose values are determined according to the fundamentals of supply and demand in the foreign exchange market [REF1.3]. These days the majority of the currencies are floating. At times of sudden and massive appreciation or depreciation, Central banks intervene in the markets to control the value of their respective currencies. They do so by buying or selling huge amount of their currencies or foreign currencies which they hold in reserve. Another factor which gives the Central banks power to control the value of their currencies is the fact that they have the authority to increase or decrease the supply of their currencies.
Volatility is inherent in the FX markets due to its size, liquidity and the numerous factors which influence the movement of one currency with respect to another. Along with unpredictable market sentiment, FX markets are influenced by macro-economic policies, economic outlooks, macro-economic and micro-economic statistics and geo-political relations.
FX risk:
FX risk, also known as FOREX risk or currency risk is the financial risk arising out of the change in one currency's value with respect to another. It is the sensitivity of a company's profitability, net cash flows and market value to change in exchange rates. It is one of the most common financial risks as every corporate which does business across borders or has foreign currency transactions and operations is exposed to FX risk.
Types of FX risk
The FX risk that a corporate is exposed to can be divided into a few categories.
Accounting risk or Translation risk: Firms with foreign subsidiaries are primarily exposed to Accounting risk. When a foreign subsidiary's financial statements, revenues, profits and losses need to be incorporated in the parent company's books, the net income in the parent company's books is highly sensitive to the variation in the exchange rate between the parent's currency and the foreign subsidiary's currency.
Economic risk or Operating risk: This is the extent to which a firm's market value is sensitive to unexpected changes in the exchange rate between currencies that it deals in. Currency fluctuations can affect the firm's operating cash flows, income statement, its position relative to its competitors and therefore the firm's market share and stock price.
Balance sheet risk: Balance sheet risk is the extent to which the items in a company's balance sheet are sensitive to changes in FX rates. Volatility in FX rates can affect a company's assets and liabilities, accounts payable and receivables, inventory, value of loans in foreign currencies and investments in other countries.
Transaction risk: [REF1.4] Transaction risk is the risk faced by companies involved in international trade that the currency exchange rate might move against them after they have already entered into a financial obligation. Transaction exposure measures changes in the value of financial obligations incurred before a change in exchange rates but to be settled after the change [REF1.5]. To illustrate this with an example, lets say that a Singaporean exporter has signed a contract with an American importer that it would supply goods for the next six months and that the importer will be paying the Singapore firm in USD. This exposes the Singapore firm to transaction risk because it will have to convert the USD receivables in SGD. And if the SGD rises in value against the USD, that would mean that it would receive lesser SGD.
Competitive risk: Competitive risk is the risk that a company's future cash flows, revenue and profit margin vary as a result of a competitor's FX exposure. For example, let's suppose that an American car manufacturer has all of its manufacturing and sales denominated in USD. Its competitor is a major South Korean car manufacturer who builds its cars in South Korea. Now if the KRW (Korean Won) falls in value with respect to the USD (US Dollar), the Korean manufacturer will earn more KRW for each car that it sells. This gives the Korean company two options, first, keep their sale price the same and enjoy the bigger profits, or second, decrease their sale price and increase market share..
