The risk of foreign exchange transactions is the risk whereby a business venture’s value changes due to currency fluctuation rates. According to Baillie (316), this is a “risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. It is also known as currency risk or exchange-rate risk”. The risk normally affects businessmen indulging in export-import trade; it can also impinge on businesses involved in international investments. A good example is when cash must be changed to another currency to perform a particular investment. After this, any alteration in the exchange rate might cause the investment’s worth to either shrink or increase upon the sale of the investment and conversion into an original currency.
Other aspects encompassed in foreign transaction risks are the risks that the rates will change adversely overtime or the accounting risk, proportional to, “the number of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency” (Baillie, 322). This paper will therefore examine the return and risks of foreign exchange transactions then highlight foreign exchange risk and relative assert return. The paper will then conclude by showing how to avoid these risks.
Risks of foreign exchange transactions
Exchange rate risks linked with foreign-denominated tools are the key elements in international investments. The exchange risk takes place beginning with differential monetary policies and an increase in real productivity. This is responsible for the differential inflation rate. For example, a businessman from the U.S. has stocks in the UK; returns realized are affected by changes in stock price and the sterling pound against the dollar. If at all he gets a return in the stocks of 20% but the pound depreciates 20% against the dollar, he would realize a small loss.
When investors carry out business deals in different currencies, they are vulnerable to risks. These risks are brought about by the fact that currencies may fluctuate relating to each other. If the investors are buying and selling, then returns and costs can shoot up or down depending on the alteration of the exchange rates connecting the currencies involved. “If investors borrow funds in a different currency, the repayments on the debt could change or, if they have invested overseas, the returns on investment may alter with exchange rate movements. This is usually known as foreign currency exposure” (Hedrick, 124).
Currency risks are present despite the place one is investing, be it domestically or internationally. If one invests domestically, and the domestic currency devalues, he or she realizes a loss. All market investments are vulnerable to currency risk. This is, “despite the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system” (Hedrick, 124).
Foreign exchange risk and relative assert return
Currently, it is known that the un-biasness hypothesis using the available forward exchange rate in predicting future spot exchange charges is in general inapplicable. To understand this, current experiential literature has been stressing the risk premium hypothesis utilizing the information of latent variables. These analyses, nevertheless, accentuate time sequence properties by looking into the orthogonal of foreign exchange surplus returns to insulated predicted errors.
Then again, the explanation of exchange has been paying attention to relative asset return degree of difference. For example, Engel (136) developed, “a model that links foreign exchange excess returns to expected real interest rate differentials across countries. Conversely, other researchers proposed that foreign exchange excess returns are significantly related to stock excess return differentials for the trading countries”. This analysis is portrayed by Engel (136) who says:
It highlights the real interest rate differential as, an argument to explain the foreign exchange excess returns. This model has its empirical appealing since, both the hypothesis of real interest rates are constant, and the hypothesis of expected real interest rates being equal across countries are generally rejected by empirical data. It can be shown that the risk implicitly embodied in Engel’s model stems from the uncertainty in the return on commodity markets relative to the fixed income return investing in short-term fixed income markets. In his study, Engel provides convincing evidence in supporting the hypothesis that real interest rate differential is significant in explaining the risks premium on foreign exchange markets (Engel 136).
On the contrary, current studies by other researchers come up with evidence that real interest rate degree of difference does not account fully for expected mechanisms of foreign exchange excess returns (Engel, 143). In deviating from Engel’s move toward the effect of probable real asset return on the foreign exchange rate, other researchers separately hypothesize that foreign exchange risk is connected with equity market risk.
Embedded in the analysis is the supposition that the major basis of exchange risk, together with political threats and country risks, are reproduced in equity market risk. In his empirical analysis, Engel (143) gives authenticate proof to hold up the hypothesis that predictable excess return in the international exchange market can be foreseen by the relative risks, reproduced in relative projected equity risks in the home and foreign countries. Recently, Chiang (79) demonstrated that:
Foreign exchange excess returns are correlated to volatility in the currency market and volatility in the stock markets. His findings suggest that foreign exchange excess returns are significantly correlated with conditional variances and the results show that the volatility from stock markets appears to be, a more important factor than the volatility from the currency market. Taking together, the evidence along this line of research substantiates the important role of the equity market jeopardy in explaining the foreign exchange risk.
Therefore as mentioned here the relative expected real-interest rate together with expected equity-risk-exchange hypotheses gives sound hypothetical analyses and applicable empirical proof in clarifying the foreign exchange risk. Though it should be indicated that the source of the foreign exchange risk in real interest rate representation is due to the uncertainty of real returns, it further depends on the uncertainty of future inflation rates.
Because the probable modifications in exchange rates are brought about by, market forces that manipulate transactions concerning commodities and monetary assets in the stability of payments, any unstable change in probable returns in goods and monetary asset markets will cause an enhancement in doubt for the money market. The best way to steer clear of the return and risk of foreign exchange transactions is by, investing in the products that hold a value that does not depend on any financial system.
Baillie, Thomas. Foreign exchange rate markets. Journal of International Money and Finance 24. 9 (2000): 309-324. Print.
Chiang, Jiang. Foreign exchange excess returns. New York, NY: Oxford University Press, 2002. Print.
Engel, Cornelius. The forward discount anomaly and forward exchange risk: a survey of recent evidence. Journal of Empirical Finance 16.3, (2006): 123-192.
Hedrick, Hansen. Foreign Exchange Markets. Journal of Monetary Economics 14. 7 (2004). 108-143. Print.