Understanding Forex Risks

Risks and trade come as a package deal, both being inseparable from each other. However, the thumb rule to trading is to never risk more than what you can afford. If the boundary is crossed, it is no longer a trade. It becomes a gamble that is driven more by greed than by speculation as is the case in trade. Nevertheless, like all trades, Forex trading has its own set of financial risks that are set into motion by abrupt changes in foreign exchange rates and can significantly impact one’s finances. People and institutions dealing in Forex trade are exposed to various risks that include:

Transaction Exposure

This type of risk occurs between two parties bound by a contract dealing in foreign currency, and the foreign exchange rates fluctuate between the dates when the cash value was agreed upon and the date when the payment is actually due. This leads to significant losses for the firms involved in international trade. To manage this risk, companies calculate forward rates to fix an exchange rate when entering into financial obligations.

Economic Exposure

This type of risk involves a change in a company’s future cash flows as a result of sudden, unanticipated changes in exchange rates. The risk is long term and significantly impacts the market value of a company, affecting its competitiveness globally. Economic exposure is relatively difficult to manage as it is a result of unforeseen changes in exchange rates rather than currency rates.

Translation Exposure

All firms are required to draft consolidated financial statements. So, a firm’s translation exposure is the degree to which its reporting is affected by changes in exchange rate. The institution’s assets, liabilities, equities and income on the balance sheet change in value when exposed to this risk. Although translation exposure does not affect the institution’s cash flows, it does alter the firm’s recorded earnings, thereby affecting its stock price.

Contingent Exposure

Such an exposure arises when a company faces transaction or economic risk based on the outcome of an ongoing contract or negotiation. A firm faces contingent exposure when dealing with imports or exports and when the prices are not yet finalised. For example, if a firm is in process of negotiating an import deal and the price is not fixed yet, then the movement in exchange rates will affect both parties and the exposure will be converted to transaction exposure. Any scenario in which exchange rate variation will affect cash flows where values are not fixed, gives rise to contingent exposure.

Forex brokers, traders and companies are all exposed to these risks alike. Forex traders, who are new in the field, are not usually familiar with the pattern of changing exchange rate trends and the fluctuations affect their investments negatively. To develop hindsight in Forex trading, ETX Capital offers its clients a demo account where they can control risks with nothing to lose. Hence, seasoned traders will stand a better chance at managing Forex risks than those who are still on the learning curve.

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