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Meaning
Foreign exchange risk is a financial risk, that exists when a
financial transaction is denominated in a currency other than
that of the base currency of the company. Foreign exchange
risk also exists when the foreign subsidiary of a firm maintains
financial statements in a currency other than the reporting
currency of the consolidated entity. The risk is that there may
be an adverse movement in the exchange rate of the
denomination currency in relation to the base currency before
the date when the transaction is completed. Investors and
businesses exporting or importing goods and services or
making foreign investments have an exchange rate risk which
can have severe financial consequences; but steps can be taken
to manage (i.e., reduce) the risk.
TRANSACTION EXPOSURE:A firm may have some contractually fixed payments and receipts in foreign currency,
such as, export receivables, import payables, interest payable on foreign currency
loans etc. all such items are to be settled in a foreign currency.
TRANSLATION EXPOSURE:The translation exposure is also known as accounting exposure or balance sheet
exposure. It is in essence the exposure on the assets and liabilities exposed in the
balance sheet and which are not going to be liquidated in the near future. It refers to
the probability of loss that the firm may have to challenge because of decrease in value
of assets due to devaluation of a foreign currency despite the fact that there was no
foreign exchange transaction during the year.
At-the-money option:If the option holder does not lose or gain whether he exercises his option or
not, the option is said to be at the money. While solving question in the
examination, it is assumed that if the option is at the money, it is not exercised by its
owner.
Currency Swaps:
In a currency swap, two parties agree to pay each others debt obligation
denominated in different currencies.
A currency swap involves:
o An exchanges of principal amounts today.
o An exchanges of interest payments during the currency of loan.
o A re-exchange of principal amounts at the time of maturity.
SOVEREIGN RISKS
The risk that a foreign central bank will alter its foreign-exchange
regulations thereby significantly reducing or completely nulling the value of
foreign-exchange contracts.
Probability that the government of a country (or an agency backed by
the government) will refuse to comply with the terms of a loan agreement
during economically difficult or politically volatile times. Although
sovereign nations don't "go broke," they can assert their independence in
any manner they choose, and cannot be sued without their assent. Sovereign
risk was a significant factor during 1970s after the oil shock when
Argentina and Mexico almost defaulted on their loans which had to be
rescheduled.
Political risks
This is the risks of loss that is caused due to changes in the political
structure or in the politics of country where investment bank is
made . The main historical data provides a good understanding of
the key factor such as behavior of the society ,the government the
private sector, political and relation with neighbor country. there are
2 types of aspects
1.Political forces which act in the country their representative and
the main national issue must be focused.
2.Social aspects their key indicator like population growth rate,
unemployment ratio, composition of the population.
3.Critical aspects the geographic positioning and its related strength
and weakness are also critical aspects.
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