Forex Risk Management - Dissertation Example

? FOREX RISK MANAGEMENT must NOT appear in the project;  ACKNOWLEDGEMENT To acknowledge and thank anyone whom you want to for giving assistance with your project. This page is very much optional.  ABSTRACT  Taking into context the situation of big companies, researcher takes an explication about Forex Risk and how to manage risk exposure by utilizing some protective tools, such as hedging, in protecting vested interests of traders. The study also relates Forex Risk Management as generally part of financial risk management that needs to be reduced to secure investors and the company from eventual losses. TABLE OF CONTENT Title page Acknowledgement Abstract Table of Contents Introduction……………………………………………………………….….….5 Purpose of the Study……………………………………………………….…....6 Evidence and Valuation…………………………………………………………7 Learning form Cases of Companies……………………………………….….....7 Presentations/Findings..........................................................................................8 Forex Risk Management.......................................................................................9 Other Tools for Forex Risk Management …..………………………………....12 Discussion……………………………………..……………………………….13 Conclusion……………………………………..………………………….…...16 Bibliography Introduction A billionaire once related that with worrying trend of their national economy which is characterized by burgeoning debt, increasing unemployment rate, spiraling number of foreclosures of mortgage properties, there is one option to earn substantially—and, this is to trade currency. This billionaire then ranted about many of his friends who amassed a fortune after staking their money at the trading center. This is what economist call managing money through foreign exchange rate (Forex). With the expansion of a borderless economy, traders and investors, especially taipans could just enter into international markets with much freedom and liberal options for competitive and economic gains. But how are they influenced and controlled by the market? Forex is a huge trading market that is geographically dispersed and exchanges could either be favorable or not, depending on the measures of risk management employed by limiting “trade lot size, hedging, trading only during certain hours or days, or knowing when to take losses”(Milton, 2011). Forex trading may seem easy, but in all honesty so difficult, indeed. Traders would either experience sudden corrections in currency exchange rates; bewildering variations in exchange rates; susceptibility to market’s rapid change for profit opportunities; lost payments; delay in the confirmation of receivables and fees; discrepancy of bank drafts received and the contract price” (Milton, 2011). Forex has four interdependent spot markets where currencies are traded. These are the spot market, futures market, option market and derivatives market. Most of the time, these markets are availed by key actors in direct and indirect investments, such as, exporters, importers, investors, speculators, and governments. Trading is often done at interbank markets and financial institutions although the most common currency traded is the US dollars. Exchange rates are managed either in fixed rate, semi-fixed systems, and floating rates. People trade to profit and such made the trading attractive to gain regardless where the market is going. Purpose of the study But Forex trading is not at all positively experienced. Many experienced problems too and were exposed to risks. Forex trading can make you rich or make you poor. It is about buying and selling currencies. If the value of the currency brought rise up, there is assured profit. But if it goes down, one’s loses. It is indeed risky. It is in this context that this study aims to explicate measures on how to protect the interest of the traders in a rapidly changing and fluctuating foreign market and to identify shields from foreign exchange exposure. Specifically, it will discuss forex risk management and its implication to the personal wealth/financial security of trader. It will attempt to explicate foreign exchange risk and to manage it. Evidence and Valuation This researcher makes use of secondary information sourced from journals, books, magazines, and publications both printed and online. The researcher is however limited in exploring the information on forex risk management with reliance on secondary information in the absence of direct experience on forex trading. Researcher will consolidate all possible and available information taking into accounts some published testimonies of traders that were successful or not in forex trading. Enterpretivism, realism and positivism may be employed as analytical tools in understanding and explicating forex risk management Learning from Cases of Companies Let us look into some company cases that are exposed to forex risks to contextualize our precepts. In 1994, Orange Country of Califormia invested support of many pension liabilities. The company lost USD 1700 MM from structured notes and leveraged repo positions (Holton,2006). Members of the board later realized that they were not properly informed of the critical information relating to the risks confronted by the company (Holton,2006). Another case is that situation where Barings bank lost GBP827MM because Nick Leeson, a trader residing in Singapore made some unauthorized futures and options positions linked to the Nikkei 225 and Japanese government bonds (JGBs) whilst he was controlling 49% of open interest in the Nikkei 225 March 95 contract (Holton,2006). Despite the finance margin calls as the bank lost money, the Barings' board and management claim to have been unaware of Leeson's activities (Holton, 2006). The same case happened in 1995 with Daiwa Bank with a US-based bond traders who concealed USD 1100MM in bond losses covering a ten year period (Holton,2006). When discovered, there were member of the management who hid the losses form from US regulators (Holton, 2006). In the long ran, Daiwa was closed in US and penalized with $340MM in a plea agreement with US prosecutors. Another case was that of a Japanese trader who pretend to have lost USD 1800MM in 1996 (Holton, 2006). He also hid these facts for ten years where Hamanaka made USD 20 billion of unauthorized trades a year (Holton,2006). In the 1970s, regional wars and violent conflicts weaken the economy; failed all agricultural production; result to price destabilization; and skyrocket inflation. These cases have exposed the companies into many market risks, credit and operational risks, and foremost with forex risks. Presentation of Findings Forex exchange risk is the degree of danger where a company is exposed in the trade market (Dash, 2009). These arise due to the flow of different currencies and other external factors affecting its rate’s stability. Murray (2005) explicated that forex risk is a transaction risk which happens whenever currencies are converted to another currency. Such risks usually happen when they’d hold assets or liabilities in a foreign currency. Holding the accounts receivable toward the closing period may end with translation risk and may result as unrealized forex gain or loss. Abor (2005) on the other hand suggest that forex risk can be managed by adjusting prices to effect changes in import prices as a consequence of currency fluctuation, as well as by buying and saving foreign currency ahead of predicted period when currency fluctuates. Jesswein et al (1995) who have learned the pattern of American foreign exchange management strategies commented that the new entrants of the market still need to adopt innovative foreign exchange risk management. Yazid and Muda (2006), who have been analyzing forex management strategies in multinational corporations, pointed that multinationals must strategize itself in foreign exchange risk management to minimize operational overall cash flows that are affected by currency fluctuation. Many multinational corporation centralize risk management to impose greater control by frequent reporting on derivative activities. It is likely that huge financial losses related to derivative trading in the past led to top management being extra cautious in their financial deals. Forex market , on the other hand, is an international market where transitions are done by exchanging currency rates. These are often done by banks, dealers interlinked in highly organized system. Dixon and Homes (1992) allows individuals and companies to transfer purchasing power between countries to facilitate borderless trading. This is a 24/7 market place and perceived as the highest cash value traded that deals with billion of dollars. Many of these transactions are done by companies, rich individuals, commercial banks. Trading is often done online in a trading flatform (Russell,2011). The trader selects the currency paired in trade, the amount of the deal and how much one is allowed or willing to risk. Though the trading sound so simple, but lack of knowledge on how the system operates will certainly put the person at the sideline and at a loss (Russell,2011). Economists explicated that Forex rates are affected by major factors affecting cash flows in the trading business. This is because currencies are susceptible to market volatile state. These factors are interest rate differentials net of expected increase of prices of commodities in the market; fluctuation of currency rates in the trading centers; international capital and trade flows; sentiments of investors from international investors; economic and political instability; some developments of the monetary policy of the central bank; levels of domestic debt of the country; and some economic circumstances that are beyond control. They further explained that exchange rates are determined by purchasing power parity (PPP) which means that exchange rates are in equilibrium when prices of goods and services in many countries are the same (Bredin and Hyde, 2004). If domestic prices increase compared to the other country’s price, the local currency is expected to decline (Bredin and Hyde, 2004). Exchange rates are also influenced by balance of payments which illustrates that forex rates are result of trade and capital transactions (Bredin and Hyde, 2004). Monetary theory on the other hand argued that forex exchange rates are influenced by supply and demand (Bredin and Hyde, 2004). This means that whenever there is increase in money supply viz the trading partners, prices would tend to rise and currency depreciates. The asset approach, meanwhile, explicate that currency holdings by foreign investors are factors for real interest rates. Changes of a country’s income happen because the demand for imports relies on the income of a country. If the income of the country falls, the demand for import also fall (Colander, 2001:328). On the same context, the demand for foreign currency to buy these imports falls. Such meant that the supply of the country’s currency to buy the foreign currency falls. With regards to changes of prices in a country, this can be illustrated by citing an example. The US demand for imports, for instance, and the foreign demand for US exports relies on the prices of US goods compared to prices of foreign competing goods. The increasing inflation rate within US market will affect the dollar supply outward and the dollar supply inward (p. 378). On the other hand, the changes of interest rates also affect forex rates. This is because persons prefer to invest savings on assets that will yield higher return (p. 378). As such, an increase of interest rates in a country relative to those abroad will increase demand for US assets (p. 378). As a result, demand for dollars will increase whilst at the same time, the supply for dollars will decrease as few number of Americans well dollars to buy foreign assets (p. 378). Conversely, a fall of US interest or a rise thereof, will have its opposite effect (p. 378). But the question reverberates, how must traders be protected? Forex Risk Management Forex risk management is basically protecting a foreign currency from losing value against the domestic (Levinson, 2005) “currency before an export payment is received as well as enabling markets to attach price to risk, permitting firms and individual to trade risks until they’d hold to what they wanted to retain” (Russell, 2011). Forex risk management is a protectionist system that also contributed to the increase of financial movement in the market in late 1990s after the financial crisis hit worldwide (Russell, 2011). The market actors have maximized all measures to deter negative impact in the currency trade by “innovating derivatives and asset-backed securities to redistribute risk.” Investors these days can now make an option what to bear and use as financial instruments to shed unwanted risks. Investors, either individual or institutional, who are motivated to and to gain capital are assured of this market’s system of resiliency in risk management (Russell, 2011). This is further supported by the institutionalization of formal markets where investors can immediately raise capital by selling shares at the stock exchange (Russell, 2011). The company or person who wanted to pursue trading must illustrate deeper understanding on how the market operates. This means that the trader must know to identify the regularity of trades and stop loses strategically. Thus, it must gain leverage to win in a trade and hit the average or use win-lose ratio to be certain that the trader have a high return of investment. Kevin Lee (2010) cited an example about getting an average profit: If I have a trading account of $12,000 My amount to risk per trade will be = $12,000 x 3% = $360 If I am going into a trade with a stop loss of 20 pips = $200 (for standard account where 1 pip = $10) Number of Lots = 360/200 = 1.8 standard lot Let’s say that I have a strategy with 60% winning percentage and I place 10 trades per month. I will have 6 wins and 4 losses. If I always trade with a risk reward ratio of 1:2, below is what I will get every month. My Win = 6 x $720 = $4,320 My Loss = 4 x $360 = $1,440 Total Profit = $2,880 (Lee, 2010) While losing is a reality, still it is good to stake when the probability of winning is high. If the system is regularized and developed, as well as proven excellent, then the trader can develop consistency with it and observe discipline in following rules and procedures (Hallet, 2011). The trader must also maintain certain level of reasonableness. To institutionalize the system, the trader should have basic technical analysis, ability to manage money, and logical procedures in making the trade and documenting the entry for reference. Trader should maintain a checklist for each trade as part his or her plan with certain target for profit and loss. Such plan should be clearly written and outlined with proper description to ensure that the trader’s goals will have a high probability of being realized. In summary, the underlying philosophy of trading is to design a trading system which can provide a higher than chance win-loss ratio together with a strict set of trading rules that will allow the trader to trade mechanically and objectively. Hallet (2011) suggested that traders must be able to determine what motivated a company or person trade currency as winning and losing is a daily affair of this business. It’s also better for trader to ascertain strength, weakness, opportunities and threats (SWOT) to be effective in the trade. The SWOT analysis will help trader determine where he or she is most vulnerable and learn how to manage your finances—that is intended for personal, housekeep, investments and for trading. Trader may also use Risk Profile Analysis, a series of questionnaire offered by brokerage that will assist trader on evaluating self and his tolerance to risk as well as in determining what mechanism is most appropriate to protect him from loss. Trader may also use political, economic, social, technology environment and logistical analysis (PESTEL) in trading especially if the company is strategizing itself in global marketing. Trader must also possess the values and attitude in seizing opportunities and to accept lose with sense of confidence albeit the situation (Easy Forex, 2011). He must be possessed with the worst impact that may affect him in case of losing but also appreciate the procedure to gain. Hallet (2011) explicated that there are styles of trading depend on one’s capacity. These are (a) Position Trading, when a trader held trades a certain period from a few days or weeks to a few month specially if one isn’t so updated with the markets trends; (b) Swing Trading, is strategy of traders to capture short term financial movements within 2 or 5 days and to peep on profit whilst market is fluctuating its developments; (3) Day Trading is often utilized among online traders although considered dangerous; and (4) Scalping which is often used by professional traders that is already so adept in reading markets trends and developments (Hallet, 2011). Trader may also opt to select a market mediator who can provide weekly updates and trading recommendations. This person should be knowledgeable of the system and can accurately advise when engaging in the trade, how much to invest and decisive to step out. This mediator should be someone who can also provide a newbie trader with comprehensive tutorial on the strategies and techniques of trading. Of course, traders should not be just passive investors but must also pro-actively study to master the system. Other traders proposed that forex risk can be managed by stabilizing the exchange rates (Colander, 2001:384). This is however widely debated if fixed exchange rate, flexible exchange rate or both are effective for stabilization of forex (p. 384). Fix exchange rate refers to an option where a certain government selected a specific exchange rate and offers to buy and sell currencies at that price (p. 384). For instance, if a country buys francs at 25 cents and sells dollars at 5 francs, this is fixed exchange rate (p. 384). To effect this, the government must have sufficient official reserves to support that rates. Flexible exchange rate on the other hand, refers to an option when governments do not enter into foreign exchange market at all, and rely on currency traders to determine the exchange rates (p. 384). This means that the country is allowing market forces to dictate the rise and fall of the price of the currency (p. 384). Partial flexible exchange rate also refer to an option where a government buy and sell currencies to influence the state of exchange rate but also at the same time permit private market to operate. This is what economist called ‘a dirty float because its partly government and partly market determined rate. Which of these are effective, remained to be seen. But economists however maintained that government intervention increases the amount of private speculation in the system (p. 386). The private sectors on the other hand perceived that forex are better managed in their hands than policymakers do. Other forex traders on the other hand, expressed disbelief to private sectors. Other Tools for Forex Risk Management How should a trader control his loses? Expert in trading currency suggested that investors should think twice to set limits on potential “pressure or drawdown” one is willing to stake in trading. They also advise make use of “correct lot sizes and to start at lower amount depending on one’s level of risk tolerance (Easy Forex, 2011). But for experts, the best rule is to utilize small account balance. They also advised tract “overall exposure” to be abreast of the developments and correlation of currency pairs (Easy Forex, 2011). Gain complete risk control and define your opportunity when the right time presents. Forex professional also exercise due diligence of limiting risk (Easy Forex, 2011). Other trader use calculated risk reward ratio and considered this as effective risk management in Forex trading to gain leverage. Risk reward ratio is perceived as a calculation of maximum risk and rewards in a specific trading date. Trader must determine how much he or she is willing to loss and how much he intends to gain. It is either 1:2 or 1:6 or higher than that (Easy Forex, 2011). But if minimum requirement is not met, the trader should not gamble to trade. It is essential that one must exercise caution to protect one’s account in an uncertain and fluid market. Hence, it is indeed necessary for traders to be truly knowledgeable with typical foreign exchange risks; of “hard currency”; in diversifying investments and utilizing “hedging strategies” (Easy Forex, 2011). Diversification permits trader to neutralize risks of keeping currencies that “deteriorates in value” and instead make use of currency with competing or gaining value (Easy Forex, 2011). This is feasible for business sectors who are conducting several businesses in various countries. As such, one can “convert profits into separate foreign currency reserves and/or coordinating cash flow with basic hedging strategies are ways to achieve diversification” (Easy Forex, 2011). Other introduced tools for risk management like employing VT Trader™ to decide in behalf of the trader to decide a limit and stop of orders while one isn’t attending the market’s development (Easy Forex, 2011). Anent to this is also a tool dubbed as Trader's Guardian that will analyze, evaluate and interpret, in behalf of the trader, the risk exposure in the market. The tools have a Margin Use Level(s) and a Warning Level that is visible at all times (Easy Forex, 2011). Possible exposure can also be tracked in different currencies using the Instruments Exposure and Currency Portfolio tools.  There is also a tool named Trader’s Range as an easy way to “minimize the costs associated with missing an entry or exit on a position, during an extremely fast moving market” (Easy Forex, 2011). Still others avail of Bundled Entry Orders that permits setting of limits and stops for pending position as well as “stop order at preset level thus, limiting your losses” while a number also make use of forex brokers to manage their investment and exact leverage (Russell, 2011). Hedging the Trade Many traders opted hedging as strategy to protect financial investment. Hedging with financial derivatives is a contemporary and flexible alternate to currency risk management who are conducting foreign trade transactions. Hedging aims to protect currency risk by hindering an exchange rate perceived as effective for foreign trade activity of the market. The noticeable growth of derivative markets in many countries illustrated their impact on the global financial scene. With these developments at hand on securities markets, market participants, investors and regulators perceived different ways to effectively enforce risk management and hedging using derivative instruments. This process however, also recognize realities that derivative markets bring more complex regulatory control or issues for all market participants which must be properly responded if derivative markets are to gain and preserve investors’ confidence. This does not however hinder companies to use futures and derivatives to sustain its level of competitiveness in a rapidly changing world featured with unparalleled opportunities and extraordinary risks. Thus, trader must be imbued with substantial and technical knowledge on how the market works for profits and avoid losses in a cutthroat-competing economy. Discussion Managing foreign exchange risk literally meant financial risk management to prevent the interest of the trader presumably clouded with the condition of surrounding potential investments (Levinson, 2005). An investment is deemed at risk if there is uncertainty in the return of investments and there are problems in the expected cash flows (Levinson, 2005). It is in this context that financial managers and investors strategize many ways to raise money and to avoid risks. Fluctuations of currency and interest rates truly threaten companies because it can risk it purchasing power and encourage borrowings (Levinson,2005). Exposure to financial risk affects the markets, commerce and the behavior of buying-and-selling among stakeholders (Levinson,2005). Whenever an organization has financial market exposure, this could either mean gain’s opportunity or the possibility of loss; strategic benefit or a sad sudden financial loss. Risk could mean losing due to circumstances defined by the market and inability of a person or a company to reduce risks (Levinson, 2005). An economist says that risk is the probable variability of returns. With unpredictability of events, what seemed “low probability” of impact to loss may actually transpire highly to everyone’s detriment. Financial risks happen whenever an organization is exposed to forex risks, inflation rates or fluctuation of prices in the market, including increases of interest and exchange rates. It also happens when an organization made transactions as vendor, customers and counterparties in derivatives transactions. Sometimes, risks happened due to internal actions or failures of the organization, people, and processes or of payments. Corporation’s financial managers and investors should ascertain that potential economic fluctuations do not threaten the firm’s standing and its businesses’ status, otherwise it’s not only the company that is destabilized by bad financial turn-out but also its investors and capitalists who provided blood for its operations. Thus, it is paramount that companies and individuals must seriously consider investments and its financing decisions because these are crucial to firms and individual's success. Smart investing means that the persons or the investors are knowledgeable about the risks, fully aware of the risks surrounding their investments and potential returns it targeted to earn from investments. Many companies prefer to provide minimal information to investors regarding the risks confronted. Many companies would prefer fewer risks to put down conflict of interests among companies and between shareholders or investors. There are times, when companies leave to investors to discover the risks confronted in the market. Investors who lacked market information and strategies in safekeeping their investments invest money in companies lacking relevant information on the level of risks they are exposed about with little knowledge or with assumption that their investments will yield constant high returns. This is the danger whenever investors are misled to believe with sugar coated projection of company’s plans and investments (Korap, 2006). They were not informed of the volatility of the market, the high risks on currency and how fluid business transaction can get, especially in trading (Korap, 2006). It is therefore relevant for individuals and organization to deal forex risk management as part of financial risk management in order for the company to address this concern strategically and through internal policies. This require resolute decisiveness to reduce risks, sometimes by the use of derivatives that are either called as future, forward, options, and swaps (Kapitsinas, 2008). Stakeholders must therefore refine expectations to rapidly changing market forex rates, business environment, and international conditions by determining and prioritizing key financial risks; identifying level of risk tolerance; enforcing risk management strategy; and constant monitoring, reporting and refining of market figures. Further, they must pro-actively accept risks but must hedge a portion of exposures and by hedging (Kenourgios, Samitas & Drosos ,2005) all possible exposures. Moreover, traders must be able to read the level of market interest rates that are affected levels of inflation, economic instability, monetary policy and central bank decisions as well as forex market activities (Franks, 2011). They must also be fast in noting foreign investors demand for debt securities as well as the development of political markets (Franks, 2011). Thus, they must be able to predict changes using forecasting tools such as yield curve to know the index of leading indicators. Conclusion Forex risk management intends to “preserve the value of currency inflows, investments and loans, while enabling international business compete abroad” (Bredin and Hyde, 2004). Risks can’t be feasibly eliminated, but as trader, bad outcomes of forex can be predicted and effectively managed. The trader must determine his trading strategy, control and flexibility when market either “take a profit or cut your losses” (Bredin and Hyde, 2004).   Successful currency traders utilize informed decisions and target the “right time” in making money from foreign exchange markets. They must be knowledgeable on the factor that affect forex trading, often governed by situation of supply and demand that are shaped by economy, foreign trade, international investors decisions. Traders must illustrate its capability to analyze its strength, weakness, opportunities and threats (SWOT) to be effective in the trade and for traders to determine his/her most vulnerable aspect to manage finances. Trader may maximize Risk Profile Analysis, a system that contained series of questionnaire offered by brokerage that will assist trader on evaluating self and his tolerance to risk as well as in determining what mechanism is most appropriate to protect him from loss. Trader may also use political, economic, social, technology environment and logistical analysis (PESTEL) in trading especially if the company is strategizing itself in global marketing. Hedging, as most adopted protective mechanism in currency trade, can be utilized too with financial derivatives as contemporary and flexible alternate to currency risk management who are conducting foreign trade transactions. All these, and other similar protective measures, can be done solely by informed traders. BIBLIOGRAPHY  Holton, Glyn A. (2006). Financial Risk Management. RiskGlossary.http://www.riskglossary.com/link/risk_management.htm Accessed April 15, 2011. Levent Korap (2006). An Analysis of Central Bank Interventions on Forex Market For The Post-Crisis Period. Working Papers 2006/4, Turkish Economic Association. Franks, Sandy (2011) The "Billionaire's Currency:Forget stocks, bonds and mutual funds. There's a better (and easier) way to make money in today's "crippled economy." Taipan Publishing Group LLC and Smart Investing Daily, 16 W. Madison St., Baltimore, MD Dash, Mihir, Kodagi, Mahesh, B. 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