Foreign Exchange Rates

Foreign Curency Translation risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency.

Exchange Rate Risk

In the context of a currency transaction, the exchange rate risk refers to the possibility of the market exchange rate deviating significantly from the exchange rate at the time of the transaction immediately or shortly after the transaction is agreed upon. In other words, if a market participant decides to buy or sell a currency, there is always a risk that the currency exchange rate will change, and that if he had waited another couple of seconds he could have gotten a better (or worse) exchange rate.

Counterparty Risk

Counterparty risk is the risk that the party you are dealing with (another bank or a broker), will not honor its currency delivery obligations. Although this is a remote possibility, market participants should take into consideration even remote risks, especially after the collapse of celebrated investment bank and hedge fund broker Lehman Brothers in September 2008.

A Video about Counterparty Risk

Computer Security

Computer security is another area of potential concern. Even though foreign exchange transactions are conducted on extremely secure computer networks, the chance of a cyber attack and subsequent damage to transaction systems is always real.

Measuring and managing transaction risk becomes a difficult proposition because of the following:

• Exposures are fragmented over multiple oil blocks which are managed by different operators
• Managing transaction risk on capex imports by buying dollars forward can become counter-productive because it presumes that import payments are serviced out of INR borrowings or earnings

While dealing in a dollarized commodity and where foreign currency denominated borrowings are a key source of funding, transaction risk largely arises due to mismatches in timing of cash flows.

The solution to improved transaction risk management lies in improved liquidity management as opposed to use of derivatives to manage currency risk.