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What is meant by foreign exchange risk?
Foreign exchange risk means taking the risk that tomorrow’s exchange rate will differ from today’s rate.
What specific problems does foreign exchange present in an organization?
An organization may encounter a problem with foreign exchange when they are competing with another seller for a specific item and the amount of the currency fluctuates.
For example A Chinese beauty supply distributor enters into a contract with a Indian supplier to buy hair from India for 8,800. The amount is payable on the delivery of the hair, 30 days from today. We see the range of spot rates that we believe can occur on the date the contract is consummated. On the thirtieth day, the Chinese importer will pay some amount in the range of $13,699.84 (8,800 × 1.5568) to $15,087.60 (8,800 × 1.7145) for the hair.
At the time of purchase the Chinese distributor is not certain what its future dollar outflow will be in 30 days. Therefore, the dollar value of the contract is uncertain.
The variability of the exchange rate induces variability in the future cash flow.
How may an organization that needs euros in 6 months protect itself from currency fluctuations?
An organization should contact their bank to assist with a form of hedging being that political stability or lack thereof has an impact on currency fluctuations. Typically the more stable the political situation the less likely a currency is to fluctuate. Hedging is a means of insuring against the price of an item or currency moving against you in the future.
Typically the more stable the political situation the less likely a currency is to fluctuate.
The political situation would typically inform managers on how aggressive to approach hedging strategies.
Clearly, for the American investor, the exchange factor induces a greater variability in the dollar rate of return. Hence, the exchange rate fluctuations may increase the riskiness of the...
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