Forex Currency risk and exchange rate regimes

Forex Currency risk and exchange rate regimes

Apart from the risks they pose as any conventional investment, investments denominated in foreign currency as supporting a foreign exchange risk due to currency fluctuations. Any investment abroad is thus a function of market performance and that of the currency.Although international investment offers the prospect of improved profitability, the net effect it has on the overall risk investors face in general depends on the portfolio diversification of the latter and hedges that 'they have conducted. It has been a flight of hedging foreign exchange markets.

Currency risk is perceived differently by investors by type of regime. In a floating exchange rate regime, the price of the currency is freely determined by the market based on private transactions. If the market is efficient, the exchange rate is supposed to reflect the fundamental value of money as determined by economic fundamentals of the country. In practice, it is the monetary authorities who administer the floating exchange rates of some currencies, central banks herald no targets to maintain, but they can intervene massively in currency markets to stabilize the currency. The Bank of Canada does not do so to influence the course of the dollar long term.

In East Asia, many countries except Japan, have pegged their currency to another currency, national monetary authorities that have committed to maintain the market price of the currency within a narrow range. In such schemes, investors, confident in the stability of this connection, have a different behavior in case of currency fluctuations. If they do not covertheir foreign exchange exposure, these investors face an increased risk. Hedging transactions involve derivatives such as options contracts , the futures and forward contracts in order to anchor the cost or income to a future existing parity.

Many Asian companies do not undertake any hedging transaction with respect to their currency positions before the collapse of the summer of 1997, as most Asian currencies were pegged to the U.S. dollar, and currency risk seemed negligible. In a survey of 110 CFOs in the CFO Forum held in Manila in November 1997, 55 p. 100 respondents said they did not use hedging instrument. After the depreciation of the national currencies of Indonesia, Malaysia, Thailand and South Korea, many Asian companies have suffered significant losses, and others have had to declare bankruptcy. American or European multinationals have generally suffered less, because they have long used hedging to protect themselves.

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