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Exchange Risks in Forex

Forward exchange operations provide an opportunity to traders to safeguard themselves against the risks arising from changes in. exchange rates. Normally traders are interested in making their profits by marking up tile purchase price by a certain percentage.

In foreign trade, the purchase and sale price of the traders is expressed in terms of different currencies. When purchase and sale price are expressed in terms of different currencies, changes in exchange rate may upset all the calculations of the traders.

Risks from changes in exchange rates are particularly high under the system of free and fluctuating exchange rates. Such risks are not very important under pegged exchange rates and gold standard. If the traders wish to avoid these risks and to concentrate on their normal functions (i.e., trading activities), and the risks involved in these, they can contract in advance to buy or sell foreign exchange, equivalent to the amount of payment they expect to make or receive, at a guaranteed rate.

Suppose, for illustration, that an Indian exporter contracts to export tea to the United Kingdom for which he will receive payment in terms of sterling after ninety days. To avoid the risk of a change in the exchange rate at the time he receives payments, he can contract with his bank in advance to sell the amount of sterling which he expects to receive after ninety days at a guaranteed exchange rate.

Similarly, an importer placing an order for goods from the United Kingdom, knowing that he has to make payment in terms of sterling after ninety days, can contract with his bank in advance to buy sterling after ninety days at the guaranteed exchange rate and thus safeguard himself from the risks arising from changes in the exchange rate, forward exchange facilities also enable foreign investors and foreign debtors to cover themselves against exchange risks.

Limitations of forward exchange facilities--- insuring against exchange risks through forward exchange deals involve a cost. If this cost is not fairly low, exporters who are ready to undertake the exchange risks in addition to trading risks will be in a position to undersell those exporters who have to pay a charge for insuring against exchange risks and may thus oust them from the export business.

Similarly, importers who do not insure themselves against exchange risks can under quote those who insure against exchange risks and thus put them to great losses. Changes in exchange rates affect not only the amount of the national currency which the exporters receive for their exports and the importers have to pay for their imports but also the prices of the exported and imported commodities in terms of the national currency.

Forward exchange facilities can cover the traders against only the former type of risks (i.e., direct exchange risks).

These are available only for important commodities for which there exist forward markets. If the domestic price of the imported goods rises (falls) by the full amount of the depreciation (appreciation) of the national currency, the loss (gain) to the uninsured importers on account of depreciation (appreciation) will be fully offset by the gain (loss) from a rise (fall) in the domestic price of the imported commodity.

Under such conditions the uninsured importers will be as well of as the importers who pay to cover themselves from both the kinds of risks mentioned above, i.e., (i) the direct exchange, risks, and (ii) the indirect exchange risks. Similar situation will arise in case of exports if the domestic price fails (rises) by the full amount of the depreciation (appreciation) of the domestic currency.

In order to avoid the risks arising from changes in the prices of commodities in terms of national currency as a result of changes in exchange rates: (i.e., the indirect exchange risks), the traders will have to pay an additional charge for availing of hedging facilities available in forward commodity markets. Hedging facilities are not available for all commodities.

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