5 Steps to Manage Your Currency Risk and Interest Rate Risk
Jun 18, 2024
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Currency risk is commonly referred to as exchange-rate risk. It arises from the change in the price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses.Many multinational corporations and institutional investors, such as hedge funds and mutual funds, use forex, futures, options contracts, or other derivatives to hedge the risk. While investing in fast-growing foreign countries may appear straightforward, there is an unforeseen risk that can significantly impact your returns: foreign currency risk. While foreign countries may offer higher growth, their currencies may also be less stable than what American investors are used to. So it’s important not to overlook the risk presented by a fluctuating currency.
Investing in foreign assets has proven the merits of diversification, and most individual investors take advantage of the benefits of international assets. However, unless the foreign securities have been issued in U.S. dollars, the portfolio will experience currency risk. Currency risk is the risk that one currency moves against another currency, negatively affecting an investment's overall return. In other words, the exchange rate between the two currencies can move adversely and erode the returns of a foreign investment.1 Investors can accept currency risk and hope for the best, or they can employ hedging strategies to mitigate or eliminate the risk.managing currency and interest rate risks is paramount for businesses and investors. Whether operating globally or navigating domestic markets, implementing sound risk management strategies can safeguard against potential losses and optimize financial outcomes. Here are five essential steps to effectively manage currency and interest rate risks:
1. Formulate a Risk Management Policy:
Begin by developing a comprehensive risk management policy tailored to your organization's objectives and risk appetite. Define clear guidelines for identifying, assessing, and mitigating currency and interest rate risks. Establish protocols for decision-making, monitoring, and periodic review to ensure alignment with evolving market conditions and business priorities.
2. Customize Hedging Strategies:
Tailor hedging strategies to minimize exposure to currency and interest rate fluctuations effectively. Utilize a combination of hedging instruments, including forward contracts, options, swaps, and structured products, to align with your specific risk profile and financial objectives. Leverage expert insights and analytics to optimize hedging decisions and enhance risk-adjusted returns.
3. Maximize Value Addition through Outsourcing:
Consider outsourcing specialized risk management functions to experienced partners with a focus on value addition. Collaborate with reputable service providers to access advanced risk analytics, technology platforms, and market intelligence. Leverage external expertise to augment internal capabilities, drive efficiency, and unlock strategic insights for informed decision-making.
4. Actively Utilize Financial Products:
Take advantage of a diverse range of financial products available on both over-the-counter (OTC) and exchange platforms. Explore vanilla and structured instruments tailored to your risk management objectives, liquidity requirements, and market preferences. Stay abreast of product innovations and regulatory developments to capitalize on emerging opportunities while mitigating potential risks.
5. Optimize FX Borrowing Strategies:
Evaluate borrowing needs meticulously and analyze prevailing market conditions to devise optimal FX borrowing strategies. Develop a robust framework for managing long-term FX exposure, balancing cost efficiency with risk mitigation objectives. Engage with trusted advisors to navigate the borrowing process, negotiate favorable terms, and implement effective currency risk mitigation strategies.
6. Evaluate Performance:
Measure treasury performance to evaluate which strategies and products worked and didn’t work and whether processes can be modified to better achieve the objectives of the treasury while implementing the risk management policy.
Frequently Asked Questions
What are some types of market risks that First Basis manages?
Interest Rate risk: Interest rate fluctuations are the source of interest rate risk, which is especially important when it comes to fixed- income assets like bond. Interest rate changes can alter bond and prices, which can have an effect on the performance of the entire portfolio.
Commodity risk: This type of risk is related to changes in the pricing of commodities like gold, crude oik, and agricultural items. commodity prices are influenced by a number of factors, including weather patterns, geopolitical conflicts, and the dynamics of supply and demand.
Currency risk: Currency risk, sometimes referred to as Exchange - rate risk is the result of fluctuation in the relative price of different currencies. Currency risk may be present for investors with foreign currency-denominated assets.
How Currency, Interest Rate and Commodity Risk affects Business?
Currency rate fluctuations can also have an impact on the future value of your business, its competitiveness in the medium or long term, and your investments. With currency transaction risk, failure to protect your future transactions could expose your business to significant losses. For example, if the exchange rate changes unfavourably between the time you make a sale or accept a quote and the time you receive payment or pay your supplier, you’ll suffer what’s called a dead loss. With economic risk, your foreign assets, investments, or financing could depreciate and reduce the value of your business. With currency conversion risk or accounting exchange risk, changes in currency rates could adversely affect the financial statements of an international business when consolidating the results of foreign subsidiaries.
Interest rate fluctuations affect borrowing costs, investment returns, especially for fixed-income securities like bonds and may delay or accelerate investment decisions based on interest rate expectations. Whereas, Commodity price swings can disrupt supply chains and affect production costs. Industries like agriculture, oil and gas, and metals and mining are directly affected by commodity price changes.
How does First Basis manage Currency, Interest Rate and Commodity Risk?
Currency Risk (or FX risk), Interest Rate Risk or Commodity Risk management are strategies used by companies to avoid or minimize potential losses that could result from fluctuations in exchange rates, interest rates and commodity prices. It involves assessing the type and level of risk, measuring it, and deciding on appropriate methods to manage the risk.
To avoid impacts on earnings, First Basis support organizations in managing their forex exposure and borrowings by creating and implementing risk management policies to guide the firm’s foreign exchange, interest rate and commodity purchase/sale operations, supporting corporates to arrange financial hedging facilities with banks or exchanges, assisting in buying or selling foreign currencies/ commodities at spot rates or forward rates, training treasury personnel and most importantly, performance measurement and reporting. First Basis’ corporate treasury experience combined with expertise in technical and fundamentals of financial markets enables them to transform an organisation’s treasury into a dynamic, professional one with industry best practices in risk management, execution, and reporting.
