Foreign Currency Exchange Risk Management

The foreign exchange market is characterized as carrying a significant degree of risk. There are several types of forex risks that participants should examine when considering the option of trading there. They are as follows:

1. Exchange rate risk

   The exchange rate forex risk results from the constant changes in the prices of currencies during a trading period. Losses from this type of risk can be minimized if appropriate measures are taken.

   Position limit and loss limit are the measures that are commonly used for the purposes of minimizing losses and keeping them within reasonable boundaries. A maximum amount of a particular currency is set, which the trader is allowed to carry during the regular trading hours in order to limit a position. On the other hand, stop-loss levels are set under the conditions of a loss limit in order to avoid losses that cannot be sustained by the trader.

2. Interest rate risk

   This risk results from the interest rate differential between currencies of two different countries in a foreign exchange contract.

   A limit on the total amount of mismatches is established in order to minimize interest rate risk. Many traders tend to group mismatches according to maturity date (e.g. those with a maturity date up to six months, and those above six months). Additionally, changes that can have an influence on the outstanding gaps call for the continuous examination of the interest rate environment.

3. Credit risk

   This type of risk includes the likelihood that a counter party may fail to repay an outstanding currency position on purpose or unintentionally. There are several types of credit risk, such as:

   • Replacement risk - results when the counterparties who should pay the refunds are not able to pay their due.
   • Settlement risk - caused by geographic differences in time. As a result the trading of a currency may occur at different price at different times during one and the same trading day.
4. Country Risk

   This type of risk is related to governments that participate in foreign exchange market by interfering in the currency flow.

Finally, every investment hides its risks but the risk of sustaining a loss when trading on the foreign exchange market is even bigger. Therefore you should realize and be familiar with all the risks connected with currency trading before you start participating in forex.

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