Our Beginner’s Guide to FX Risk Management Strategies
Jul 26, 2022
While FX trading can be extremely lucrative, you’ll want to be aware of all the risks involved. Volatility within the foreign exchange market offers a range of opportunities to make money but also presents added risks to traders. When you trade forex, risk management allows you to set up rules that prevent you from losing too much money.
A forex risk management plan enables you to establish a set of rules and measures that ensure the negative impact of a forex trade can be managed. It’s better to have a risk management plan in place before you start trading, since then you can create a strategy that suits that plan. Risk management is most effective when you know ahead of time how you are going to implement your strategy. Successful currency-trading strategies will account for these risks. If you want to learn how to effectively and efficiently manage risks, then we’ve got just the thing for you. Here’s a guide on FX risk management strategies that you have to know about.
Types of Foreign Exchange Risk
Before we get to the strategies, it’s important to understand the risks involved. There are three categories of foreign exchange exposure that you may face: transaction exposure, translation exposure, and economic (or operating) exposure. We’ll look at each of these in greater detail below.
Transaction Exposure: This is the simplest kind of foreign currency exposure and arises when an actual payment takes place in a currency other than the entity’s functional currency. An exposure arises due to the time difference between when a customer is entitled to receive cash and when that customer physically receives the cash. Or, in the case of payables, the time difference between when an order is placed and when it's settled.
Translation Exposure: This is the process of converting a set of financial statements, such as a profit and loss or balance sheet, from one currency to another. This arises because the parent company must provide consolidated financial statements in its reporting currency for all of its subsidiaries.
Let’s say the US-based company decides to set up a subsidiary in Germany to manufacture machines. The subsidiary will report its financial results in Euros, and the US-based parent company will translate them into US dollars.
Economic Exposure: Firms might experience an unexpected impact to cash flows and market value if exchange rates change unexpectedly, which makes it important to understand and control foreign exchange exposure over time. This can impact long-term strategic decisions such as where to invest in manufacturing capacity.
Understand the Forex Market
The first thing you have to do is to understand the forex market. The foreign exchange market (forex, FX, or currency market) is a global decentralized or over-the-counter market for the trading of foreign currencies. This market determines the foreign exchange rate. The main participants in this market are called currency traders and typically are large banks, multinational corporations, financial institutions, and other financial traders. The foreign exchange market assists international trade and investments by enabling currency conversion. It also supports direct speculation and evaluation relative to the value of nations' currencies.
There are three different types of forex markets that you have to know about:
Spot Market: A currency exchange takes place the moment the trade is settled.
Forward Market: An agreement is made to buy or sell a set amount of a currency at a specified price on a specified date in the future or within a range of future dates.
Futures Market: When you enter into a futures contract, you agree to buy or sell a set amount of a currency at a set price and date in the future. Unlike forwards, futures contracts are legally binding.
Get a Grasp on Leverage
When you speculate on the price movements of foreign exchange (forex) using spread bets or contracts for difference (CFDs), you will be using leverage. Leverage enables you to make full market exposure from a small initial deposit – known as margin. While using leverage has its benefits, there are also downsides – such as the possibility of magnified losses.
For example, if you wanted to trade with the British pound against the US dollar using CFDs, and the pair was trading at $1.22485, with a USD price of $1.22490 and a GBP price of $1.22480, you might decide that the pound is set to appreciate against the US dollar, so you decide to buy GBP/USD CFDs at $1.22490. In this case, buying one GBP/USD CFD is roughly equivalent to trading $10,000 for £12,249. You decide to buy three CFDs, so your total position size becomes $36,747 (£30,000). However, your margin will be 3.33%, which is $1223.67 (£990).
Put Together a Good Trading Plan
Failing to plan is planning to fail. A trading plan can act as your personal trading guide in order for you to make decisions. It can help you maintain discipline in the volatile forex market. How does a trading plan work? The purpose of this plan is to answer important questions, such as what, when, why and how much to trade.
When creating your forex trading plan, it is essential to make sure it is personal to you. It is not good to copy someone else's plan because that person has different goals, attitudes, and ideas. They also have a different amount of time and money to dedicate to trading than you do. A trading diary is another tool you can utilize to track your trades, recording information about your entry point and exit choices when trading, as well as your emotional state at the time.
Have a Set Risk-Reward Ratio
Forex traders that want to minimize the risk of trade while maximizing the rewards, should consider the risk-reward ratio. Whenever you take a trade, you want the positive effects of that trade to outweigh the negative effects. While this may seem complicated, all you really need to do is to have a set risk-reward ratio. To calculate the ratio, divide the amount of money you could lose on an FX trade by the amount of money you could potentially make. If the most you could lose on a trade is £200 and the most you could gain is £600, the ratio would be £200/$600, or 1:3. In other words, for every £3 of potential gains, there's a potential loss of £1. If you had ten trades with this risk-reward ratio and were successful in three out of them, you would make £400, despite only being right 30% of the time.
Utilize Stops and Limits
Because the forex market is very volatile, and you have to decide on entry and exit points before you open a position, you can use various stops and limits to do this:
Normal stops will automatically close your position if the market moves against your trade. However, there is no guarantee against slippage.
Guaranteed stops ensure that the stop loss will be executed at the price you specified, so you can eliminate the risk of slippage with that requirement.
Using trailing stops, you will close your position by trailing your stop further from the market as the price rises
Limit orders will automatically attempt to close a position when the price hits your chosen profit target.
Manage Your Emotions
You’ll want to keep your emotions out of trading. Volatility in the foreign exchange market can knock you off your feet as it is, so you’ll want to minimize any other factors that could negatively affect how you trade. Fear, greed, temptation, doubt and anxiety may tempt you to trade, or they might cloud your judgment if you do. Either way, your emotions could harm the outcome of your trades. When it comes to trading, it’s best to be as objective and as detached as humanly possible. While it might be difficult to trade objectively, be sure to keep your goal in mind so that every move works towards achieving that goal.
Keep Track of the News and World Events
Predicting the price movement of currency pairs can be challenging, as the market could be affected by numerous factors. To ensure you are not surprised, watch central bank decisions and announcements, political news and market sentiment. This shouldn’t be all too difficult as the internet makes valuable information extremely accessible.
Transact in Your Own Currency
Businesses may be able to insist on transactions in a single currency when involved in international trade. For instance, a business with a dominant position selling a product or service with high brand recognition may be able to insist on invoicing and payment in US dollars even when operating overseas. This passes the exchange risk onto the local customer or supplier. In practice, this may be difficult because merely paying taxes and salaries in a different currency would pose a risk.
Build Protection Into Your Commercial Contracts
For long-term contracts that involve a significant foreign currency component, companies in the oil and gas, energy, and mining industries may be exposed to exchange-rate risk. Foreign exchange clauses can protect revenue from erosion due to shifting exchange rates. These clauses must be carefully drafted because revenue recouped in such cases is usually the responsibility of the customer/supplier rather than the company.
These can be a very effective way of protecting against foreign exchange volatility, but they require several stipulations to be included in the contract. The first stipulation is that the legal language must be clear and the indices against which the exchange rates will be measured must be specified. The second stipulation is that once the exchange rate clause is triggered, the finance and commercial teams must regularly review the situation to ensure that any necessary action is taken to recoup the loss.
Make Use of Natural Foreign Exchange Hedging
When a company’s revenues and costs are matched in different currencies in a way that minimizes the exposure is called a natural hedge. For example, a United States company operating in Europe might look to source products from the European Union to supply into its domestic United States market in order to utilize Euros. This is an example of how a company can use its operations across countries to increase profits. The setup, however, does create an issue for the finance team and the chief financial officer: because net transactions must be tracked in multiple currencies, managers must manage a parallel balance sheet along with the traditional books of account.
Practice on Demo Accounts
A demo account is designed to be as realistic as possible, simulating a live trading environment without risking the loss of real money. When you open a demo account, you’ll usually get access to the real trading platform that you plan on using, along with a set amount of virtual funds.
We hope this article proves to be useful when it comes to furthering your understanding of how to manage FX risks. While it can be rather tricky, this isn’t something that you won’t be able to do as long as you are well-informed. While it may seem daunting, many of the risks involved in FX trading are related to commercial and strategic factors that you'll be able to prepare for. We understand that this may be a lot to take in all at once. Luckily, you are free to come back to this article when you need a brief refresher on this subject. For the best results, it would also be wise to utilize all the resources you have available so that you can effectively manage the risks. Be sure to keep everything you’ve learned here in mind so that you can make the most informed decisions possible.
When it comes to FX risk management, you’ll want to do all you can to ensure that your interests are protected. Bound is an auto hedging platform dedicated to making currency protection better for businesses of all sizes. For more information on what we can do for you, we implore you to visit our website today!