Exchange risk refers to the effect that unanticipated exchange rate fluctuations may have on the value of transactions, assets and liabilities denominated in a currency which is different from the local currency of the firm(s) undertaking the transaction. Exchange rates react quickly to news, exhibiting behavior that is characteristic of other speculative asset markets.
Exchange rate fluctuations typically result in potential gain or losses to the parties in a transaction; for example, the cost of a project in Lagos, Nigeria financed by US Dollars provided by a bank in the United States will be impacted by a rise or fall in the value of the US Dollar. Consequently, individuals and firms entering into cross border transactions would be well advised to utilize financial and legal tools to protect themselves against risks arising from exchange rate fluctuations. Risk management tools in this respect include the use of forwards, futures and options
In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects those currencies to go. Foreign exchange is, of course, the exchange of one currency for another. Trading or “dealing” in each pair of currencies consists of two parts, the spot market, where payment (delivery) is made right away (in practice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.
In addition, a firm which intends to embark upon a transaction may purchase a US Dollar Option contract, thereby limiting the negative impact of upward movements in the exchange rate of the Naira to the USD. However, if the value of the dollar falls the consequential loss to the firm is limited to the cost of purchasing the option contract.For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or the USD rise).
Modern research in finance supports the reasoning that earnings fluctuations that threaten the firm’s continued viability absorb management and creditors’ time, entail out-of-pocket costs such as legal fees, and create a variety of operating and investment problems. Currency exposure is complex and can seldom be gauged with precision, however, these contracts offer the ability to lock in the anticipated change and mitigate the economic damage which may arise from unanticipated fluctuations in Foreign exchange values.