Summary - Foreign Exchange Risk

The exchange rate stated simply is the price of one currency in terms of another currency. Exchange rate can therefore be expressed in terms of the law of one price which states that "in the presence of a competitive market structure and the absence of transportation cost and other barriers to trade, identical products which are sold in different markets will sell at the same price in terms of a common currency" (Pilbeam, 1992). Importers and exporters are exposed to the fluctuation in foreign currency (FC) exchange therefore undergoing business risks as they operate mainly in international markets. They are, in global market terms, therefore affected by the fluctuation mainly in the value of the US dollar, the Euro and to a lesser extent the British pound, and other foreign currencies. In principle, in the normal course of doing business, importers and exporters employ derivatives financial instruments, including forward contracts and foreign currency options to manage their exposure to fluctuation in foreign currency exchange rates.…