Any transaction in foreign exchange involves foreign currency risk. Understanding forex risk and how it impacts your trades will help you become a better trader.
Currency is a separate asset class that gives opportunities to profit in the short term. But like any other business, currency trading involves risk. Anyone who wants to enter the currency trading realm must understand the risks involved.
The primary type of risk involved with currency is foreign exchange risk. Foreign currencies are quoted in pairs, and their price varies depending on demand and supply factors, meaning the price of one currency keeps changing throughout the day. The continuous price change results in profit opportunities, but it also involves risks. Let’s understand with an example.
The value of USD 1 may be Rs 80 today. So, if the rupee strengthens tomorrow, USD 1 may equal Rs 78.
What is Currency Risk?
To put it simply, foreign exchange risk is the risk of financial impact due to fluctuating exchange rates. Currency risk also impacts a business’s economic performance. It is the possibility of losses arising from exchange rate fluctuations.
Forex risk is relevant to individuals involved in the trading of foreign currencies.
Currency risk example
To trade in currencies, you need to understand the foreign exchange risk.
Suppose you buy USD 100 at Rs 76/USD1. So, you spent Rs 7600 to purchase USD 100.
If, after two days, you try to sell USD 100 and the exchange rate has changed to Rs 77, you profit Rs 1000 from the transaction.
But the exchange rate can also decrease, in which case you will incur a loss on the trade. The possibility of facing losses in currency trading is called foreign exchange risk.
Types of Forex Risks
Forex risk can be classified as follows.
Transaction risk–
It refers to the risk of currency rate change during settlement. Companies trading abroad face transaction risks. The time delay between the transaction and payment is the extent of transaction risk.
Economic risk–
Several macroeconomic factors and geopolitical instances are responsible for Forex rate fluctuations. These are the economic risks of currency trading.
Translation risk–
Companies headquartered domestically and operating abroad are exposed to translation risks. The translation risk increases when the company holds a significant portion of its assets, liabilities, and equities in foreign locations.
Important Things You Should Know About Currency Risk
- Currency risk is not limited to currency trading.
- You’ll incur currency risk for all foreign transactions, like investing in foreign stocks.
- It is impossible to eliminate currency risk, but you can minimize your exposure through hedging techniques.
- You can reduce your risks by diversifying your portfolio.
Types of the Currency Market
There are two primary kinds of currency markets – the spot market and the futures market, where currency futures are traded.
Opening trading account–
To trade in currency, you must open a currency trading account. Do your research to find a suitable broker.
Understand Currency Trading–
Every currency trader has a trading style that aligns with their risk profile. Understand your limits and risk appetite before betting on your money.
Know your limit–
Before entering a trade, specify your entry and exit to minimize losses. No transaction is guaranteed, so you should always have an exit plan when it doesn’t go according to your expectation.
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