Introduction to currency risk management
Fluctuations in currency prices are one of the sources of risk that may influence the financial results of corporations or individuals having credits/liabilities in foreign currencies. Assuming that the company:
- has assets or business operations across national borders;
- invests abroad;
- has credit or loanes in a foreign currency
It follows that it is exposed to currency risk, as long as the management does not decides to hedge the positions.
Volatile exchange rate fluctuations that occurred during recent years had a significant influence on the financial results of many corporations, often weakening their position among competitors. Moreover, higher volatility of exchange rates may lead to a decrease in incomes for exporters and more expensive goods for importers. For the reasons described above, an increasing number of corporate clients are investigating the possibilities of currency risk management, looking for optimal solutions.
The derivative instruments offered by X-Trade Brokers enables one to manage the currency risk simply and cheaply. High liquidity, with no hidden costs and easy access 24 hours a day - make CFD and financial options attractive and convenient tools to manage currency risk.
Risk management
Importance of Risk Management
Risk management is crucial to the long term success of any trader. It is very important to treat your trading account like you would any other business. Trading is not a game, it's real money and it's very easy to lose it if you don't know what you are doing. Risk management can make or break a good trading system.
What Is Risk Management?
Risk management is an essential part of effective investing. It separates investors from gamblers. In its simplest form, it is understanding which risks are likely to be profitable and which are not. In investment lingo this is described as "limiting one's risk exposure". Some risk is necessary to earn a profit, too much will empty your account. You need to find a profitable balance.
Below are three risk management techniques that can help create this balance.
Stop Loss Order
A stop loss order, or sometimes referred to as a conditional placement, can be broken into different categories based on a traders requirements. The various types include:
- Sell Stop Loss Order
- Stop Limit Order
- Buy Stop Loss Order
- Trailing Stop Loss
- Trailing Stop Limit Order
- Bracket Order
Setting adequate stop loss orders in Forex is extremely important. As it is a leveraged product, the fluctuations in pricing can be quite significant on a daily basis. Recent economic and monetary policy changes have spurred a new wave of volatility in the markets and will continue to cause uncertainty. Stop Loss orders are a fantastic way to manage appropriate risk and keep within your own personal trading guidelines and rules.
Determining Trading Risk
An investor can determine the exact risk of a given trade by using a risk-reward ratio. While novices tend to only focus on the potential gains, potentially losses play an equally important role. The risk-reward ratio helps the trader to focus on both aspects of each trade. What is a good risk-reward ratio? While 1:2 ratio is acceptable number a better ratio is 1:3 or 1:4. A 1:1 or 2:1 risk-reward ratio is unacceptably risky.
Keeping The Profits
A third and very rewarding risk management tool is to regularly remove any profits from a winning trade. This automatically reduces your risk exposure and forces you to keep your gains.
Implementing effective risk management strategies is the difference between investing and gambling. Being disciplined about this will dramatically increase your chances of long term and profitable forex trading.
Risk: Reward Ratio
The risk:reward ratio is used to compare expected returns of an investment versus the amount of risk associated with those returns. It is calculated by dividing the amount of profit expected when the position closes (reward) by the amount the trader stands to lose if price moves in an unexpected direction (risk).
Forex Trading Examples
Please be advised:
- 1 lot equals 100,000 of the first named currency on the MetaTrader 4 platform
- Pip values are calculated in the second named currency
- Profit is calculated by (sell price – buy price) x contract size
- Profit is converted to the account currency by the price quoted in the currency/exchange rate
Example 1
A client buys 1 lot of AUD / USD 0.9169
The position is closed 0.9179 Profit / Loss is calculated as 0.9179 - 0.9169 x 100,000 = US$100
The profit / loss is converted to the account currency by the following calculation: 100 / 0.9179 = $108.94
Example 2
A client sells 0.5 lots of EUR / GBP 0.8333
The position is closed 0.8403. Profit / Loss is calculated as 0.8333 - 0.8403 x 50,000 = -GBP£350
The profit / loss is converted to the account currency by the following calculation: 350 / 0.5923 = -$590.52
Example 3
A client buys 0.5 lots of AUD / JPY 77.35 The position is closed 78.20 Profit / Loss is calculated as 78.20 – 77.35 x 50,000 = JPY¥42,500
The profit / loss is converted to the account currency by the following calculation: 42,500 / 78.20 = $543.48