Posted by forex at 9:55 AM
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1. Identify the cash flows of your business that need to be converted into another currency. If the numbers are not crystal clear (e.g., expected profits), at least come up with some estimated numbers. A good idea is to have different estimates for different scenarios.
2. Net your cash flows by linking incoming and outgoing cash flows denominated in the same currency. For example, if you are an American exporter, and your European operations have revenues and costs both denominated in euros, for purposes of measuring foreign exchange risk, you can net them out and be interested only in profits, which you may want to repatriate. In this case you are only exposed to having your profits cost less as a result of the euro declining against the U.S. dollar.
3. Analyze what exchange rates you are exposed to and study their historical and expected movements. Read experts' opinions about different possibilities for exchange rate movements. What is the most likely scenario? Also look at the worst possible exchange rate moves.
4. Figure out how much money you can potentially lose if the exchange rates move as expected. Here again, you need to come up with a range, including the worst-case scenario, the likely one, and the situation when the exchange rates move in your favor. Remember the probabilities (paying most attention to the most likely exchange rate moves), but also prepare for the worst. After you have measured your currency risk, you can hedge it.