Understand Forex Risk Management

Introduction: Trading means exchanging goods or services among two or more parties/people. For example, if you need gasoline for your car, you would trade your dollars for gasoline. Earlier and still in some societies, trading was done through the barter system, where one commodity was exchanged for another.?

The moment you enter the worldwide web, and all of a sudden, risk becomes totally out of control due to the speed at which a transaction can take place.??

What is forex risk management?

Forex risk management comprises individual actions that allow traders to protect against the downside of a trade. Effective forex risk management enables currency traders to minimise losses resulting from exchange rate fluctuations. Consequently, having a proper forex risk management plan can make for safer, more controlled and less stressful currency trading.?

An effective strategy needs proper planning from the outset, so it's better to have a risk management plan before you start trading.

What are the risks of forex trading?

Exchange Rate Risk: This is the risk caused by changes in the value of the currency. It depends on the effect of continuous and usually volatile shifts in the worldwide supply and demand balance. This risk can be quite valuable and is based on the market's insight of which way the currencies will move to focus on all possible factors that happen (or could happen) at any point of time, anywhere in the world.?

Interest Rate Risk: Interest rate risk is the potential for investment losses that result from a change in interest rates. For instance, if interest rates rise, the value of a bond or other fixed-income investment will decline. The difference in a bond's price given a change in interest rates is known as its duration.

Credit Risk: It is generally a concern of corporations and banks. Credit risk is significantly low for an individual trader (margin trading), as this also holds for companies registered and regulated by the authorities in G-7 countries.?

The known forms of credit risk are:

1. Replacement Risk
2. Settlement Risk

Leverage Risk: Low margin deposits or trade collateral are normally needed in Foreign Exchange (just as with regulated commodity futures). Let's suppose, at the time of purchase, 5% of the price of a contract were deposited as margin, a 5% decrease in the price of the contract would be if the contract were then closed out, resulting in a complete loss of the margin deposit before any deduction for brokerage commissions.

Transactional Risk: Mistakes in the communication, handling and confirmation of a trader's orders may result in losses. Often, even where an out trade is mainly the error of the dealing counter-party institution, the trader/customer's recourse may be limited in looking for compensation for resulting losses in the account.?

Conclusion: It's useful to keep in mind that the huge majority of forex transactions are made by banks, but not individuals, and they are using forex to reduce the risk of currency fluctuation. Any investment that offers potential profit also has a drawback of risk, up to the point of losing much more than the value of your transaction when trading on margin.