Derivatives and Foreign Exchange Term Paper Example | Topics and Well Written Essays - 2500 words

Derivatives and Foreign Exchange - Term Paper Example Within the financial context, derivatives include several financial contracts such as the swaps, futures, options, forwards, and; variations i.e., floors, caps, credit default swaps, and collars. Quite a number of derivatives are marketed via the off-exchange (over-the-counter) or through exchanges i.e., the Chicago Mercantile Exchanges, even though a number of insurance contracts have adopted the use of separate industry (Moffett, Stone-hill, & Eiteman, 2009). Financial Exposure Risks a) Economic Exposure Economic risks or operation exposure are experienced by any business organization when its targeted market’s value has been completely influenced by any unexpected exchange rates’ fluctuations, which have the impact of severely influencing negatively the market position/share with respect to its active competitors (Moffet, Stone-hill, & Eiteman, 2009). With this happening, the organization’s future cash flows and values are also affected. Therefore, transaction s exposing any organizations of firms to certain foreign exchange risks have additional potential exposure risks to the economical performance, as can be caused by any other business involvements, i.e., future cash flows from the available fixed assets. Hence, it can be concluded that a shift in the exchange rates that influences the demands for goods in some region or countries can as well be considered as an economic exposure for firms that sell that particular type of products. b) Transaction Exposure This occurs whenever a company has any payables and receivables, or contractual cash flow with any value subjected to unanticipated alterations within the exchange rates as a result of contracts being denominated in foreign currencies. To react to this change and for the company to ensure realization for its domestic values of its foreign-denominated cash flows, it has to effectively conduct an exchange of foreign currencies for the domestic types of currencies. Therefore, the proce ss of immense negotiation contracts with the laid down prices and delivery dates in the face of a volatile foreign exchange market with exchange rates that are in a constant rate of fluctuations, such institutions are bound to face risks of changes in the exchange rates between the foreign and domestic currencies. c) Contingent Exposure Firms do face contingent exposures whenever they are in the processes of bidding for foreign projects, or while making negotiations for other contracts and/or foreign direct investments. Contingent exposure therefore steps in from the potentials of the firms to abruptly undergo the economic foreign exchange or transactional risks. d) Translation Exposure A translation exposure is an extent to which firms’ financial reporting are affected by the exchange rates’ movements. This is brought about by the fact that all firms are bound to come up with their consolidated financial statements for their reporting reasons, the consolidation proces s for the multinationals have to take into account the translation of foreign assets and liabilities or the stated financial reporting of foreign subsidiaries for the foreign to domestic currencies (Levi, 2005). Although such exposures may not be of