The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. It determines the relative values of different currencies. A local currency is a currency not backed by a national government, and intended to trade only in a small area. Currency is used as a medium of exchange in goods and services. It has vital role in the economy. Because devaluation of a local currency makes its goods relatively cheaper; it increases the capacity of exports. With the decrease in demand for local country’s goods and services, its local currency devaluates and reverse is the case if its volume of exports increases.
The currency exchange rate is one of the important factors which affect balance of payment of a country. A balance of payments (BOP) sheet is an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, and financial capital, as well as financial transfers. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item. Foreign exchange is the methods and instruments used to adjust the payment of debts between two nations that employ different currency systems. A nation's balance of payments has an important effect on the exchange rate of its currency. Bills of exchange, drafts, checks, and telegraphic orders are the principal means of payment in international transactions. Buying or selling foreign currency in order to profit from sudden changes in the rate of exchange is known as arbitrage. The chief demand for foreign exchange within a country comes from importers of foreign goods, purchasers of foreign securities, government agencies purchasing goods and services abroad, and travelers.
Siddiqui (2009) describes that Pakistan where economic, political and financial institutions are yet to be strengthened and administrative structure is needed to be disciplined. Pakistan is experiencing the most terrible politico-economic crises in its history. This worst situation of crisis is adversely affecting its local currency in addition to other real and monetary variables. Pakistan’s exchange rate changes more frequently than the exports and imports. The economy of Pakistan is experiencing slowdown in inflows as compare to outflows of foreign currency.
Foreign exchange risk is the change in the value of the firm occurs due to the potential changes in currency exchange rate (Christine, 1985). Pakistan imports are much more than its exports. When our exports are less than our imports it becomes a curse for economy. This curse also effect on our firms returns and also on the profitability. The foreign exchange risk appears when, on the payment day, the domestic currency has a buying...