This post discusses foreign exchange risk and foreign exchange risk management. In this post, you will understand the meaning of foreign exchange risk and how to manage foreign exchange risks.

WHAT IS FOREIGN EXCHANGE RISK?

Foreign exchange risk (also known as currency risk, FX risk and exchange-rate risk) refers to the losses an international financial transaction may incur due to currency fluctuations. Currency risk, commonly referred to as exchange-rate risk, arises from the difference in the price of one currency to another. Currency risk entails the possibility that an investment value may decrease due to changes in the relative value of the involved currencies. Investors may experience jurisdiction risk in the form of foreign exchange risk.

Foreign exchange risk should be managed where exchange rate fluctuations impact the business’s profitability. In an industry where the core operations are other than financial services, the risk should be managed so that the firm focuses on providing the core goods or services without exposing the business to financial risks. Investors or companies with assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Many institutional investors, such as hedge funds, mutual funds, and multinational corporations, use forex, futures, options contracts, or other derivatives to hedge the risk.

UNDERSTANDING FOREIGN EXCHANGE RISK

Firms and individuals that operate in overseas markets are exposed to currency risk. Foreign exchange risk arises when a company engages in financial transactions denominated in a currency other than the currency where that company is based. Any appreciation/depreciation of the base currency or the depreciation/appreciation of the denominated currency will affect the cash flows emanating from that transaction. Foreign exchange risk can also affect investors, who trade in international markets, and businesses engaged in the import/export of products or services to multiple countries. Hence, the need for a sound foreign exchange risk management.

SOURCES OF FOREIGN EXCHANGE RISK

Foreign exchange risk for a business can arise from several sources, including:

• Where the business imports or exports;

• Where other costs, such as capital expenditure, are denominated in foreign currency;

• Where revenue from exports is received in foreign currency;

• Where other income (such as royalties, interest and dividends) is received in foreign currency;

• Where the business’s loans are denominated (and therefore payable) in foreign currency; and

• Where the business has offshore assets such as operations or subsidiaries valued in foreign currency or deposits.

IMPACT OF MOVEMENTS IN FOREIGN EXCHANGE RATES ON BUSINESSES

Sound foreign exchange risk management can be used to impact of foreign exchange rate fluctuation of a business. Here are the implications of movements (falling and rising) of foreign exchange rates on businesses. A falling domestic exchange rate can have the following effects:

• It can increase costs for importers, thus potentially reducing their profitability. This can lead to decreased dividends, which in turn can lead to a fall in the market value of the business;

• Domestically produced products can become more competitive against imported products;

• It can increase the cost of capital expenditure where such expenditure requires, for example, importation of capital equipment;

• The cost of servicing foreign currency debt increases;

• Exporters may become more competitive in terms of costs, potentially increasing their market share and profitability;

• The business could become a more attractive investment proposition for foreign investors; and

• For the business, the cost of investing overseas could increase.

IMPLICATIONS OF RISING DOMESTIC EXCHANGE RATE

Implications of a rising domestic exchange rate include:

• Exports can be less competitive, thus reducing the profitability of exporters. This can lead to decreased dividends, which in turn can lead to a fall in the market value of the business;

• It can decrease the value of an investment in foreign subsidiaries and monetary assets (when translating the value of such assets into the domestic currency);

• Foreign currency income from investments, such as foreign currency dividends, when translated into the domestic currency, may decrease;

• The cost of foreign inputs may decrease, thus giving importers a competitive advantage over domestic producers;

• The value of foreign currency liabilities will fall. Hence, the cost of servicing these liabilities decreases;

• The cost of capital expenditure will decrease, for instance, if it is for the importation of capital equipment;

• The business potentially becomes a less attractive investment proposition for foreign investors; and

• The cost of investing overseas may decrease.

TYPES OF FOREIGN EXCHANGE RISK

There are three types of foreign exchange risk: transaction, translation, and economic.

1. Transaction risk: Transaction risk arises when a company is importing or exporting. This is a company’s risk when buying a product from a company located in another country. The product’s price will be denominated in the selling company’s currency. 

2. Translation risk: A parent company owning a subsidiary in another country could face losses when the subsidiary’s financial statements, denominated in that country’s currency, have to be translated back into the parent company’s currency. Translation risk affects companies with foreign subsidiaries. 

3. Economic or Operating risk: Forecast risk refers to when a company’s market value is continuously impacted by unavoidable exposure to currency fluctuations. The source of economic risk is the change in the competitive strength of imports and exports. 

TYPES OF FOREX MARKET

There are three types of forex markets:

1. Spot market: the physical exchange of a currency pair occurs at the time the trade is settled – that is, ‘on the spot’.

2. Forward market: a contract is agreed to buy or sell a set amount of a currency at a specified price, at a set date or within a range of future dates.

3. Futures market: a contract is agreed to buy or sell a set amount of a currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding.

FOREIGN EXCHANGE RISK MANAGEMENT

Foreign exchange risk management entails strategies that help a company or investor protect their cash flows, assets or liabilities from adverse fluctuations of the exchange rate. Companies subject to foreign exchange risk can implement hedging strategies to mitigate that risk. This usually involves forward contracts, options, and other exotic financial products and, if done correctly, can protect the company from unwanted foreign exchange moves.

Effective management of currency risk is beneficial to international businesses. Such benefits include:

1. Protection for the business cash flow and profit margins.

2. Improved financial forecasting and budgeting.

3. A better understanding of how currency fluctuations affect an organisation’s balance sheet.

4. Increased a firm’s borrowing capacity.

METHODS OF MEASURING FOREIGN EXCHANGE RISK

There are several ways to measure foreign exchange risk, from simple to complex. Sophisticated measures such as ‘value at risk’ may be mathematically complex and require significant computing power. Here are some ways of measuring foreign exchange risk that most businesses can apply and understand: (1) register of foreign currency exposures, (2) projected foreign currency cash flows, (3) sensitivity analysis, and (4) value at risk.

STRATEGIES FOR MANAGING FOREIGN EXCHANGE RISKS

Understanding where and how currency fluctuations affect a company’s cash flow is complex. Many factors, from macroeconomic trends to competitive behaviour within market segments, determine how currency rates affect cash flows in a given business. 

Here are five strategies for managing foreign exchange risks:

1. Review your operating cycle.

2. Accept that you have unique currency flows.

3. Decide what rules you want to apply to your FX risk management 

4. Manage your exposure to currency risk.

5. Automate FX handling to free up your time.

FOREIGN EXCHANGE RISK MANAGEMENT PROCESS

Like all risks, Foreign Exchange (FX) risk is managed using the standard risk management process, which looks something like this for FX: 

1. Identify FX Risks: Gather underlying exposures from cash flow forecasts. Once the policy has been set, which is usually an infrequent activity, treasuries need to identify the FX exposures that must be hedged. This is the most critical part of FX risk management – inaccurate exposure data will lead to wrong hedging, increasing, rather than reducing, volatility.

2. Analyse FX Risks: Determine Value At Risk or other metrics of FX exposures. This analysis will form the basis for FX risk management evaluation and must be specified precisely in the FX policy. FX risk, both before and after treatment or hedging (also known as gross and net exposures), is commonly analysed using (1) Notional exposure, (2) Mark-to-market, (3) Value at Risk (VaR), and (4) Stress testing.

3. Treat or Manage FX Risks: Hedge with forwards (or options and collaborative strategies). Treating FX risk is usually achieved with some form of hedging. Commercial (non-financial) businesses typically use some or a mix of the following tools: (1) Natural hedging, (2) Loan hedging, (3) Forward hedging, and (4) Option hedging. 

4. Monitor FX Risks: Daily mark-to-market to ensure that hedging works as intended and risk limits are not exceeded. After hedging the FX exposures, treasurers continuously monitor the net FX exposures on the basis set out in their FX policy, which will typically include some combination of (1) Nominal exposure, (2) Mark-to-market, (3) Value at Risk (VaR), and (4) Stress testing. The treasury management system will generally automate this and trading systems, continuously (near real-time) or at least daily recalculating these metrics using current market rates and flag any limit breaches or other exceptions.

FOREIGN CURRENCY RISK MANAGEMENT TOOLS

Are you an importer or a business that makes regular overseas payments in foreign currency? Currency fluctuations can significantly impact your bottom line. Getting the proper protection from adverse currency fluctuation is one of the most important steps any business dealing in international trade can take. 

Here are six valuable currency risk management tools that a firm can engage in to protect its business from volatile exchange rates and enhance its competitive advantage:

1. Forward Exchange Contracts

A forward exchange contract is a binding agreement to sell (deliver) or buy an agreed amount of currency at a specified time at an agreed exchange rate (the forward rate). A forward contract eliminates the risk of exchange rate fluctuation by allowing the user to hedge expected foreign currency transactions by locking in a price today for a transaction that will take place in the future. For importers and those paying overseas suppliers, predicting and projecting future cash flow can eliminate uncertainty when doing business abroad.

2. Currency Futures

Think of these as items you can buy and sell on the futures market and whose price will closely follow the exchange rate. Suppose a US exporter is expected to receive €5m in three months, and the current exchange rate is US$/€1.24. Assume that this rate is also the price of US$/€ futures. The US exporter will fear that the exchange rate will weaken over the three months, say to US$/€1.10 (that is fewer dollars for a euro). If that happened, then the future market price would decline too, to around 1.1. The exporter could arrange to make a compensating profit on buying and selling futures: sell now at 1.24 and buy later at 1.10.

Therefore, any loss caused by the primary currency transaction is offset by the profit made on the futures contract. This approach allows hedging to be carried out using a market mechanism rather than entering into the individually tailored contracts that the forward and money market hedges require.

3. Options

Options are radically different. They give the holder the right, but not the obligation, to buy or sell a given currency at a fixed exchange rate (the exercise price) in the future (if you remember, forward contracts were binding). The right to sell a currency at a fixed rate is a put option (think: you ‘put’ something up for sale); buying the currency at a fixed rate is a call option.

4. Limit Orders

A limit order can be used to set the ideal exchange rate at which to buy a particular currency. This is a favoured strategy when current market rates are less favourable for currency buyers. They are highly favoured by businesses that need to make payments but are not confined to deadlines.

5. Stop Loss Orders

Businesses can use stop-loss orders to lock in a deal so that it never trades below what it deems to be an acceptable exchange rate. This effectively guarantees a minimum rate at which the currency is exchanged. It is an instruction to buy or sell currency at a predetermined ‘worst case’ exchange rate. Stop-loss orders are often used when there is negative sentiment about currency movements, and the risk of exposure of such movements can then be reduced.

6. Foreign Currency Bank Accounts and Loan Facilities

These alternative methods of managing foreign exchange risk can be used when the timing of the foreign currency inflows and outflows do not match. The timing issues can be managed by depositing surplus foreign currency in a foreign currency account for later use or borrowing foreign currency to pay for foreign currency purchases and then using the foreign currency to repay the loan.

See video on Foreign Exchange Risk and Foreign Exchange Risk Management: https://youtu.be/mZyqFm1xMH0