Knowing Foreign Exchange Risk

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Foreign exchange risk, also known as FX risk, currency risk, or exchange rate risk, refers to the risk involved in doing foreign business. It is the financial risk that comes from the danger of losing the investment value brought by the fluctuations in currency exchange rates, forming an income uncertainty for your business. If your company buys a product from an international provider, with payment due in the foreign currency of the provider, it may cost your company more in your own currency to pay the provider, based on the changing exchange rate. Businesses that export and/or imports their products, services, and supplies are the ones commonly exposed to the foreign exchange risk. FX risk can also affect your company’s profitability and/or the value of its assets and liabilities.

In order to eliminate the exchange rate risk, you should determine the nature and extent of the risk exposures, and incorporate a comprehensive foreign exchange risk management strategy, which includes the use of the forward contracts, options, and other financial products that can help hedge risk and guard the business’ cash flow when exposed to FX risk.

This article will focus on the different types of foreign exchange risk to give an idea of how these risks can impact a company’s growth and success.

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What are the types of FX risk?

1. TRANSACTION RISK

This type of foreign exchange rate risk that changes between the transaction date and the succeeding settlement date. In other words, it refers to the gain or loss that may arise on conversion. This is the particular risk involved in import and export businesses. If a company exports products on credit, then it has a certain amount of money for debtors in its accounts. The amount it will finally gain is based on the foreign exchange trends from the transaction date to the settlement date.

Transaction risk can affect the company’s cash flows, that’s why many companies prefer to hedge against such exposure. Quantifying and checking transaction risk is usually an essential component of treasury risk management.

The level of exposure depends on:

a) The dimension of the transaction;

b) The hedge period, the time period before the expected cash flows happens;

c) The projected volatility of the exchange rates during the hedge period.

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Foreign Exchange Risk

2. ECONOMIC RISK

While transaction risk is centered on reasonably short-term cash flow effects, economic risk also includes these as well as the long-term effects of changes in exchange rates on the company’s market value. This basically means a change the current value of the future after-tax cash flows because of the changes in exchange rates.

A company can be exposed either directly or indirectly to economic risk.

Directly:

If your company’s home currency reinforces, then international competitors can obtain sales at your expense because your products have cost more, or you have lessened your margins, in the eyes of customers both overseas and locally.

Indirectly:

Even if your home currency does not move in relation to your customer’s currency, you may still lose a competitive position. For instance, a South African company is selling into Hong Kong and its main rival is a New Zealand company. If the New Zealand dollar weakens against the Hong Kong dollar, then the South African company has lost some competitive position.

Economic risk cannot be measured easily, but a favored strategy to handle it is to diversify internationally, in terms of sales, production facilities’ location, raw materials, and financing. Such diversification is likely to considerably lessen the effect of economic risk relative to a completely local company, and give much greater flexibility to respond to the real changes in exchange rates.

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3. TRANSLATION RISK

The financial statements of foreign subsidiaries are normally translated into the home currency so that they can be consolidated into the group’s financial statements. It should be noted that this is completely a paper-based process – it is the translation not the conversion of real money from one currency to another.

The posted performance of a foreign subsidiary in home-based currency terms can be cruelly damaged, if there has been a considerable movement of foreign exchange. For instance, if the exchange rate is firstly given by $/£1.00 and an American subsidiary is worth $500,000, then the UK parent company will estimate a balance sheet value of £500,000 for the subsidiary. A decline of the U.S dollar to $/£2.00 would result in only £250,000 being translated.

Translation exposure will not usually be hedged if the managers believe that the company’s share price will decline as a result of indicating a translation exposure loss in the company’s accounts. In an efficient market, the company’s share price should only respond to the exposure that has a potential effect on cash flows.

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