Foreign exchange risk

What is Foreign exchange risk?

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the reporting currency of the consolidated entity. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the date when the transaction is completed. Investors and businesses exporting or importing goods and services or making foreign investments have an exchange rate risk which can have severe financial consequences; but steps can be taken to manage (i.e., reduce) the risk.

Foreign exchange risk typically affects businesses that export and/or import their products, services and supplies. It also affects investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment’s value to either decrease or increase when the investment is sold and converted back into the original currency.

Types of exposure

Transaction exposure

A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it.

Applying public accounting rules causes firms with transactional exposures to be impacted by a process known as “remeasurement”. The current value of contractual cash flows are remeasured at each balance sheet date. If the value of the currency of payment or receivable changes in relation to the firm’s base or reporting currency from one balance sheet date to the next, the expected value of these cash flows will change. U.S. accounting rules for this process are specified in ASC 830, originally known as FAS 52. Under ASC 830, changes in the value of these contractual cash flows due to currency valuation changes will impact current income.

Economic exposure

A firm has economic exposure (also known as forecast risk) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm’s market share position with regards to its competitors, the firm’s future cash flows, and ultimately the firm’s value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good. Economic Exposures cannot be hedged as well due to limited data, and it is costly and time-consuming. Economic Exposures can be managed by, product differention, pricing, branding, outsourcing,

Translation exposure

A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm’s cash flows, it could have a significant impact on a firm’s reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments.

Contingent exposure

A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.

Measurement of Foreign exchange risk

If foreign exchanges market are efficient such that purchasing power parity, interest rate parity, and the international Fisher effect hold true, a firm or investor needn’t protect against foreign exchange risk due to an indifference toward international investment decisions. A deviation from one or more of the three international parity conditions generally needs to occur for an exposure to foreign exchange risk.

Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. Variance represents exchange rate risk by the spread of exchange rates, whereas standard deviation represents exchange rate risk by the amount exchange rates deviate, on average, from the mean exchange rate in a probability distribution. A higher standard deviation would signal a greater currency risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations, be they positive or negative, and for automatically squaring deviation values. Alternatives such as average absolute deviation and semivariance have been advanced for measuring financial risk.

Managing transaction exposure requires that the company’s treasury collects all information on the volume and timing of the exposure. In order to obtain this information, the company may set up a system to log all transactions that give rise to transaction exposure. This can be based on monthly reports sent to the treasury by all entities detailing incoming payments and disbursements in foreign currency, the currency denomination and any existing covers (hedges). The consolidation of the data from all subsidiaries enables the group treasury to determine the group’s overall net transaction exposure and manage it in the most appropriate way.

Where economic and translation risk exposures are concerned, measuring FX risk exposure can prove difficult. Translation risk is typically measured by the exposure of foreign-denominated net assets (assets less liabilities) to potential exchange rate developments. Some firms use sensitivity analyses or value-at-risk (VaR) models, which define a maximum loss for a given exposure over a specified time period with a certain degree of confidence (eg 95%).

Economic exposure analysis involves measuring the potential impact of an exchange rate deviation from a budget or benchmark rate used to forecast revenue streams and costs over a given time period. The currency effects on the various cash flows have to be netted over the company’s operations and markets. The more diversified a company is, the more these effects should cancel each other out and the net exposure may be comparatively small. However, companies that have invested heavily in one or two key foreign markets are typically exposed to more significant economic FX risk.

Value at Risk

Practitioners have advanced and regulators have accepted a financial risk management technique called value at risk (VaR), which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Banks in Europe have been authorized by the Bank for International Settlements to employ VaR models of their own design in establishing capital requirements for given levels of market risk. Using the VaR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates.

Management of Foreign exchange risk

Firms with exposure to foreign exchange risk may use a number of foreign exchange hedging strategies to reduce the exchange rate risk. Transaction exposure can be reduced either with the use of the money markets, foreign exchange derivatives such as forward contracts, futures contracts, options, and swaps, or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting.

Firms may adopt alternative strategies to financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange risk exposure.

Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards. For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods such as the temporal method and current rate method. Firms can manage translation exposure by performing a balance sheet hedge. Since translation exposure arises from discrepancies between net assets and net liabilities on a balance sheet solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure.

Internal FX exposure management

Before a hedging decision is made, the management of FX risks will first make use of all those financial management techniques available to a company that aim to prevent or reduce FX risk exposures. These techniques can include netting, matching, leading/lagging, pricing decisions and asset/liability management.

Netting

Netting involves the consolidated settlement of receivables, payables and debt among associated companies. These intra-group cash flows between the subsidiaries of a company are netted out in order to minimise the amount of foreign currency exposure and the need for FX trades.

For example, a UK subsidiary owes a Spanish subsidiary the USD equivalent of €4m and in return expects receivables of $2m. Both amounts are netted out and only one payment of $2m has to be effected instead of two payments of a total of $6m, resulting in savings in terms of transfer and exchange costs.

Matching

Matching involves the pairing of foreign currency inflows and outflows in terms of timing and value. This can apply to both intra-group and third-party transactions. The need to obtain currency in the foreign exchange market is reduced by timing currency inflows and outflows. In practice this is difficult to achieve as the timing of third-party receipts is often uncertain and much depends on the quality of information with regard to payables and receivables flows.

Leading and lagging

Leading and lagging are effectively adjustments made to credit terms between companies. Leading, the payment of an obligation in advance of the due date, and lagging, the delayed payment beyond its due date, are techniques that can be used to benefit from expected exchange rate changes.

For example, a company that has to pay a foreign currency obligation in three months time and expects that its home currency will have depreciated by then could opt to pay in advance. Alternatively, if the home currency is expected to appreciate, the company could benefit by paying later. As these techniques are mostly not mutually beneficial they are mainly used between associated companies, leaving group treasury to decide on the most appropriate timing of intra-group settlements for the group as a whole.

Pricing policy

In order to avoid foreign exchange risk, companies could always invoice in their domestic currency or in a currency in which they incur costs. However, when buyers have a different preference the pricing policy will often reflect this and customers may be invoiced in their desired currency to support sales. It can also be argued that payments will be made faster if customers can pay in their desired currency, ie home currency. The effects of the pricing policy in terms of FX risk exposure must therefore be weighed against its impact on sales and DSO.

Operation hedging

Alternatively, companies can attempt to net their exposure by shifting their cost base, for example payments to suppliers or production costs, to currencies in which they receive income. Companies which have the ability to shift sources of supply, product-lines or production facilities can therefore reduce their FX risk exposure. However, generally these types of changes to the operating profile are very costly and any adaptation in response to FX risk exposure will therefore only be considered when all other less costly measures have been exhausted.

Asset and liability management

Asset and liability management can be used to manage cash flow, balance sheet or income statement exposure. A company with an aggressive strategy may aim to maximise profits in the foreign exchange market by attempting to increase both cash flows and assets in currencies that are expected to appreciate and cash outflows in currencies that are anticipated to depreciate. This could entail the increase of exposed cash, debtors and receivables in strong currencies as well as the increase of borrowings and trade creditors in weak currencies. At the same time, the company will aim to reduce existing borrowings and trade creditors in strong currencies as well as cash, debtors and loans receivable in weak currencies.

History of Foreign exchange risk

Many businesses were unconcerned with and did not manage foreign exchange risk under the Bretton Woods system of international monetary order. It wasn’t until the switch to floating exchange rates following the collapse of the Bretton Woods system that firms became exposed to an increasing risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure. The currency crises of the 1990s and early 2000s, such as the Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis, led to substantial losses from foreign exchange and led firms to pay closer attention to their foreign exchange risk.

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