Table of Contents
- How exchange rate risk works
- Types of foreign currency exchange rate risk
- How foreign exchange risk is managed
- Foreign exchange risk measure
What’s it:Foreign exchange risk is the adverse exposure to fluctuations in foreign exchange rates. Under a floating regime, the exchange rate moves according to the foreign exchange market’s supply and demand fundamentals.
Small fluctuations are reasonable, and the uncertainty is relatively low. But, if it moves wild, it creates uncertainty in the economic decision making by businesses. This ultimately disrupted the company’s financial stability.
Exchange rate movements expose various aspects of business, from income, financing, investment, and operations. Adverse movements of exchange rates can jeopardize the company’s profitability, cash flow, and firm value.
How exchange rate risk works
Exchange rate risk exposes various companies involved in international transactions. They include:
- Institutional investors.As theyinvest in the capital market, the exchange rate affects the return rate on investment they get.
- Exporters and importers. For exporters, the exchange rate affects product prices in foreign markets. For importers, it affects foreign goods’ prices (such as raw materials and capital goods) when they enter the domestic market.
- Securities issuers. Some companies access funding abroad through foreign loans or the issuance of global bonds. If the exchange rate changes, it affects the cost of paying interest or paying off debt.
In general, foreign currency exchange rate risk arises when companies conduct financial transactions in foreign currencies. Meanwhile, in financial operations and reporting, they use the domestic currency.
For example, Indonesia companies use the rupiah in their daily activities and financial reporting. For a revenue source, they get it from the United States market, which is denominated in US dollars. Also, they may have loans in US dollars. So, when the rupiah exchange rate against the US dollar changes, it affects their loan interest expense and revenue.
At the end of the accounting period, they report their business results in rupiah. Therefore, they have to convert interest expense and revenue into rupiah.
One more example. US investors who hold Indonesian government bonds also face exchange rate risk. Payment of coupons and the principal of bonds is in rupiah. Meanwhile, the daily currency for investor operations is the US dollar. Thus, when the coupon and principal are realized and translated into US dollars, their value will depend on the rupiah exchange rate against the US dollar.
Say, a government bond offers a 10% coupon with a principal value of IDR100 million. Assume that only one US investor buys the bond. Suppose the exchange rate at the time of purchase is IDR1/USD. In that case, the investor will receive a USD10 million (10% x IDR100 million) coupon and USD100 million principal.
Furthermore, say, the rupiah exchange rate depreciates to IDR2 / USD (2 rupiahs = 1 US dollar). In this case, the Indonesian government still pays a principal of IDR100 million and a coupon of IDR10 million (10% x IDR 100 million).
However, the depreciation changes the principal and the coupon when investors translate these into US dollars. Specifically, investors received a principal amounting to USD50 million and a coupon of USD5 million. Therefore, on the whole, the investor loses part of his investment due to depreciation.
Types of foreign currency exchange rate risk
Foreign exchange risk exposure to companies falls into three categories:
- Transaction risk
- Translation risk
- Economic risk
Transaction risk or exposure is the risk a company faces when making direct transactions using foreign currencies. For example, domestic companies buy products from foreign companies. The product price will be determined in the seller’s currency.
Suppose the domestic currency depreciates against the partner currency. In that case, the companies making the purchase must make higher payments in their currency. Long story short, depreciation makes imported products more expensive for domestic buyers.
For example, Indonesia carmakers import steel from the United States. Steel prices remained unchanged; however, the rupiah depreciated from IDR14,000/USD to IDR14,500/USD. Therefore, Indonesia carmakers have to spend more rupiah to get 1 US dollar (from 14,000 to 14,500).
Conversely, the domestic currency’s appreciation against the partner country’s currency makes imported goods cheaper. Say, in the above case, the rupiah exchange rate appreciates from IDR14,000/USD to IDR13,000/USD. That means car makers spend less rupiah to get 1 US dollar.
Thus, exchange rate movements affect the cash outflow from the company. Apart from the purchase contract, several transactions potentially exposed to the exchange rate are exports, foreign loans, and dividend repatriation.
Translation risk is related to presentation in financial statements. Accounting standards require companies to present financial statements in a particular currency. Thus, when they have assets or liabilities denominated in foreign currencies, they must translate them into the reporting currency.
For example, a domestic company has subsidiaries abroad. In this case, the parent company must present a consolidated report by translating the accounts in the subsidiary’s report into the parent company’s currency.
Although translation risk may not affect a company’s cash flow, it impacts the company’s profitability. Exchange rate fluctuations result in translation loss (gain). You can see this on the income statement, usually after the operating profit account. Furthermore, because it impacts profitability, it is also more likely to impact the share price, especially when the exposure is significant.
Economic risk concerns the impact of changes in exchange rates on operating revenues and expenses. Its movement exposes the uncertainty to the present value of future operating cash flows. It affects the valuation of the firm value.
For example, an Indonesia company sells most of its products to the United States market. In budgeting, it uses an exchange rate assumption to estimate sales.
Say, the company assumes a stable exchange rate in the next year, just like its current level. With this assumption, the company sets the selling price unchanged and project sales to increase by around 5 percent.
In reality, the exchange rate actually appreciates. That makes the product more expensive for buyers in the United States. As a result, sales projections miss and the company posts a 10% drop in sales. Due to deviating from initial assumptions, the company’s cash flow may be in danger.
How foreign exchange risk is managed
There are several alternatives for managing foreign exchange risk, including:
- Use a single currency for all transactions.For example, Indonesia companies only make and accept payments in rupiah, not foreign currency.
- Hedging such as forward exchange rates, futures contracts, FX swaps, and FX options.For example, when taking a forward contract, the company locks in the exchange rate for future payments in foreign currency.
- Diversify sources of revenue by accepting payments in multiple currencies.It reduces the risk of concentration of revenue on a particular currency.
- Supply chain management flexibility. For example, the company has a variety of alternative suppliers with multiple payment currencies.
- Build production facilities in various countries. That way, operational risk exposure is also diversified.
Use a single currency in all transactions.
Although it is free from exchange rate risk, however, this strategy has several drawbacks. Exchange rate movements are not only detrimental but sometimes they are favorable.
- Depreciation makes product prices cheaper for foreign buyers.The company does not have to deliberately reduce the selling price directly to stimulate sales.
- Appreciation allows for cheaper payments.Interest on foreign loans is cheaper, so do with buying raw materials and capital goods from abroad.
Furthermore, using a single currency reduces flexibility. Competitors may offer more currency flexibility, which makes them attractive to some customers. As a result, potential companies lose competitiveness.
Foreign exchange risk measure
One of the measures in exchange rate risk management is the value at risk (VaR). VaR measures the value of the loss and its probability, considering normal market conditions, in a specific period such as a day.
VaR depends on three parameters: the hold period, the confidence level, and the currency unit used for the VaR denomination. Hold period refers to the length of time it is planned to hold a foreign exchange position, for example, a day. The confidence level measures the probability that a value falls within the estimated range, typically 99 percent and 95 percent.
For example, daily VaR with a 95% probability is $1 million. It means there is a 0.05 probability that the portfolio will drop in value by more than $1 million over one day. We can also interpret it, in the next 20 days, there is a possible daily loss of at least $1 million.
One way exchange rate risk is measured is through what's called a value-at-risk calculation (VaR). This calculation relies on three parameters: The currency being used. The length of time the position on the investment will be held.What are the types and management of foreign exchange risk? ›
There are three main types of foreign exchange risk, also known as foreign exchange exposure: transaction risk, translation risk, and economic risk.What are the three 3 types of foreign exchange exposure? ›
The three types of foreign exchange exposure that you may face when making transactions in FX include transaction, translation, and economic exposure. The latter is also known as operating exposure.What is the best way to manage currency risk? ›
To reduce currency risk, U.S. investors can consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country's inflation, however, as high debt typically precedes inflation.What are the 4 ways to determine the rate of foreign exchange? ›
Four ways to determine the rate of foreign exchange are:
(a) Demand for foreign exchange (currency) (b) Supply of foreign exchange (c) Determination of exchange rate (d) Change in Exchange Rate!
There are four main types of exchange rate regimes: freely floating, fixed, pegged (also known as adjustable peg, crawling peg, basket peg, or target zone or bands ), and managed float.Why is foreign exchange risk management important? ›
They are used to minimize the risk of price changes in a company's assets and liabilities in its foreign exchange position. Since the forward contract is based on foreign exchange rates, a long-duration hedge provides insurance protection against large changes in the exchange rate.What are the methods of foreign exchange control? ›
Important methods of exchange control are: (1) Intervention (2) Exchange Clearing Agreements (3) Blocked Accounts (4) Payment Agreements (5) Gold Policy (6) Rationing of Foreign Exchange (7) Multiple Exchange Rates.What is the measure of exchange rate risk? ›
Exchange rate risk refers to the risk that a company's operations and profitability may be affected by changes in the exchange rates between currencies. Companies are exposed to three types of risk caused by currency volatility: transaction exposure, translation exposure, and economic or operating exposure.What are the 3 components of exchange rate risk? ›
Three types of foreign exchange risk are transaction, translation, and economic risk.
Economic exposure is managed through two overarching strategies: operational strategies and currency risk-mitigation strategies. Operational strategies include diversification in production facilities and the markets the products are sold, flexibility in sourcing raw materials, and diversifying financing sources.What are the major types of foreign exchange? ›
Types of Foreign Exchange Markets
There are three main forex markets: the spot forex market, the forward forex market, and the futures forex market.
To eliminate forex risk, an investor would have to avoid investing in overseas assets altogether. However, exchange rate risk can be mitigated with currency forwards or futures. The exchange rate risk is caused by fluctuations in the investor's local currency compared to the foreign-investment currency.How do banks manage FX risk? ›
Monitoring FX risk
This will normally be automated by the treasury management system and / or trading systems, which will continuously (near real-time) or at least daily recalculate these metrics using current market rates and flag any limit breaches or other exceptions.
Foreign exchange risk is managed through two means (a) internal i.e. use of tools which are internal to the firm such as netting, matching, etc. and (b) external techniques i.e. use of contractual means such as forward contracts, future, option, etc. to insure against potential exchange losses.What are the 8 factors that affect foreign exchange rate? ›
- Inflation >
- Interest rates >
- Government Debt/Public >
- Political Stability >
- Economic Recession >
- Terms of Trade >
- Current account deficit >
- Confidence and speculation >
- Inflation. ...
- Interest rates. ...
- Speculation. ...
- Change in competitiveness. ...
- Relative strength of other currencies. ...
- Balance of payments. ...
- Government debt. ...
- Government intervention.
- Overview of Exchange Rates.
- Determinants of Exchange Rates.
- Differentials in Inflation.
- Differentials in Interest Rates.
- Current Account Deficits.
- Public Debt.
- Terms of Trade.
- Strong Economic Performance.
Types of Exchange Rate Regimes. In reality, there are only two types of exchange rate regimes, which are possible viz. the fixed regime and the floating regime. However, these two systems have several variations within them.What are the two methods of determining exchange rate? ›
- Multiplier method.
- Divisor method.
- Triangulation and No inverse method.
The most crucial aspect of international risk management for managers is to comply with foreign regulations and laws while dealing with risks and concerns.What do you think is the most important aspects of international risk management? ›
Answer and Explanation: The most crucial aspect of international risk management is to ensure compliance with contracts related to international operations, such as quantity, quality, legality, and cost. So, the terms of the contracts are the guides to conduct international transactions.What is risk management in foreign trade? ›
It includes all the risks that are specific to the country and that will affect the local companies' transactions with foreign investors. It includes political risk, economic risk, or transfer risk, which is the risk of the government or central bank not allowing capital to move out of the country.What are the four major functions of the foreign exchange market? ›
- Transfer Function: The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. ...
- Credit Function: ADVERTISEMENTS: ...
- Hedging Function:
- Currency Conversion. Companies, investors, and governments want to be able to convert one currency into another. ...
- Currency Hedging. ...
- Currency Arbitrage. ...
- Currency Speculation.
For example, a company based in Canada that does business in China – i.e., receives financial transactions in Chinese yuan – reports its financial statements in Canadian dollars, is exposed to foreign exchange risk.What are the two main functions of the foreign exchange market? ›
The main functions of the market are to (1) facilitate currency conversion, (2) provide instruments to manage foreign exchange risk (such as forward exchange), and (3) allow investors to speculate in the market for profit.How do you manage exchange rate volatility? ›
You can mitigate transaction exposure by keeping a flexible and liquid balance sheet to avoid financing the business with currency mismatches, using the company's credit lines to take care of foreign exchange transactions and using a treasury management system with an online platform to control currency transactions ...What factors affect foreign exchange risk? ›
- Interest and inflation rates. Inflation is the rate at which the cost of goods and services rises over time. ...
- Current account deficits. ...
- Government debt. ...
- Terms of trade. ...
- Economic performance. ...
- Recession. ...
Economic risk can also be mitigated by investing in insurance, covering the losses arising out of a counterparty defaulting to pay their obligation. Hedging. Hedging is achieved by taking the opposing position in the market.
The importer or the foreign currency borrower can hedge their risk by buying the USD-INR futures. When the rupee depreciates, the dollar will appreciate and therefore the value of the USD-INR futures will go up. Any loss on his dollar payable due to weaker INR will be compensated by the long futures on the USD-INR.What is the best way to measure economic returns? ›
While there are a number of different ways to measure economic growth, the best-known and most frequently tracked and reported measure is gross domestic product (GDP).What are 3 features of the foreign exchange market? ›
- High Liquidity: The foreign exchange market is the most easily liquefiable financial market in the whole world.
- Dynamic Market: In foreign exchange market is highly dynamic in nature. ...
- Market Transparency: The foreign exchange market is highly transparent.
Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a unit of foreign currency. According to Purchasing Power Parity theory, the foreign exchange rate is determined by the relative purchasing powers of the two currencies.What is foreign exchange risk rate? ›
Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business' financial performance or financial position will be impacted by changes in the exchange rates between currencies.What is foreign exchange risk? ›
What is foreign exchange risk? By definition, foreign exchange risk is the possibility for a company to be affected by a variation in the exchange rate between its local currency and the currency used in a transaction with a foreign country.How do banks manage foreign exchange risk? ›
Foreign currency bank accounts
A simple way to manage foreign currency risk involves setting up a foreign currency account. Then, to hedge against risk, simply deposit the required amount (plus a nominated surplus) into the account.
Three types of foreign exchange risk are transaction, translation, and economic risk.What is the difference between foreign exchange risk and exposure? ›
Foreign Exchange Risk vs Exposure
Foreign exchange risk is the change of value in one currency relative to another which will reduce the value of investments denominated in a foreign currency. Foreign exchange exposure is the degree to which a company is affected by changes in exchange rates.