Foreign Exchange Risk: Types, How To Measure and Manage - Penpoin (2023)

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

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

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

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.