FMDQ Learning: Introduction to foreign exchange risk

What is Foreign Exchange Risk?

Foreign Exchange (FX) risk is a type of market risk which occurs as a result of a change in the price of an underlying currency against another. Companies and investors are exposed to this type of risk when undertaking a financial transaction involving a different currency other than their base currency. In addition, companies involved in imports and exports, or simply carrying out business operations across country borders are also exposed to this type of risk.

Types of Foreign Exchange Risk

There are three (3) types of FX risk, with each of these affecting companies in different ways. Therefore, understanding these risks can be a very useful tool for the international finance manager, company treasurer, or investor. The types of FX risk include:

Economic Exposure: This relates with how the value of a firm is directly or indirectly influenced by fluctuations in FX rate. An adverse change in FX rate can affect a company’s market share position in relation to its competitors, and its future cash flows from fixed assets; all directly affecting a firm’s value.

By its nature, this type of FX risk is very difficult to quantify because it deals with unexpected changes in FX rates and consequently, difficult to hedge. This exposure type is long-term in nature.   Translation Exposure: This risk type is associated with the change in value of a firm’s equity, assets, liabilities or income as a result of exchange rate changes; in other words, the way a company’s financial report is affected by exchange rate movements. It is also known as accounting exposure. This type of exposure is medium to long-term.

Transaction Exposure: This refers to the risk associated with a change in exchange rate in the period between the initiation of a transaction and its settlement. This is largely faced by companies engaged in international trade, where currency fluctuations occur after financial commitments have been made. This type of FX risk is mainly concerned with how a company’s cash flows (i.e. payments and receivables) are affected by unanticipated FX fluctuations. This exposure is short to medium-term in nature.

Mitigating or Hedging Foreign Exchange Risk

FX Risk Type/ Mitigation Strategy

Economic Exposure: As noted earlier, economic exposure is difficult to quantify because it deals with effects of unexpected fluctuations in FX, which are not easy to predict. However, multinationals can mitigate this risk by diversifying their operations internationally.

Examples of diversification opportunities include: Location of production facilities; Sales and products offerings; Access to finance; and Supply chain management in the procurement of and access to raw materials.

When correctly implemented, diversification affords a company the opportunity to reduce costs and consequently, the overall impact of economic exposure. Translation Exposure As this exposure type deals with a company’s financial reporting process, mitigating against it largely depends on the accounting standards of the home country, which in turn govern how income from overseas operations are reported. Accounting techniques such as consolidation reporting and effective cost accounting evaluation procedures are used.

Transaction Exposure

There are two (2) ways of mitigating against transaction exposure, using: Financial/External Techniques and Operational/Internal Techniques Financial Techniques involve the use of financial products such as FX derivatives to hedge against transaction exposure. Some FX derivatives include FX Forwards, FX Futures, FX Options and FX Swaps. The 3rd edition of Spotlight (January 2015) provides a full introduction to FX derivatives.

Operational Techniques may include company policies such as invoicing in the company’s home currency i.e. ensuring that all foreign customers pay in the company’s home currency, and the company pays for all imports in its home currency. The drawback here is that the FX risk does not actually disappear, as it only gets passed on to the customers who are the end-users of the products or services.

In conclusion, it is imperative for companies to identify and understand FX risk, especially as financial markets grow continually and interlink with one another, while businesses are increasingly looking globally for access to new frontiers. Businesses in a position to effectively analyse FX risk, as it relates to their activities, are better able to make informed decisions regarding their operations and cash flows.