Foreign exchange risk
Foreign exchange risk (also known as 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. 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 (ie., reduce) the risk.
Types of 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.
A firm has economic exposure (also known as operating exposure) 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.
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 subsidiary|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.
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.
If foreign exchange markets 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.
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. VaR typically is the risk measure of choice for FX managers and risk departments because it expresses a portfolio’s risks in a coherent and logical manner. It is expressed in real profit-andloss terms and can directly tell a risk manager the potential risks inherent in a portfolio based on varying degrees of statistical confidence. VaR traditionally is measured in the following three ways: 1. historical simulation 2. variance/covariance (parametric) 3. Monte Carlo simulation Each method produces a statistical measurement of VaR that is calculated using an historical data assumption to give a level of confidence that is determined from the historical price action. Each method differs in complexity and has advantages and disadvantages. Historical simulation assumes that the past is a good predictor of the future and that the volatility of the analyzed currencies will remain stable, within the parameters observed in the past. It uses real historical data and therefore importantly does not assume that the returns are normally distributed. It is, however, computationally intensive and completely dependent on historical price movements, and therefore it can seriously underestimate “tail risk.” (Tail risk is a measurement of the probability of an event occurring at the extremes of a given distribution, the reasons for this will be explained later in this article.) Historical simulation is also dependent on the quality and depth of the input data, which can be problematic for emerging market currencies. Variance/covariance, sometimes known as parametric VaR, is computationally easier because historical data is used to calculate the standard deviation of the changes of risk factors and the correlations between them. It is heavily disadvantaged by an assumption of the linearity of risk (the assumption that risk vs. reward is linear in nature, which is not the case with more-complex financial instruments such as options), that correlations are stable over time, and that returns are distributed normally. Products such as options introduce nonlinear risk parameters, correlations can quickly and dramatically uncouple, and as we have seen in
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.
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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