Foreign exchange risk
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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. The exchange risk arises when there is a risk of appreciation of the base currency in relation to the denominated currency or depreciation of the denominated currency in relation to the base currency. 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.
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.
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.
Types of foreign exchange risk
A firm has transaction risk 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.
Many times, companies will participate in a transaction regarding more than one currency. In order to meet the standards of processing these transactions, the companies that are involved have to send any foreign currencies involved back to the countries they came from. As it is implied, businesses have a goal of making all monetary transactions ones that end in high profits. This goal may be delayed because foreign currency transactions as well as the currency market are always moving in different directions, and they must be carefully observed. This process may cause fluctuation to a certain extent, because it is occurring at a market exchange rate, over a very short period of time. Unfortunately, many losses may occur to the companies, because there is a time lag between the execution and the settlement. This time delay or lag occurs right after the companies have agreed on a purchase, and the foreign exchange transaction has been executed, which completes the deal. The lag that is caused by these transactions then creates a risk that the relevant exchange rate will fluctuate immensely. With the sudden movement that the transaction risk brings to the exchange rate, a company that wants to purchase will have to spend a lot more money on capital than they may have wanted to, just to complete a payment in a transaction, which is going to be in the supplier’s currency. This process can cut profits, and lead to defaults on payments as well. Fortunately, there are ways that companies can minimize their potential losses, disregarding the time lag. The volatility that fluctuations bring from transaction risks can be reduced, through using hedging techniques. Companies oftentimes must find themselves protection against transaction risk, so that they are able to protect their financial positioning. The problem of transaction risk can become even worse if large amounts of currency is being exchanged abroad from a warehouse. They are able to will buy Foreign Exchange hedging documents such as options and forward contracts, so that they are able to protect themselves. If a company decides to take out a forward contract, it will set a specific currency rate for a set date in the future. If a company decides to go with purchasing an option, the company is able to set a rate that is “at-worst” for the transaction. The positive part about this choice is that it is very popular with companies, and cheap as well. If the option expires and it’s out-of-the-money, the company is able to execute the transaction in the open market, and they are able execute it at a favorable rate to them. Using natural hedging (or netting foreign exchange exposures) will be a very helpful way to reduce a company’s exposure to transaction risk. The reason netting Foreign Exchange exposures is such an efficient form of hedging is because it will help reduce the margin that is taken by banks when businesses exchange currencies. Natural hedging is also a very simple form of hedging to understand. To enforce the netting, there will be a systematic approach requirement, as well as a real time look at their exposure and a platform for initiating the process. Unfortunately, this along with the foreign cash flow uncertainty can make the procedure seem more difficult. Having a back-up plan such as foreign currency accounts will be extremely helpful in this process. The companies that deal with inflows and outflows that are the same currency will experience efficiency and a reduction in risk by calculating the net of the inflows and outflows, and using foreign currency account balances that will pay in part for some or all of the exposure.
Applying public accounting rules causes firms with transnational risks to be impacted by a process known as "re-measurement". The current value of contractual cash flows are remeasured at each balance sheet.
A firm has economic risk (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 risk 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 risks 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 risk for a firm that sells that good.
In every organization, economic risk, or also known as forecast risk, is the possibility that macroeconomic conditions will influence an investment, especially in a foreign country (Investing Answers, n.d.). Some examples of the macroeconomic conditions are exchange rates, government regulations, and political stability. When financing an investment or a project, a company’s operating costs, debt obligations, and other economically unsustainable circumstances should be thoroughly calculated in order to produce adequate revenues in covering those investment costs (Ready Ratios, n.d.). For instance, when an American company invests money in a manufacturing plant in Spain, there are certain economic risks that influence the outcomes and values of the investment. Hypothetically, the political government in Spain might institute changes that negatively impact the American company’s ability in operating the plant, such as changing laws or even seizing the plant. In this situation, the economic risks can be hyperinflation and exchange rate fluctuations, which lead to immensely expensive rates to pay workers’ salaries. Thus, the risks might make the American company unable to move its profits out of Spain. As a result, all possible risks that outweigh an investment’s profits and outcomes need to be closely scrutinized and strategically planned before initiating the investment. Some examples of potential economic risks can be steep market downturns, unexpected cost overruns, and low demand for goods.
International investments are associated with significantly higher economic risk levels as compared to domestic investments. In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with sale and purchase foreign government bonds. Despite the risky outcomes, economic risk can tremendously elevate the opportunities and profits for investors globally. When investing in foreign bonds, investors can gain high profits due to the fluctuation of the foreign exchange markets and interest rates in different countries (Ready Ratios, n.d.). Investors should always be analytical in calculating the possible changes made by the foreign regulatory authorities. Changing laws and regulations on sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect the investments in foreign countries. For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the investment will be significantly influenced. As a result, economic risk can be reduced by utilizing various analytical and predictive tools that consider the diversification of time, exchange rates, and economic development in multiple countries, which offer different currencies, instruments, and industries.
To develop a comprehensive analysis of an economic forecast, several risk factors should be noted. One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment (Dye, 2017). In a macroeconomic model, a few main risks are GDP changes, exchange rate fluctuations, and commodity prices and stock market fluctuations. On the other hand, it is equally critical to identify the stability and volatility of the market economic system. Before initiating an investment, the firm should consider the stability of the investing sector that influences the exchange rate changes. For instance, a service sector is less likely to have inventory swings and exchange rate changes as compared to a large consumer sector.
A firm's translation risk 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 risk 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 risk deals with the risk of a company’s equities, assets, liabilities, or income. Any of these can change in value because of fluctuating foreign exchange rates. Translation risk occurs when a firm denominates a portion of its equities, assets, liabilities or income in a foreign currency. A company doing business in a foreign country will eventually have to exchange its host country's currency back into their domestic currency. Foreign exchange rates are constantly fluctuating, and if exchange rates appreciate or depreciate, significant changes in the value of the foreign currency can occur. These significant changes in value create translation risk because it creates difficulties in evaluating how much the currencies are going to fluctuate relative to other foreign currencies. Translation risk is the company's financial statements of foreign subsidiaries. The subsidiary then restates financial statement in the company's home currency. Then the firm can now prepare their consolidated financial statements. For example, U.S. companies must restate local Euro, Pound, Yen, etc. statements into U.S. dollars. These foreign currencies are added to the parent's U.S. dollar-denominated balance sheet and income statement. This accounting process is called translation. The income statement and the balance sheet are the two financial statements that must be translated. A subsidiary doing business in the host country usually follows the country’s’ translation method to be used. This depends on the subsidiary’s business operations. Subsidiaries can be characterized as either integrated foreign entity or self-sustaining foreign entity.
Integrated foreign entity operates as an extension of the parent company, with cash flows and business operations that are highly interrelated with those of the parent. Self-sustaining foreign entity operates in the local economic environment independent of the parent company. Both integrated and self-sustaining foreign entity operate by using functional currency. The functional currency is the currency of the primary economic environment in which the subsidiary operates and generates cash flows from day-to-day operations. Management must evaluate the nature of its foreign subsidiaries to determine the appropriate functional currency for each.
There are three translation methods: Current rate method, the temporal method, and U.S. translation procedures. Under the current rate method, all financial statement line items are translated at the "current" exchange rate. Under the temporal method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item's creation. Under the U.S. translation procedures, differentiates foreign subsidiaries by functional currency, not subsidiary characterization.
A common technique to hedge translation risk is called the balance sheet hedging. Balance sheet hedging involves speculating the forward market in hopes that a cash profit will be realized to offset the non-cash loss from translation. This requires an equal amount of exposed foreign currency assets and liabilities on the firm's consolidated balance sheet. If this happens for each foreign currency, net translation exposure will be zero. A change in the exchange rates will change the value of exposed liabilities in an equal amount, but in a direction opposite to the change in the value of exposed assets. If a firm translates by the temporal method, a zero-net exposed position is called fiscal balance. The temporal method cannot be achieved by the current rate method because total assets will have to match by an equal amount of debt. But, the equity section of the balance sheet must be translated at historical exchange rates. Companies can also attempt to hedge translation risk by purchasing currency swaps or future contracts. Also, companies can request clients to pay in the company's home country currency. The risk transfers to the client, and the client is responsible for conducting the exchange when doing business in the company’s country of domicile.
A firm has contingent risk when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such a risk arises from the potential of a firm to suddenly face a transnational 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 risk from the uncertainty as to whether or not that receivable will happen.
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.
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 rate
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.
Each hedging strategy comes with its own benefits that may make it more suitable than another, based on the nature of the business and risks it may impose. Forward and futures contracts serve similar purposes - they both allow transactions take place in the future for a specified price at a specified rate in order to offset any exchange fluctuations against you. Forward contracts are to an extent more flexible, because they can be customized to specific transactions whereas futures come in standard amounts and are written based on certain commodities or assets, such as cattle or other currencies. Because futures are only available for certain currencies and time periods, they cannot entirely mitigate risk because there is always the chance that exchange rates do move in your favor. However, the standardized feature of futures can be part of what makes them attractive to some and is well-regulated because they are traded only on exchanges.
Currency invoicing refers to the practice of invoicing transactions in the currency that benefits the firm. It is important to note that this does not necessarily eliminate the foreign exchange risk, but rather moves it to from one party to another. A firm can invoice its imports from another country in its home currency, which would move the risk to the exporter and away from itself. This technique may not be as simple as it sounds; if the exporter’s currency is more volatile than that of the importer, the firm would want to avoid invoicing in that currency. If both the importer and exporter want to avoid using their own currencies, it is also fairly common to conduct the exchange using a third currency that is perhaps more stable. This may be done if they cannot use any existing instrument between their currencies.
If a firm looks to leading and lagging as a hedge, they must exercise extreme caution. These acts refer to the movement of cash inflows or outflows either forward or backward in time in a way that may benefit the achievement of other goals. For example, if a firm must pay a large sum in three months but is also set to receive a similar amount from another order, they might move the date of receipt to meet their other payment deadline. If this date is moved sooner, this would be leading the payment; if it were moved later and delayed, it would be lagging.
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.
By paying attention to currency fluctuations around the world and how they relate to the home currency, firms can relocate their production to another country. For this strategy to be effective, the new site must have lower production costs. This can help meet any excess production needs that would incur larger expense elsewhere and would allow the firm to take advantage of that extra capital. If the firm has flexibility in its sourcing, they can look to other countries with greater supply of a certain input and relocate there, to reduce the cost of importing it. There are many factors a firm must consider before relocating, such as a nation’s political risk and overall state of the economy. By putting more effort into researching alternative methods for production and development, it is possible that a firm may discover more ways to produce their outputs locally rather than relying on export sources that may expose them to the foreign exchange risk they are trying to avoid.
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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