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Home > Financial Risk Management Calculations > Exchange Rate Risk

Financial Risk Management Calculations

Exchange Rate Risk

Because formulae exist to quantify, at least to a degree, the risks that accompany any investment decision, it is logical to assume that a similar formula exists to quantify what is called both exchange rate risk and currency risk. Such logic is flawed, for no such formula exists.


What It Measures

The risk of a gain or loss in the value of a business activity or investment that results from changes in the exchange rates of world currencies.

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Why It Is Important

Each business day seems to bring more international business transactions, generated by an ever-growing number of enterprises from an ever-increasing number of countries. Enterprises in developing nations, especially, are vying for their share of world commerce.

However, the economies of these developing nations can be especially fragile, while economies of mature nations periodically sputter and suffer recessions. Asia, Latin America, and Eastern Europe have all endured economic turmoil in the past decade, while such regions as the Middle East have been volatile for several decades, principally because of the wide swings in oil prices.

Currency exchange rates can be just as volatile, and this clearly poses risks to any enterprise conducting business in foreign markets and any investor holding either stock in a foreign-based company or an interest in a mutual fund that invests in foreign companies. The effects on a company’s earnings, cash flow, and balance sheet can be significant.

The main exchange rate risk to an operation or investment is that any profits realized will be partially reduced—or wiped out altogether—when they are exchanged for the domestic currency, be it US dollars, pounds sterling, the euro, or Japanese yen.

More often, exchange rate risk will affect a company’s price competitiveness in a product or service also offered by a competitor whose costs are incurred in a foreign currency. If the competitor’s currency weakens, its relative competitive position improves because its costs decline, enabling the competitor to reduce its price and attract a larger share of a market.

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How It Works in Practice

There is a simple way to avoid the risk posed by exchange rates: don’t do business abroad! For large companies, as well as an increasing number of small and medium-sized companies, that would be like sticking one’s head in the sand.

A second defense against exchange rate risks is almost as unrealistic: conduct all business in your home currency. Requiring foreign customers to pay up only in, say, dollars, puts the burden of currency fluctuations squarely on the customer’s shoulders and completely insulates the selling company from any shrinkage of profits from exchange rate differences. The price of such insulation, however, is likely to be a steady loss of customers.

The practical course of action, then, is to gain a basic understanding of exchange rate risks, if only enough to sort out the reams of opinions on the subject, and to select knowledgeable advisers and use their counsel wisely. This is a sophisticated, complex realm that has been examined for over a century. It is certainly no place for amateurs.

At the same time, however, exchange rates, interest rates, and inflation rates have been linked to one another via a classic set of relationships that can serve as leading indicators of changes in risk. These relationships are:

  • The Purchasing Power Parity Theory. While it can be expressed differently, the most common expression links the changes in exchange rates to those in relative price indices in two countries:

Rate of change of exchange rate = Difference in inflation rates

  • The International Fisher Effect (IFE). This holds that an interest rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions. Practically speaking, the IFE implies that while an investor in a low-interest country can convert funds into the currency of a high-interest country and earn a higher rate, the gain (the interest rate differential) will be offset by the expected loss due to foreign exchange rate changes. The relationship is stated as:

Expected rate of change of the exchange rate = Interest rate differential

  • The Unbiased Forward Rate Theory. This holds that the forward exchange rate is the best and unbiased estimate of the expected future spot exchange rate:

Expected exchange rate = Forward exchange rate

Other than these yardsticks, defending against exchange rate risk is largely a matter of observation. In the floating exchange rate environment that has existed for almost the past 30 years, currency exchange rates respond to a host of factors: political climates, the flow of imports and exports, the flow of capital, inflation rates in various countries, consumer expectations, and confidence levels, to name a few. Frequently, limits are placed on exchange rate fluctuations by government policies—actions that themselves can arouse controversy or debate.

Even so, the exchange rate risks these factors create can be arranged into three primary categories:

  • Economic exposure. Due to changes in rates, operating costs will rise and make a product uncompetitive in the world market, thus eroding profitability. There’s little that can be done about economic risk; it’s simply a routine business risk that every enterprise must endure.

  • Translation exposure. The impact of currency exchange rates will reduce a company’s earnings and weaken its balance sheet. In turn, the denominations of assets and liabilities are important, although many experts contend that currency fluctuations have no significant impact on real assets.

  • Transaction exposure. Caused by an unfavorable move in a specific currency between the time when a contract is agreed and the time it is completed, or between the time when lending or borrowing is initiated and the time the funds are repaid. This is the most common problem that confronts most companies. Requiring payment in advance is rarely practical, and impossible, of course, for borrowing and lending.

To reduce translation exposure, experienced corporate fund managers use a variety of techniques known as currency hedging, which amounts to diversifying currency holdings, monitoring exchange rates, and acting accordingly, depending on specific conditions. Its advocates contend that taking appropriate action can greatly reduce translation risks, if not avoid them altogether. Currency hedging, however, is also technical and sophisticated.

Transaction exposure can be eased by a process known as factoring. Major exporters, in particular, transfer title to their foreign accounts receivable to a third-party factoring house that assumes responsibility for collections, administrative services, and any other services requested. The fee for this service is a percentage of the value of the receivables, anywhere from 5% to 10% or higher, depending on the currencies involved. Companies often include this percentage in selling prices to recoup the cost.

Commercial and country risks can affect exchange rates, too. Commercial risks include the default or bankruptcy of major foreign customers. While this risk mirrors what can also occur at home, foreign-based companies operate under different laws and relationships with their governments. More worrisome are country risks: political or military interventions and currency restrictions that less stable nations might impose. Insurance is available to address such risks, but it can be costly.

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Tricks of the Trade

  • Any number of models have been created to explain and forecast exchange rates. None has proved definitive, largely because the world’s economies and financial markets are evolving so rapidly.

  • A forward transaction is an agreement to buy one currency and sell another on a date some time beyond two business days. It allows an exchange rate on a given day to be locked in for a future payment or receipt, thereby eliminating exchange rate risk.

  • Foreign exchange options are contracts which, for a fee, guarantee a worst-case exchange rate for the future purchase of one currency for another. Unlike a forward transaction, the option does not obligate the buyer to deliver a currency on the settlement date unless the buyer chooses to. These options protect against unfavorable currency movements while allowing retention of the ability to participate in favorable movements.

  • A producer facing pricing competition caused by fluctuations in exchange rates can also use currency contracts to try to match competitors’ cost structures and reduce costs.

  • Companies doing larger volumes of business in a foreign country often establish a local office there to pay expenses and collect revenues in local currencies to reduce the impact of sudden and pronounced exchange rate fluctuations.

  • Private-sector subscription services monitor currencies and publish alerts. One US-based service has established numerical ranges that indicate risk, from 100 (no risk) to 200 (extreme risk or an outright currency crisis).

  • Exchange rate risks cannot be insured against per se.

  • The US Export-Import Bank (Eximbank) may be a source of advice for companies, especially smaller and medium-sized companies, seeking assistance.

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Further reading on Exchange Rate Risk

Book:

  • Giddy, Ian H., and Gunter Dufey. “The management of foreign exchange risk.” In Frederick D. S. Choi (ed). Handbook of International Accounting. New York: Wiley, 1991. Also online at: www.stern.nyu.edu/~igiddy/fxrisk.htm

Article:

  • Magos, Alice. “Ask Alice about foreign exchange risk.” Business Owner’s Toolkit. Online at: tinyurl.com/3zdfx4z

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