Foreign Exchange Risks

Foreign Exchange Risk refers to the risk of an unfavorable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency). This risk arises from movement in the base currency rates or the denominated currency rates and is also called exchange rate risk or FX risk or currency risk.

Foreign exchange risk management can be related to the transactional, transitional, or economic risks involved in the transaction. The appreciation or depreciation of either of the currencies involved accounts for the majority of the risk involved in such transactions. Such shifts in the movement of currencies can adversely affect the profit of the company.

• Foreign exchange risk, or currency risk, refers to the possibility of experiencing financial losses or gains due to fluctuations in exchange rates between currencies.
• Foreign exchange risk affects a wide range of individuals and entities, including those involved in international trade, investors with foreign investments, multinational corporations, and anyone engaging in currency conversions or cross-border transactions.
• Foreign exchange risk arises from multiple factors, including economic indicators, differences in interest rates, geopolitical events, political stability, market sentiment, and supply and demand dynamics in the foreign exchange market.

Foreign exchange risk is the uncertainty of the transactions involving currencies of two countries. Businesses indulging in trade overseas often receive their payments in the currency of the country in which the trade takes place. Therefore, they usually convert it into the domestic currency to record and file through their books of accounts.

Companies also take up insurance against such transactions for their foreign exchange risk hedging. As in, any movement in either of the currency in the time frame between the trade and payment can result in an adverse effect on the profitability of the deal. Therefore, businesses secure insurance to hedge the risk of losing money due to factors beyond their control.

Foreign exchange risk poses a threat, and it is important to hedge open exposures. But at the same time, it is wise to keep updating the global information and gain from the volatility offered by the foreign exchange market by holding the open positions within the risk appetite. The availability of several products and round-the-clock operations has made both the speculation & hedging easy and ha

Foreign exchange risk management can be classified into the following three types of risks: Transactional, transitional, and economic. Let us discuss each of these types in detail to understand the concept in detail.

#1 - Transaction Risk

Where the business transactions are entered in a currency other than the home currency of the organization, then there is a risk of change in the currency rates in the adverse direction from the date of entering the transaction to the date of settlement. This type of foreign exchange risk is known as transaction risk. This risk arises on the actual and probable import and export transactions.

#2 - Translation Risk

Where a business organization has a foreign subsidiary whose reporting currency is other than the reporting currency of the parent company, then for consolidation purposes, the subsidiary balance sheet items are converted into the parent company’s reporting currency based on the prevailing accounting standards. The risk of movement in the consolidated financial position and earnings resulting from exchange rates is termed as Translation Risk. The results, in turn, impact the stock prices. It is also termed as Accounting Exposure.

#3 - Economic Risk

It is the risk of change in the market forecast of the company’s business and future cash flows resulting from a change in the exchange rates. This, in turn, impacts the market value of the firm. E.g., a monopoly product of the company starts facing competition when the lower exchange rate renders the imported product cheaper. This type of foreign exchange risk is also termed as Forecast Risk.

When a company invests in security other than home currency, then the rate of return is a combination of the rate of return in foreign currency and the rate of appreciation or depreciation in the exchange rate.

Where:

• R_H = rate of return in the home or base currency
• R_F = rate of return in denominated or foreign currency
• R_ex = rate of appreciation or depreciation in the exchange rate

Let us understand the concept of foreign exchange risk hedging with the help of a couple of examples. These examples will help us understand the implications of the movements in the market and how it can have an effect on businesses.

Example #1

A US-based multinational wishes to invest surplus funds of USD 1 million. It can invest the same in US corporate bonds and earn a return of 2.5% p.a. The treasurer is considering another option to invest the same in Turkish corporate bonds and get a return of 20% p.a. The exchange rate today is 1 USD = 5 TRY. After one year, the exchange rate is expected to be 1 USD = 4.3 TRY. Advise which investment is better.

Solution

Here,

• R_H = 2.5%
• R_F = 20%

R_ex = (5 - 4.3) / 5 = 14% (depreciation)

By formula,

(1 + R_H) = (1 + R_F) (1 ± R_ex)

• = (1 + 20%) * (1 – 14%)
• = 1.2 * 0.86
• = 1.032

R_H = 3.2%

Here, the Turkish investment is giving a return of 3.2% as the rest of the return has been eaten by the foreign exchange movement. Hence, the TRY investment should be preferred over the USD investment (3.2% > 2.5%).

Example #2

In December 2022, owing to war and recession in Ukraine and Turkey respectively, the risk of dealing in foreign currency was rated “very risky” by risk analysis firms.

The major reason behind the rating was that these countries had a high amount of Dollar deposits in their reserve which accounted to more than 10% of their total reserve. Moreover, the ongoing economic situations of these countries for their respective reasons meant that the repayment of their already high loans from foreign countries could be defaulted for months together.

These risks boiled down to local businesses and foreign companies dealing with businesses in these countries.

Let us understand the advantages of foreign exchange risk hedging through the points below.

• Foreign exchange fluctuation provides an opportunity of gaining from favorable movement in the currency of open foreign exchange position.
• Availability of numerous new and innovative products to hedge the risk.
• Risk can be hedged by pairing the open positions in currencies with the same or precisely opposite foreign exchange movements.
• The flexibility of hedging the risk in an exchange-traded or an Over the Counter OTC market as both the markets are very much liquid.
• Foreign exchange markets operate round the clock in one or the other country; hence the hedging or speculation is possible anytime.

Despite the advantages mentioned above, there are a few factors that prove to be a hassle for both parties involved in the transaction. Let us understand the disadvantages of foreign exchange risk management through the explanation below.

• It can result in huge losses even if there is a small movement in the rates where the open position is huge.
• Hedging the risk involves an additional cost.
• Hedging results in margin requirements along with a change in the foreign exchange rates.
• Rate and spread determination is a complex process and is often opaque.

It is a well-established fact that the transaction of two parties from different countries is faced with a couple of limitations because of which foreign exchange risk hedging becomes a difficult task. Let us understand the limitations through the discussion below.

1. The first one is the high volatility of the foreign exchange market, which is affected by a change in global policies and economic situations. Further, these changes are reflected in the exchange rates instantly as the markets operate on a 24-hour basis. Hence, a person needs to be on their toes to speculate in this market and capitalize on the foreign exchange risk.
2. Secondly, a perfect hedge is rare to locate in the market. The exchange-traded derivatives are often standard and hence result in an incomplete hedge which continues to pose a risk. The OTC market tries to solve the issue but results in increased cost and counterparty credit risk.

This has been a guide to what are Foreign Exchange Risks. Here we explain its types, examples, advantages, disadvantages, and its limitations in detail. You can learn more about accounting from the following articles –

• Calculate Risk-Weighted Asset
• Interest Rate Risk
• Currency Devaluation Causes
• Spot Rate Examples