Exchange Rate Risk & Management

EXCHANGE RATE RISK & MANAGEMENT:

It is 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. 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. 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 (i.e., reduce) the risk

TYPES OF EXPOSURE:

Transaction 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.

Applying public accounting rules causes firms with transactional exposures to be impacted by a process known as "re-measurement". The current value of contractual cash flows is re-measured at each balance sheet date. If the value of the currency of payment or receivable changes in relation to the firm's base or reporting currency from one balance sheet date to the next, the expected value of these cash flows will change. U.S. accounting rules for this process are specified in ASC 830, originally known as FAS 52. Under ASC 830, changes in the value of these contractual cash flows due to currency valuation changes will impact current income.

Economic exposure:

A firm has economic exposure (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 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 influence the demand for a good in some country would also be an economic exposure for a firm that sells that good.

Translation exposure:

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.

Contingent exposure:

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.

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 probability. 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 semi variance 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:

        Historical simulation

        Variance/covariance (parametric)

        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.

DEALING WITH EXCHANGE RATE RISK:

If your business exports or imports goods or services, you need to consider how you will protect yourself against changes in the exchange rate. Even a tiny variation in the rate could cost your business thousands of pounds.

You'll also need to decide how to make and receive payments in foreign currencies.

This guide is aimed at businesses that regularly deal with customers who are based outside of the UK. It explains how to price goods or services, how to combat the risk of exchange rate changes and the practicalities of dealing in foreign currencies.

Foreign currency issues when importing or exporting

Businesses that import or export goods need to bear in mind a number of key issues when making transactions in foreign currencies:

Foreign currency transactions are sensitive to fluctuations in the exchange rate. A price you agree with a customer or supplier on one day could rise or fall if the exchange rate changes. This is especially true in the current economic climate where currency is fluctuating on a daily basis, making it more difficult to keep track of exchange rates

If you're exporting, you must decide whether it's best to price your goods or services in the local currency of the country with which you're trading. The decision will depend on individual circumstances and on factors such as how you want to present yourself in that market and how your competitors set their prices

If you're importing components priced in a foreign currency that form part of goods you're selling in sterling, you'll need to decide how to price those goods to reflect the exchange rate

If you're trading with companies in the euro zone (ie the European Union member states that use the euro) there are many practices and standards to make life easier. See the government's guide on trading in the EU(Link opens in a new window)

Identifying foreign exchange risks

When your business deals in a foreign currency you are exposed to certain risks.

If you trade in foreign currency

For example, company might find that after agreeing a price for exported or imported goods, the exchange rate changes before delivery. Clearly, this can work both for and against you.

Some currencies are more volatile than others because of their unstable economies or inflation. However, the current economic climate is also affecting more stable currencies such as the euro and the US dollar. Your bank should be able to advise you about this.

As exchange rates can go both up and down, it can be tempting to gamble that this will work out in your favor. However, this is extremely risky and could land you with a significant financial loss.

It's safer to reduce the risk by using one of the forms of hedging available through a bank.

Hedging:

It means insuring against the price of currency moving against you in the future. There are many different types of currency hedging and your bank should be able to help you with the best solutions for your business.

If company trade in sterling

Company could trade overseas in sterling – effectively transferring the foreign exchange risk to the business you're dealing with. Whether this is appropriate will depend on the product in question and the relative bargaining strength of you and your trading partner.

Company could be affected even if you don't trade overseas

Bear in mind that exchange rates could have an effect on your business' competitiveness even if you don't trade overseas. When a country's currency loses value against the pound, imports from that country into the UK become cheaper, so you may have to respond to aggressive pricing from competitors who source from that country