What is Exchange Rate Risk?

It is the possibility that the value of a currency will fluctuate in the future. In the wake of globalization, business establishments have increasingly ventured into international markets. The volume of international trade has prospered excellently in the near past and is expected to be more affluent in the future. The use of exchange-traded derivative financial instruments has been multi-folded to provide for the requirements of various MNCs and offshore potential investors. Most banks and financial institutions have helped integrate the global economies. Our Government has introduced some bold and extreme measures to fulfil the purpose behind the fiscal, industrial, and monetary policies. The enactment of GST is a huge step towards streamlining the taxation system of the country. Owing to Covid-19, this aspect of corporate risk management has become critical.

Types of Foreign Exchange Risks

Transaction risk

It is like a financial risk. When a financial transaction is denominated in a currency other than the domestic currency of the company, the FX risk exists. The transaction risk is known to increase the volatility of a company's exposure to market fluctuations. The transaction risk affects the receipts and obligations of a company. The amount of transaction risk is always more than the economic and accounting risk.

Economic risk

It is also known as forecast risk. When a company's market value is impacted by unavoidable exposure to exchange rate fluctuations, it is under economic risk. Some macroeconomic conditions such as geopolitical instability and/or government regulations are responsible for economic risks.

Translation risk

It is associated with import and export by a company. The amount received by a company by exporting goods depends on the foreign exchange at the time of realization. This affects the account book entries done at the time of export.

Types of quote

American and European quotation

A pair of currencies are expressed in terms of the unit price of the currency required to buy/sell one unit of the base currency. The money spent in exchanging currency which is expressed in terms of the number of USD (US Dollars) required for getting 1 unit of a foreign currency is an American Quotation. Whereas the European Quotation quotes the number of units of a foreign currency required to get 1 unit of USD (US Dollars).

Direct and indirect quote

A direct quote is expressed as the number of units of home currency required for 1 unit of foreign currency. For example, 1$ = ₹ 74 is a direct quote for our country. While the indirect quote is the money spent in exchange for foreign currency for 1 unit of home currency.

Hence the implication is that: Direct Quote = 1 / Indirect Quote

Exchange rate forecasting

The forex market has undergone dynamic changes over the past decade. The finance managers need to forecast exchange rates and analyze the right data in the right manner for short-term decision making, capital budgeting, earnings assessment, long-term financing, hedging as well risk management, etc. There are various methods for which are generally used are named as shown below:

Technical forecasting

This is the most basic method as well as one of the most used methods of exchange rate forecasting. It involves the use of historical data to forecast future movements based on similar patterns and sensitivity. One example of Technical forecasting is the time series model.

Fundamental forecasting

This method of forecasting establishes and analyses the link between economic variables and foreign exchange risk. For example, GDP, Inflation rates, Industrial production levels, the state of balance of payments, and the stats of unemployment in the country. It emphasizes that the market will endure fluctuation and will evolve through volatility to reach its intrinsic value. However, while using the results of fundamental forecasting for actual use, care has to be taken to use it in the right context.

Market-based forecasting

This approach reflects the market's expectations of the spot in the future. The forecasters use the current spot and forward rates to estimate the expected spot rate in the coming days accruing to the market movements and currency risk fluctuations.

Mixed forecasting

It is a conclusion of 2 more forecasting methods. It approximates the weighted average i.e. overall results of all the methods' results. This method is however of no significance else for theoretical understanding because no two market conditions are the same.

Foreign exchange exposure

Foreign Exchange exposure is the effect on the net cash flows of the company on account of the variation in the exchange rate. The management of this exposure is a time-taking task. An importer who has imported the goods may fear paying more amount of home currency for the same liability. The exposure is divided into the following categories:

Transaction exposure

It is the measure of change affecting the outstanding liabilities due to a previous date, which has to be settled today. This event happens frequently especially because of the receivables and payables and the other contractual obligations. For example, Suppose there is a receivable 4 months from now, the exchange rate of that depreciates after 4 months. This will cause a change in the net receipt. This is referred to as Transaction exposure. The transaction exposure can be said to be the difference between the agreed receipt/ payment for a future date which varies on the execution date because of a change in the exchange rates. The derivative instruments and various other financial tools help to minimize this risk but this risk cannot be eliminated in the normal market conditions when the economies are free-floating. It is quite difficult to deal with this. This exposure also varies according to the term of the time lag between the agreement and execution. However, since the time lag is usually not long that's why the short-term derivative instruments are useful.

Translation exposure

It is also called accounting Exposure. It refers to the gains or losses arising on translation of foreign currency assets and liabilities into the currency of the parent company for the preparation of consolidated financial statements.

Economic exposure

The fluctuation of the value of assets and liabilities is due to the exchange rate fluctuations. It is also called Operating Exposure. It is an aggregate of all changes in the costs and revenues, assets, and liabilities.

Hedging the risk

The management of Exchange rate risk is an important function of a finance manager. It is important to insulate the company's operations against forex market volatility. There are 2 approaches to Hedging Exchange rate risk.

1. Internal techniques

These are the steps of the company to minimize their transaction costs to completely or partially insulate cash flows against Foreign Exchange Risk. These are as follows:

Invoicing in domestic currency

The importers and exporters prefer invoicing in the domestic currency unless and until they are market leaders. The transaction exposure is eliminated but often this practice is difficult the other party across the border may not agree to do so.

Leading and lagging

Leading and lagging refer to the settlement to take advantage of favorable exchange rate movements. Leading is making the payment before the due date in case of expected devaluation of the currency. Lagging is delaying the payment after the agreed date when an appreciation in the currency rate is expected.

Netting

Netting involves the inter-affiliate companies netting off their receivables and payables and other payments against each other. However, bilateral netting is an arduous decision to select the right currency against which to set off keeping all the important things in mind.

Matching

The companies having two-way cash flows of a currency match the receivables and payables so that the net amount is exposed to the currency risk.

Price variation

This involves increasing the prices of the goods exported so that exchange rate losses can be set off in monetary terms. However, this is the only escape in countries where there are strict regulations and monitoring of such acts.

2. External techniques

The 2 external techniques for currency risk hedging are :

Money market hedging

It is an agreement to exchange a static amount of 1 currency against a static amount of other currency on a future date. When an MNC is expecting to receive an amount in a foreign currency then he will cover the risk of receiving less payment by booking a hedge today so that risk is covered and vice-versa.

Derivative instruments

A derivative is a bilateral contract or payment whose value is arrived at from a rooted asset. There are numerous mutually negotiated as well as exchange-traded derivative instruments. For example;  Contracts traded on exchanges, Mutual Contracts between parties, Options Instruments, Warrants, Swaps.

Difference between the risk and exposure

Foreign Exchange Risk is the possibility of an event that may occur and which may either be favorable or unfavorable. However, the risk does not specify the number of losses/gains. Foreign Exchange Exposure is the extent to which the loss/gain is expected to occur.

Feasible strategic options

The attitude of a company towards the risks prevailing and the policy of managing 'Foreign Exchange Exposure' differs widely. A company may select a particular option for the risk, performance, nature, and scope of activities. A company may take up one of the following options :

• Low Risk, Low Reward: Hedging all the exposures. Low risk is emphasized even if the rewards are lower. All the possible risks are minimized and no sort of risk is taken apparently.

• Low Risk, Reasonable Reward: Categorial hedging wherever there is a good opportunity. Only the high-risk areas are neutralized and some reasonable risks where some returns are possible tend to be prone to the risks.

• High Risk, Low Reward: No hedging, open market operations. All the risks and exposures are left to the market. None of the risks are dealt with and almost none of the returns are managed.

• High Risk, High Reward: Continuous hedging, conscious effort to hedge all possible risks. A conscious effort to deal with the market fluctuations and also taking advantage of the high return opportunities by bearing all sorts of risks.

Context and Application

This topic has wider applications in the field of finance and can be primarily studied in the following areas-

• Banking
• Chartered Financial Analyst (CFA)
• Masters in Commerce

Practice Problems

Question-1 Select the currency of the highest valuation?

1. Euro
2. US Dollar
3. British Pound
4. Turkish Lira

Answer- a-Euro

Explanation-The Euro is the most valued currency among Euro, US Dollar, British Pound, and Turkish Lira.

Question-2 What is the other name of Accounting Exposure?

1. Money Market Exposure
2. Transaction Exposure
3. Translation Exposure
4. Economic Exposure

Answer- c- Translation Exposure

Explanation-The translation exposure is the other name of the Accounting Exposure.

Question-3 The companies delaying the payment after the due date in other to hedge currency exposure is a term for one of the following?

1.  Currency Swap
2. Put Option
3. Covered Interest Arbitrage
4. Lagging

Answer- d-Lagging

Explanation- The strategy of intentionally delaying the payment on foreseeing a favorable exchange rate movement is called lagging.

Question-4 What will be the result of the devaluation of the home currency on the net profit?

1. No change
2. Increase
3. Decrease
4. Net off

Answer-c-Decrease

Explanation- The cross-border profits of the company will decrease when the home currency devaluates.

Question-5 Select the derivative instrument which does not involve exchange trade?

1. Forward Contract
2. Initial Public Offer
3. Call option
4. Index Futures

Answer- a. Forward Contract

Explanation- The forward contracts are informal and do not trade on an exchange.

Common mistakes

Students often interpret exchange rate and exchange rate risk as to the same word. Exchange rate risk refers to the risk of exchange rate fluctuations, while exchange rate exposure refers to the extent to which a company's funds are affected by foreign exchange risks.

Related concepts

1. Exchange rate theories
2. Exchange rate forecasting
3. Financial Risk management
4. Call and Put Options
5. Option Warrants
6. Import/Export Regulations