Risk Analysis in Foreign Exchange Transactions - Example

Risk Analysis in Foreign Exchange Transactions Name Institution Risk Analysis in Foreign Exchange Transactions Every profit maximizing firm finds it vitally important to manage risks of various forms. In every venture, project or investment it would be expected that the management will assess the risk profile involved and based on management perception of risk, make a decision to continue with the strategy, change the approach or quit it. With the business interaction going global, then foreign exchange risk joins the portfolio of risks that modern managers must keep to check. Organizations whether multinationals or not will find themselves in a situation where they have to deal with a currency different from that of the local country. The exchange rates at which different currencies trade vary by day, season and time, depending on certain economic or/and political forces. It follows therefore, that the firm must undertake measures to eliminate or reduce the effect of this risk and consequently protect the firm’s fortunes (Crabb, 2001). This paper evaluates the objective of foreign exchange risk management and the techniques that organizations can apply to do that. The management of an organization is concerned to fulfill the goal of wealth maximization of the shareholders as mandated by the terms of their engagement. To achieve this they must prudently analyze risk. One assignment that the management is charged with is preparation of periodic financial reports. These reports involve transactions or ownership of property and real assets in cross border regions where the currency in use is different from the ruling local currency. Some multinational companies have shareholders in many countries. The final books of accounts must be translated into different currencies to serve the differentiated purposes. The various items of the income statement, balance sheet, and cash flow statements are subject to different foreign exchange risks and hence their treatment differs (Crabb, 2001). This involves managing translation exposure hence risk analysis from the point of view of foreign exchange rate is justified on these grounds. Another objective of risk analysis is to enable management of transaction exposure. The organization engages itself with contractual arrangement involving payment or receipt of cash in foreign currency. Care is needed to ensure that by so doing the does not company suffer losses as a result of fluctuations in foreign exchange. It implies that one of the requirements of managing business on an international scale is to analyze risk with an intention of identifying the source, extent of exposure, possibility of occurrence and the impact it could have on the organization (Deventer, Imai & Mesler, 2004). Eventually this is done with an intention of making a decision in a professional way as regards to whether it would be rational under the prevailing circumstances to accept that risk. Risk analysis is required to enable the management of economic exposure. This is embedded upon the concept of future foreign currency cash flows. When parties enter a contractual arrangement to sell and buy an item of value at a future date, there is the complexity of ascertain the monetary value of the item (DeMarzo & Darrell, 1995). Another apparent reason as to why risk analysis is significant is when companies are dealing with cross-border loans. The borrower receives money in lump sum or phases and the same to be repaid in installments and in the future. Risk analysis is important for the two parties in the agreement to ensure that the agreed rate of refinancing the same is objective enough to cover the lender against the foreign exchange exposures while at the same time not exploiting the borrower or making the credit too expensive to the detriment of investment. These objectives necessitate response of one kind or the other an effort to mitigate the extent of exposure to various risks. It is largely argued that there exists no standard fit it all strategy to hedge all risks. What experts contend is that the chosen strategy should depend on the size of the organization and the prevalence of the risk being hedged, other factor remaining constant (Allen, 2003). This means that the strategy choice to hedge a risk depends on type and nature of the risk. Transaction risk is hedged purposely to preserve cash flows of the firm. This is commonly referred to as tactical or selective hedging. It is usually applied by firms to cushion themselves form transaction exchange risks. Tactical hedging addresses short term transactions involving accounts payables and receivables (Mazin & Janabi, 2006). Another tactic in application by firms to cover the same type of risks is the use of passive hedging. In this one the firm opts to stick to a standard hedging structure without concern for the expectations in the currency behavior in the money markets. in this sense, the decision to hedge is passive rather than active hence the term passive hedging (Mazin & Janabi, 2006). Another type of prevalent risk is the translation risk or the balance sheet risk. This is the risk that arises for multinational firms having to report to shareholders who do not share the same currency denomination. It implies that all the income statement items have to be converted to an different currency from the parent one. The tricky part comes because most balance sheet items are long term hence application of naked spot rates for conversion would leave the company exposed. The most commonly technique is the optimization hedging. This is used to cover not only the assets but also the firm’s debt (Fama, 1984). The residual currency risk that remains after optimization is reduced by tactical hedging. This exemplifies that a company can employ more than one strategy to cover the same exchange risk where circumstances necessitate that. The economic risks are usually hedged as a residual risk since it is technically difficult to quantify. In essence it represents the probable effect of changes in exchange rates on the present value of future cash flows. The impact is assessed against the markets and product lines with the net economic varying with respect to the extent that a firm invests in foreign markets. This means that the firms that invest in many foreign markets have a smaller risk due to compensating effect. An economic risk exposure could arise out of a subsidiary of a company operating in a country with very high exchange rate fluctuations (Fama, 1984). Firms also reduce their exposure to foreign exchange risks by application of forward contracts. In this arrangement, one party is entitled to buy an item at a fixed price at a certain future date. The contract enables the two parties to lock in prices now, such that the effects of foreign exchange rate do not affect the payment value of the transaction (Fama, 1984). Use of option is another strategy used by firms to protect themselves from foreign exchange exposure in the financial markets. There are basically two types of options – call option ad put option. A call option is an arrangement whereby the holder has the right to buy a certain fixed number of shares at an agreed price in some future date. A put option on the other hand gives the holder a right to sell a certain fixed number of shares at an agreed price at a specified future date. The agreed price is called exercise price. Options enable their holders to lever their property while without exposing themselves to unnecessary risk (Deventer, Imai & Mesler, 2004). Firms may also choose to hedge with futures. These are similar with forward contracts in the purposes they serve but are different in the manner of operation. While forwards are tailor-made, futures are standardized. There are many types of futures but their usages fall into two categories – commodity underliers, which are physical goods and financial underliers which are securities (Fama, 1984). A final form of derivative in common application is the swap. In this contract the parties agree to exchange two streams of cash flows over a period of time. This arrangement allows a company to borrow at a fixed rate and then can arrange to pay at floating rate. In the light of the discussion ensuing, a conclusion can be made that risk management is as crucial just like any other management function say marketing, finance or human resource. This is because firms are risk averse hence would only afford to increase their risk profile if and only if there is a proportionate or greater than proportionate increase in the reward that can be derived from the engagement that increased the risk. Uncertainties prevent the managers from ascertaining what will happen in the environment in the future short run or long run and hence the exact risk factor cannot be objectively quantified (DeMarzo & Darrell, 1995). Due to this limitation managers use precautionary measures of foreign exchange loss mitigation just in case the worst case scenario happens. Some of the options open to them are readily provided by the money and exchange markets while others are tailor-made, having been designed by the parties to suit their shared objective. References Allen S. L. (2003). Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, Hoboken. New Jersey, John Wiley and Sons. Crabb P. (2001). Multinational Corporations and Hedging and Exchange Rate Exposure. International Review of Economics and Finance, 11(3) 11-15. DeMarzo, P.M. & Darrell D. (1995). Corporate Incentives for Hedging and Hedge Accounting, Review of Financial Studies, 8(3) 743-771. Deventer D.R., Imai, K. & Mesler M. (2004). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. New Jersey, John Wiley and Sons. Fama E. F. (1984) Forward and Spot Exchanges. Journal of Monetary Economics, 14 (3) 319- 338. Mazin A.M. & Janabi A.L. (2006). Foreign-exchange trading risk management with value at risk: Case analysis of the Moroccan market. Journal of Risk Finance, 7(3) 273 – 291. Read More