Types of Foreign Exchange Risk - Example

Running Head: Risk Analysis Risk Analysis Name Course Lecturer Date Risk Analysis Introduction Foreign exchange risk refers to the danger that the financial position or performance of a business organisation will be influenced by variations in different currencies’ exchange rates. This type of risk is more pronounced in firms, which carry out their transactions in various currencies, For instance, a firm exports its goods to a different nation and the buyer is allowed to pay for the goods using their own currency. Risks relating to foreign exchange ought to be controlled where exchange rates’ fluctuations affect the profitability of a company (Dufey & Giddy, 2008, p.69). This paper will talk about the objectives of carrying out risk analysis, as well as the key techniques that are used in foreign exchange risk analysis. Types of Foreign Exchange Risk Transaction risk According to Dominguez & Tesar (2001, p.396), this is experienced when an organisation borrows, lends or trades in an alien currency, or disposes fixed assets belonging to its subsidiaries located in another country. All the undertakings involve time decay from the time the transaction takes place to the delivery of receipt of payment. In that time gap, exchange rates will definitely change and thus the organisation is at risk which may be favourable or adverse. Transaction exposure is more common in the import and export business. The risk usually goes to the exporter because the selling price of the goods is quoted in the currency of the buyer. Economic risk This measures the variation in a firm’s present value as a result of any change in its future cashflows that is caused by an unforeseen exchange rates’ change. A firm’s future revenue may be categorised into revenue from contractual transactions and that from expected future transactions. To some extent, transaction exposure forms a part of economic exposure. However, the difference between transaction exposure and economic exposure is that, the former arise from a company’s contractual transactions and the values to be received or paid are known, while in the latter, the values are based on approximation and are uncertain (Dominguez & Tesar, 2001, 398). Translation risk It arises from conversion of financial statements that are made in foreign currencies to the local currency. When an organisation combines the financial performances of its subsidiaries in foreign countries, it should present shareholders with an annual report and the values in the report should be quoted in a single currency. Moreover, the organisation’s liabilities and assets that have foreign currency denominations must be translated to reflect one currency. Balance sheet values are shown in past exchange rate values which vary from the rate at the close of an accounting period. Therefore, if a company undertakes the conversion using a new exchange rate, profits or losses will occur (Dominguez & Tesar, 2001, p.399). Objectives of Risk Analysis Crabb (2001, p.31) maintains that, after identification of the exposures of foreign exchange, a company ought to be informed on the impact of exchange rate on all parts of its business undertakings. Therefore, its risk analysis objectives should reflect the attitude and tolerance of the company’s management towards foreign exchange exposures. The objectives of risk analysis vary from one company to another but can be categorised into two main groups namely; financial objectives and protection objectives. Financial objectives Drawing from Crabb (2001, p.31), the main financial objective of risk analysis is to take every rational step to lessen losses that may result from combined earnings exposure. This objective helps protect the company from any financial losses that may come as result of the combined effects of all the main foreign exchange exposures. Additionally, risk analysis aims at ensuring that, a company’s worldwide operations are funded at the least after-tax cost in order to enhance profitability. Different types of risks are involved in doing business in different parts of the world. Thus, assessing the potential risk in every part in advance and taking in account such risks in a company’s planning; will enable it to avoid unnecessary costs during its global operations. Moreover, through foreign exchange risk analysis, a firm aims at ensuring that it has liquidity for all its global operations and that, it can access the local credit marketplace. This is made possible by having adequate knowledge of the type of currency that is used in different countries alongside their estimated exchange rates. By doing so, a firm ensures that it has adequate finances for carrying out its business transactions effectively. Furthermore, risk analysis aims at protecting a company’s assets worldwide. Assets may include; cash, stock, motor vehicle and land. This objective mainly relates to economic exposure where change in economic conditions may affect the value the assets (Crabb, 2001, p.32). Protection objectives According to Hekman (2001, p.256), these objectives relate to when a company should or should not hedge. Hence, the main protection objective of risk analysis is to avoid the making of hedging decisions without taking into consideration efficiency and cost. A company is not supposed to hedge its stand in a given currency under conditions such as; when loss’ risk is minimal, expense of covering its stand is prohibitive and when the covering means are not available in the marketplace. It is the responsibility of the management to ensure that, every measure that is taken to reduce exposure is cost-effectively reasonable based on after-tax costs. Protection objectives may be expressed in quantitative or qualitative terms. For instance, prohibitive cost may be stated in terms of dollar, or it may be left freely for interpretation by a suitable manager appointed in the risk analysis policy of a company. Risk Analysis Techniques Kavaliova (2007, p.12) asserts that, there are a number of techniques for measuring the risks that relate to foreign exchange ranging from easy to very complex ones. Complex methods of risk analysis like value at risk can be arithmetically complex and need significant computing capacity. Therefore, a bigger percentage of companies opt for the simples techniques. The four main techniques applied in risk analysis are as follows: Foreign Currency Risks’ Register One of the simplest risk analysis method it maintaining an exposures’ register together with their related hedges of foreign exchange. Under this method, the particulars of every hedge are basically recorded against their relevant exposure. This kind of approach to risk analysis is very significant to business organisations since they can help them in complying with set hedging accounting standards. Such standards include AASB 139 which deals with financial instruments, recognition and measurement (Kavaliova, 2007, p.13). Table of foreign exchange projected cashflows This method is also among the simple techniques for risk analysis. In case a certain firm both pays as well as gets foreign currency, measurement of the net deficit or surplus for every currency is necessary for such a firm. The firm can do this by forecasting the likely cashflows from foreign exchange. The forecast not only shows whether the firm has an excess or shortage of a given currency, but also indicates currency flows’ timing (Kavaliova, 2007, p.13). Sensitivity Analysis Drawing from Wang (2009, p.98), this is an extension of the projected cashflows table’s method. Carrying out sensitivity analysis aims at measuring the likely impact that an unfavourable change in foreign exchange rates may have on a business. This can be achieved by settling on subjective exchange rate movements or by basing the fluctuations of exchange rate on past experiences or trends. For instance, a firm may want to ascertain the amount it will lose or gain for a certain variation in foreign exchange rates. Where goods are involved, firms sometimes create a matrix indicating the collective outcome of commodity and currency price movements. Value at Risk Technique Some organisations, especially financial institutions, apply a probability method when carrying out their sensitivity analysis. Such a method is called value at risk. Though it is helpful for a firm to be aware of the likely effect of a particular movement in exchange rate, may be one cent USD movement, a firm will be interested in knowing the frequency of such a movement. Accordingly, a firm can undertake sensitivity analysis utilizing past price data and implement it in its current position. Subsequently, given the current position of the firm, and according to the exchange rates’ trends observed in the previous two years, it may be about 99 percent sure that, its loss will not exceed a given amount, in a particular exchange rate movement. Actually, the firm has used real exchange rate history in modelling the likely effect of changes in exchange rate on its exposures of foreign currency (Wang, 2009, p.99). Conclusion Foreign exchange risk results from variations in the various currencies’ exchange rates and mainly affects firms which transact using different currencies. Transaction risk relates to business activities that are done using alien currencies like in import and export business. Economic risk arises from the impact of unforeseen exchange rate’s change on future cashflows. Translation risk concerns the conversion of the values in subsidiaries’ financial statements into a local currency. The objectives of risk analysis are either financial or protection objectives. The main risk analysis techniques that are applied in foreign exchange transactions are foreign currency risks’ register, table of foreign exchange projected cashflows, sensitivity analysis and value at risk. References Crabb, P. (2001). Multinational Corporations and Hedging Exchange Rate Exposure. International Review of Economics and Finance, 11(3), 25-32. Dominguez, K., & Tesar, L. (2001). A re-examination of Exchange Rate Exposure. American Economic Review, 91(2), 396-399. Dufey, G., & Giddy, I. H. (2008). International Financial Planning: The Use of Market-Based Forecasts. California Management Review, 21(1), 69-81. Hekman, C. R. (2001). Foreign Exchange Risk: Relevance and Management. Managerial and Decision Economics, 2(4), 256-262. Kavaliova, M. (2007). Foreign Exchange Risk Management: Which Hedging Techniques Can Be Used by a Mid-size Company. Tennessee: Lightning Source Incorporated. Wang, P. (2009). The economics of foreign exchange and global finance. Berlin: Springer. Read More