Risk AnalysisIntroductionForeign 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 RiskTransaction riskAccording 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 riskThis 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 riskIt 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 AnalysisCrabb (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.