Foreign Exchange Risk Management

Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by movements in exchange rates - and will seek to manage their risk exposure. This page looks at the different types of foreign exchange risk and introduces methods for hedging that risk.

Types of foreign exchange risk

Transaction risk

This us the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion.

This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.

As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component of treasury risk management.

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?

(b) The hedge period, the time period before the expected cash flows occurs.

(c) The anticipated volatility of the exchange rates during the hedge period.

The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on whether the Treasury Department is been established as a cost or profit centre.

Economic risk

Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the longer-term affects of changes in exchange rates on the market value of a company. Basically this means a change in the present value of the future after tax cash flows due to changes in exchange rates.

There are two ways in which a company is exposed to economic risk.

Directly: If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.

Indirectly: Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong SAR and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong SAR dollar the South African firm has lost some competitive position.

Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.

Translation risk

The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is the translation not the conversion of real money from one currency to another.

The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement.

If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then the UK parent company will anticipate a balance sheet value of £500,000 for the subsidiary. A depreciation of the US dollar to $/£2.00 would result in only £250,000 being translated.

Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.

Hedging transaction risk - the internal techniques

Internal techniques to manage/reduce forex exposure should always be considered before external methods on cost grounds. Internal techniques include the following:

Invoice in home currency

One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.

However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.

Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.

Leading and lagging

If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.

If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.

The problem lies in guessing which way the exchange rate will move.

Matching

When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other.

It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.

An extension of the matching idea is setting up a foreign currency bank account.

Bilateral and multilateral netting and matching tools are discussed in more detail here.

Decide to do nothing?

The company would "win some, lose some".

Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.

In the short run, however, losses may be significant.

One additional advantage of this policy is the savings in transaction costs.

Hedging transaction risk - the external techniques

Transaction risk can also be hedged using a range of financial products. These are introduced below with links to more detailed pages.

Forward contracts

The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward rate of exchange. This effectively fixes the future rate.

Forward contracts can be explored in more detail here.

Money market hedges

The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur. This effectively fixes the future rate.

Money market hedges can be explored in more detail here.

Futures contracts

Futures contracts are standard sized, traded hedging instruments.

The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.

Currency futures can be explored in more detail here.

Options

A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.

A call option gives the holder the right to buy the underlying currency.

A put option gives the holder the right to sell the underlying currency.

Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.

Currency options can be explored in further detail here.

Forex swaps

In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a fixed rate/fixed rate swap.

The main objectives of a forex swap are:

To hedge against forex risk, possibly for a longer period than is possible on the forward market.

Access to capital markets, in which it may be impossible to borrow directly.

Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.

Forex swaps can be explored in further detail here.

Currency swaps

A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies.

In effect a currency swap has two elements:

An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.

An exchange of interest rates - the timing of these depends on the individual contract.

The swap of interest rates could be fixed for fixed or fixed for variable.

Currency swaps can be explored in more detail here.

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