What is Exchange Rate Risk?
Exchange Rate Risk is defined as the risk of loss that the company bears when the transaction is denominated in a currency other than the currency in which the company operates. It is a risk which occurs due to change in relative values of currencies. The risk which the company runs is that there may be an adverse currency fluctuation on the date when the transaction is completed and currencies are exchanged. Foreign exchange risk also occurs when a company has subsidiaries operating in different countries and the subsidiaries prepare their financial statements in the currency which is different from the currency in which the parent company reports its financial statements.
Import and export businesses involve a large number of foreign exchange risks as the import/ export of goods and services involve transactions in different currencies and exchange of currencies at a later date and time. Exchange rate risk also affects international investors and institutions which make the overseas investment in international markets.
Types of Foreign Exchange Risks
#1 – Transaction Risk
Transaction risk occurs when a company buys products or services in a different currency or has receivables in a different currency than their operating currency. Since the payables or receivables are denominated in a different currency, the exchange rate at the initiation of a transaction and on the date of settlement may have changed due to the volatile nature of the forex market. This can cause a gain or loss for the company depending on the direction of movement of exchange rates and thus poses risk to the company.
Example of Transaction Risk
A company X operating in the united states of America buys raw material from company Y in Germany. The operational currency for Company X and Y are USD and EUR respectively. The company buys raw material for EUR 100 Mn and needs to pay company Y 3 months down the line. At the initiation of a transaction, suppose USD/ EUR rate is 0.80; thus if the company X had paid for the material up front, it would have bought EUR 100 Mn for USD/ EUR 0.80 * EUR 100 Mn = USD 80 Mn.
Now suppose, after three months USD depreciates to USD/ EUR 0.85, then the company would have to pay USD 85 Mn to buy the EUR 100 Mn to pay the company Y in Germany. Thus, company X has to pay USD 5 Mn extra due to the volatility of the USD-EUR pair. Had the dollar appreciated against the Euro, company X would have paid less to buy the EUR 100 Mn.
#2 – Translation Risk
Translation risk occurs when a company’s financial statement reporting is affected by the exchange rate volatility. A large multinational generally has a presence in many countries and each subsidiary reports their financial statements in the currency of the country in which they operate. The parent company generally reports the consolidated financials and this involves translating foreign currencies of different subsidiaries to the domestic currency. And this can have a huge impact on the company’s balance sheet and income statement and can ultimately affect the stock price of the company.
Example of Translation Risk
A company X operating in the United States of America has subsidiaries in India, Germany, and Japan. So, to report the consolidated financials, company X needs to translate INR, EUR, and YEN respectively into USD. So if the INR, EUR, and YEN fluctuate in forex market relative to USD, it can impact the reported earnings and balance sheet of company X. This can ultimately affect the share price of company X.
#3 – Economic Risk
A company faces economic risk when the volatility in the exchange rate market can cause changes in the market value of the company. It basically represents the effects of exchange rates movement on revenues and expenses of a company which ultimately affects the future operating cash flows of the company and its present value.
Example of Economic Risk
Change in the exchange rate of a pair of currency can cause changes in the demand for a product that a company produces. Since the exchange rate movement is affecting the demand and revenue of the company, it can affect its present value.
How to Manage Foreign Exchange Rate Risk?
- Managing Transaction Risks – The most common way to manage transaction exchange rate risk is hedging strategies. In hedging, each transaction can be hedged by the ways of forwards, futures, options, and other financial instruments. Hedging strategy is generally employed to lock in a future exchange rate at which the foreign currency can buy or sell, thus leaving the company immune to volatility in the exchange rate market. Since the future rate is locked at the outset, exchange rate movement will not result in losses to the company. However, there is a downside too for hedging transactions – though it prevents the losses, it can also cut down profits of a transaction in case of favorable currency movements as the exchange rate is locked at the initiation of the transaction.
- Managing Translation Risk – The second exchange risk i.e. translation risk or balance sheet risk is difficult to hedge or control as it involves balance sheet items such as long term assets and liabilities which are difficult to hedge due to their long term nature. And this risk is hedged very occasionally.
- Managing Economic Risk – The third risk, economic risk is also difficult to hedge as it is complicated to quantify the risk and then hedge it. Economic risk is the residual risk and is often hedged at last and in many cases, left unhedged.
To conclude, we can say that foreign exchange rate is an important factor for companies which transact internationally, have subsidiaries abroad, and whose market value is dependent on exchange rates and affect profitability and market value of companies. The different types of exchange rate risks are transaction, translation, and economic risk. And these can hedge depending on the nature of risk.
This has been a guide to what is Exchange Rate Risk and its definition. Here we discuss types of exchange rate risks (transaction, translation & economic risk) along with examples and how to manage them. You can learn more about Risk Management from following articles –