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 money in which the company operates. It is a risk that occurs due to a change in the 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 riskForeign Exchange RiskForeign exchange risk is an unfavourable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency), also referred to as currency risk or exchange rate risk. also occurs when a company has subsidiaries operating in different countries. The subsidiaries prepare their financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. 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 include 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 overseas investments in global markets.
Types of Foreign Exchange Risks
#1 – Transaction Risk
Transaction riskTransaction RiskTransaction risk is the uncertainty or loss caused to the contracting party due to a change in the foreign exchange rate or currency risk on delay in settlement of a foreign transaction. occurs when a company buys products or services in a different currency or has receivables in another currency than their operating currency. Since the payables or receivables are denominated in a foreign currency, the exchange rate at the initiation of a transaction and on the date of settlementDate Of SettlementThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade. 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 the movement of exchange rates and thus poses a 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 is 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 upfront, 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 riskTranslation RiskTranslation risk describes how fluctuations in exchange rates can affect a company's financial position (assets, liabilities, and equity) when dealing with foreign currencies. 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 its financial statements in the currency of the country in which they operate. The parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. typically reports the consolidated financials, which involves translating foreign currencies of different subsidiaries to the domestic currency. And this can have a significant impact on the company’s balance sheet and income statement and can ultimately affect the stock price of the company.
Example of Translation Risk
Company X operating in the United States of America, has subsidiaries in India, Germany, and Japan. 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 the 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 riskEconomic RiskEconomic Risk is the risk exposure of an investment made domestically or abroad. These risks could be macroeconomic factors like government policies or collapse of the current government and major swing in the exchange rates. when the volatility in the exchange rate market can cause changes in the market value of the company. It represents the effects of exchange rates movement on revenues and expenses of a company, which ultimately affects the future operating cash flowsOperating Cash FlowsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. 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 market 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 evaded by the methods 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, leaving the company immune to volatility in the exchange rate market. Since the future rate is locked at the outset, the exchange rate movement will not result in losses. However, there is a downside too for hedging transactionsHedging TransactionsHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. – 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. 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 challenging 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 the foreign exchange rate is an essential factor for companies that transact internationally, have subsidiaries abroad, and whose market value is dependent on exchange rates and affect the 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 the 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 the following articles –