Foreign Exchange Risk Definition
Foreign Exchange Risk refers to the risk of an unfavorable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency). This risk arises as a result of movement in the base currency rates or the denominated currency rates and is also called exchange rate risk or FX risk or currency risk.
Types of Foreign Exchange Risks
Foreign exchange risks can be classified into the following three types of risks:
#1 – Transaction Risk
Where the business transactions are entered in a currency other than the home currency of the organization, then there is a risk of change in the currency rates in the adverse direction from the date of entering the transaction to the date of settlement. This type of foreign exchange risk is known as transaction risk. This risk arises on the actual and probable import and export transactions.
#2 – Translation Risk
Where a business organization has a foreign subsidiary whose reporting currency is other than the reporting currency of the parent company, then for consolidation purposes, the subsidiary balance sheet items are converted into the parent company’s reporting currency on the basis of the prevailing accounting standards. The risk of movement in the consolidated financial position and earnings as a result of exchange rates is termed as Translation Risk. The results, in turn, impact the stock prices. It is also termed as Accounting Exposure.
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#3 – Economic Risk
It is the risk of change in the market forecast of the company’s business and future cash flows as a result of a change in the exchange rates. This, in turn, impacts the market value of the firm. For e.g. a monopoly product of the company starts facing competition when the lower exchange rate renders the imported product cheaper. This type of foreign exchange risk is also termed as Forecast Risk.
Foreign Exchange Rate of Return
When a company invests in security in other than home currency, then the rate of return is a combination of the rate of return in foreign currency and the rate of appreciation or depreciation in the exchange rate.
- RH = Rate of return in the home or base currency
- RF = Rate of return in denominated or foreign currency
- Rex = Rate of appreciation or depreciation in the exchange rate
Foreign Exchange Risks Example
A US-based multinational wishes to invest surplus funds of USD 1 million. It has an option to invest the same in US corporate bonds and earn a return of 2.5% p.a. The treasurer is considering another option to invest the same in Turkish corporate bonds and get a return of 20% p.a. The exchange rate today is 1 USD = 5 TRY. After 1 year, the exchange rate is expected to be 1 USD = 4.3 TRY. Advise which investment is better.
- RH = 2.5%
- RF = 20%
Rex = (5 – 4.3) / 5 = 14% (depreciation)
(1 + RH) = (1 + RF) (1 ± Rex)
- = (1 + 20%) * (1 – 14%)
- = 1.2 * 0.86
- = 1.032
RH = 3.2%
Here, the Turkish investment is giving a return of 3.2% as the rest of the return has been eaten by the foreign exchange movement. Hence, the TRY investment should be preferred over the USD investment (3.2% > 2.5%).
Advantages of Foreign Exchange Risks
- Foreign exchange fluctuation provides an opportunity of gaining from favorable movement in the currency of open foreign exchange position.
- Availability of numerous new and innovative products to hedge the risk.
- Risk can be hedged by pairing the open positions in currencies with exactly the same or exactly opposite foreign exchange movements.
- The flexibility of hedging the risk in an exchange-traded or an Over the Counter OTC market as both the markets are very much liquid.
- Foreign exchange markets operate round the clock in one or the other country, hence the hedging or speculation is possible anytime.
Disadvantages of Foreign Exchange Risks
- Can result in huge losses even if there is a small movement in the rates where the open position is huge.
- Hedging the risk involves an additional cost.
- Hedging results in margin requirements along with a change in the foreign exchange rates.
- Rate and spread determination is a complex process and is often opaque.
Limitations of Foreign Exchange Risks
There are broadly two limitations of foreign exchange risks.
- First one is the high volatility of the foreign exchange market, which is affected by a change in global policies and economic situations. Further, these changes are reflected in the exchange rates instantly as the markets operate on a 24 hours basis. Hence, a person needs to be on his toes to speculate in this market and to capitalize on the foreign exchange risk.
- Secondly, a perfect hedge is rare to locate in the market. The exchange-traded derivatives are often standard and hence results in an incomplete hedge which continues to pose risk. The OTC market tries to solve the issue but results in increased cost and counterparty credit risk.
Foreign exchange risk poses a threat and it is important to hedge the open exposures. But at the same time, it is wise to keep updating with the global information and gain from the volatility offered by the foreign exchange market by keeping the open positions within the risk appetite. Availability of a number of products and round the clock operations has made both the speculation & hedging easy and has rendered the market highly liquid.
This has been a guide to what is Foreign Exchange Risk & its definition. Here we discuss the 3 types of foreign exchange risks & formula to calculate returns along with the example, advantages, and disadvantages. You can learn more about accounting from the following articles –