What is foreign Exchange Risk and its types? Explained

Foreign Exchange Risk Example

Let’s say an Indian company provides IT services to U.S companies, and all the payments are made to the Indian company in Dollars. On 25th January 2020, the INR/USD rate was at INR 70. The U.S company has to pay 200 Hrs worth of billing to the Indian company on 15th Feb 2020. The INR/USD rate is expected to increase to INR 65 /USD on interest rates being dropped.

So, notice first who faces the risk?

  • The Indian company faces the risk of receiving lower INR if the rate appreciates to INR 65.
  • Total billing is still the same. 200 Hrs x 100(Per HR $ Billing rate)= $20000, but the conversion will lead to INR 13 Lacs instead of INR 14 Lacs.
  • The prospective INR 1 Lac is nothing but foreign exchange risk.

Foreign Exchange Risk?

Foreign exchange risk, also known as the exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’s financial performance or financial position will be impacted by changes in the exchange rates between currencies. Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets. There are three types of foreign exchange risk, and they include transaction risk, economic risk, and translation risk.

Understanding Foreign Exchange Risk Exposure

Risk occurs when a company engages in financial transactions or maintains financial statements in a currency order than where it was headquartered. For example, a company based in Australia that does business in Canada – i.e., receives financial transactions in Canadian dollars – reports its financial statements in Australian dollars is exposed to foreign risk. The Canadian dollars received must be converted to Australian dollars before writing the company’s financial statements. Changes in the exchange rate between the CAD and AUD would be the risk, hence the term foreign exchange risk.

Types of Foreign Risk

There are three types of Foreign Exchange risks. They include:

  • Transaction Risk:

Transaction risk is faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before the transaction settlement. The transaction risk can be mitigated using forward contracts and options.

  • Economic Risk:

Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.

For example, an Australian furniture company that sells locally will face economic risk from furniture importers, especially if the Australian currency unexpectedly strengthens.

  • Translation Risk:

Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.

For example, a parent company that reports in Australian dollars but an overseas subsidiary based in Canada face translation risk, As the subsidiaries, financial performance is in Australian dollars is translated to Canadian dollars for reporting purposes.

Causes of Foreign Exchange Risk

  • Macroeconomic factors, including inflation, interest rates etc.
  • Government policies can affect currency value too. For e.g., import restrictions or export restrictions.
  • Political instability can also cause foreign exchange risk.

Foreign Exchange Risk Management Techniques

Mitigation of foreign exchange risk is a key risk management objective in the investment context. There are multiple ways of mitigating this, some of which are

  • Going Short the Currency: For example, if we invest in India as a U.S investor in a publicly listed company. We of course, want to take exposure to the upside of the company we invested in, but we don’t want the currency risk. So we could sell INR Equivalent to the amount of investment we have done in the stock.
  • SWAPS: These are niche products, but SWAPS in bonds of foreign countries can give us the option for cashflows in either domestic or foreign currency

How does currency get Valued?

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