Finance

Currency Risk

Currency Risk

Currency risk is also treated as Foreign exchange rate risk or exchange rate risk or Forex Risk. Currency risk is the financial risk that arises from an International financial transaction that can occur losses due to change in the value of one currency price against the other different country currency price due to unfavorable fluctuations in the exchange rates. Investors, Business Firms, Hedge Fund Managers, Mutual fund companies, Multinational companies, or foreign Intuitional Investors are exposed to currency exposure in the forex market.

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Some of the Historical Examples:

Star bucks: in 2004 it increased 34% due to depreciation of USD against the Canadian dollar and British pound.

Estimating FX Risk are mainly cauterized into three:

CURRENCY RISK

 

  1. Transaction Risk: Transaction risk is the risk related to the international transaction of Payable and receivables in a short-term period. Transaction risk(exposure) measures the profits or losses that can arise from the financial obligations in terms of foreign currency.For example, An American company that imports goods from an Indian company and pay the payment for the receivables in terms of Indian Rupee.it is exposed to INR-USD risk. If the Indian rupee gets strengthens in relation to the USD when a company faces losses it must buy an Indian rupee (INR) to pay to its suppliers. An American company sells goods in India and prices its goods in dollars. it is exposed to INR-USD risk. if INDIAN RUPEE depreciates(weakens) relative to dollar USD the company suffers from losses when it exchanges INR revenues to USD. To mitigate the Transaction Risk can be hedged the forward transactions in a future date. An FX Swap is also useful when a company owns foreign currency to purchase goods on a future date and earn interest in domestic currency.
  1. Translation Risk: Translation Exposure(risk) can also be known as either Accounting Exposure or Balance sheet Exposure.it measures the impact of changes in the exchange rate of the foreign currency on the value of assets and liabilities of the firms or multinational corporations in the physical presence of the foreign currency. These must become under the domestic currency when a financial statement is produced, which can lead to foreign exchange profits or losses. No direct impact on the cash flows of the firm only changes in the value of the accounts. 
  1. Economic Risk: It is also called operating exposure. Economic risk is the risk that relates to the company’s future operating cash flows will be affected due to unfavorable fluctuations in the exchange rate movements. Economic risk is the long-term risk that can be arises from the pricing of goods or products based on the location of investments. For Example, a US company sells software in India and denominates the software in the Indian rupee has no transaction risk however the does have the economic risk if the INR appreciates the value related to risk if customers of that company in India have purchased the product more expensive.

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Factors that lead to currency risk:

  • Balance of Payments and Trade flow: It measures the difference between the value of the exports and imports of the two different countries. For example, country A has increased its exports to country B. Country A currency demand increase when exchanging their denominated currency revenues foreign currency into domestic currency. It’s strengthened its value related to country B’s currency. Likewise, Country A increases its imports from Country B. Country A Currency demand decreases when they buy the country B currency to pay for the goods are importing.it weakens its value related to the Country B Currency.
  • Inflation: Inflation means the rate of change of the value of the currency decrease and the prices of the goods or services are increasing the country.it leads to decreases the purchasing power
  • Monetary Policy: the value of the currency is also influenced by the country’s central bank’s Monetary Policies. If country A currency value increases its money supply by 25% but Country B does not change then the country A value declined by 25% of the Country B currency.

Currency Risk Mitigation:

Currency Risk can be Mitigated by Contractual agreement, back-to-back loans, Letter-of-credit, by hedging the Derivates contracts. Derivate contracts are forward contracts, currency futures, Swaps, and Options. currency risk can be mitigated by netting or match tools.

Final Thoughts:

When a business firm or entity has an international business of any business area the currency risk is the essential part of the business. The firm faces major risks are Economic risk, Transaction Risk, and translation Risk. To reduce these risks firm can hedge the different kinds of derivates are options, forwards, futures, and swaps.

Author: John Earla

About Author: Currently pursuing Financial Risk Management from GARP(US) and completed Graduation in B.Com computers. John is interested in finance and Risk Analysis.

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