CFA, Financial Products, FRM

Foreign Exchange Risk – Full Details

What is Foreign Exchange Risk?

Foreign exchange risk refers to the risk that an investment value will change due to change in two different currencies. It is also known as currency risk or exchange rate risk.

Exposure to foreign exchange risk is the natural result of the globalization of financial institutions. This risk arises when foreign exchange currency trading and/or foreign asset-liability positions are mismatched in individual currencies. Unexpected volatility could result in significant losses for the firm, which could threaten profitability or even solvency.

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Where does it arise?

For a Financial Institution, the key trading activities that leads to foreign exchange risk are;

  1. Enabling customers to participate in an international commercial business transaction.
  2. Enabling customers to take a position on real or financial foreign investment.
  3. Offsetting exposure in a given currency for hedging purposes.
  4. Speculating foreign currencies in search of profit by forecasting.

 

How it works?

For example, An American Liquor Company signs a contract to sell a French retailer 100 cases of whiskey for a 50 euros per case, or 5000 euros in total. The American company agrees to this contract at a time when the euro and the dollar are of equal value (1 Euro = 1 Dollar).

However, it may take a few months for the Whiskey Company to deliver the goods. In the meantime, Europe undergoes economic crises, and the value of the euro goes down sharply. By the time whiskey is delivered, one euro is only worth $0.75. Thus, though the French company still pays agreed upon 5000 euros, the amount is now equal to $3750 leading to a loss to American Company.

What are the different types of foreign exchange risks?

  • Transaction Exposure – This risk occurs when the exchange rate changes between the date of the business transaction and the settlement date.
  • Translation Exposure – This happens when a company has an asset in other currencies and has to translate them for the purpose of accounting and reporting. If there are changes in the exchange rate this could affect the value of the company’s asset and must be reported.
  • Contingent Exposure – This risk arises when firms bid on projects in foreign currencies.

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How to measure foreign exchange risk?

There are a number of ways to measure foreign exchange risk the most common methods are

  • Value-At-Risk (VaR) – Value at risk is an estimate of how much a company’s investment might lose or gain under normal currency market conditions over a set time period.
  • Cash-Flow-At-Risk (CFaR) – Cash Flow at Risk estimates how a company’s future cash flow may change over a set time period as a result of FX market changes.
  • Earnings-At-Risk (EaR) – Earning at Risk estimate how much income might change over a set period. It is based on previous earning figures; the longer the period of time analyzed the higher the foreign exchange risk.

How to manage foreign exchange risk?

Exchange risk cannot be avoided altogether when investing overseas, but it can be mitigated considerably through the use of hedging techniques. There are two principal methods of better controlling the impact of foreign exchange exposure:

  • On-balance-sheet hedging is achieved when a financial institution has a matched maturity and foreign currency balance sheet
  • Off-balance-sheet hedging occurs through the purchase of forwards for institutions that choose to remain unhedged on the balance sheet.

The rule of thumb is to leave foreign exchange risk with regard to foreign investment unhedged when your local currency is depreciating against the foreign-investment currency but hedged this risk when your local currency is appreciating against the foreign investment currency.

Related:

What is Sovereign Risk and How to mitigate it?

What is Herstatt Risk?

Asian Financial Crisis

 

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