Foreign Exchange Risk

The risk arising due to fluctuations in exchange rates of currency pairs is termed as foreign exchange risk. This is also known as currency risk or exchange rate risk. The fluctuations of certain currency pairs may have impact on any business that derives a portion of its revenues from outside the country. Imagine you are a US company providing services to a company incorporated in the Euro-zone and you receive your payments in Euro. The currency risk in this case is due to possible appreciation of Euro relative to US Dollars. However, the same US firm is least bothered about fluctuations of Japanese Yen (JPY) relative to USD, provided it doesn't have any significant revenue from Japan. Broadly, there are two types of currency risks - Transaction risk and Translation risk. Transaction risk is any adverse movement of currency pairs which affects a company’s position over a long term in terms of cash flows. Translation risk is any risk which gives rise to accounting losses, not necessarily a cash loss. Translation risk is a temporary phenomenon which, may or may not result in Transaction risk.

Foreign exchange risk can affect a variety of companies and people. Governments of different countries face this risk on a daily basis and usually have sufficient reserves in a basket of currencies to manage the risk. Another straight forward example was cited in the above section. Many more types of businesses can be impacted due to adverse movement is exchange rates. A company which raises capital in a foreign currency can have a huge impact due to adverse currency movements. For instance, a company may raise capital via the Foreign Currency Convertible Bond route. Companies do this due to lower interest rates in foreign countries. This is when yield required on a FCCB is significantly lower than the interest rate in the domestic banks. There is a significant currency risk that the home currency may depreciate considerably compared to the foreign currency at the time of principal repayment. A company which borrowed money from a country of lower interest rates to invest in a country where interest rates are significantly higher also faces the same risk. The popular Yen carry trade is an example of this, when interest rates in Japan were close to zero. The borrowers invested the money into emerging economies like India, China etc. Any person who invests in overseas financial instruments also faces the currency risk.

Hedging is a way to manage the foreign exchange risk. There are various opinions in the market on aspects of hedging. Some experts believe that hedging can eat away your potential profits when the currency fluctuations are in your favor. However, some experts advocate hedging, as it offers safety and prevents excessive loss in case exchange rates move adversely. The best hedges are the ones which involve taking an opposite position to offset the risk. However, these might not always serve the purpose. There are various methods of hedging the currency risks. Some methods might be more suitable than others. A hedge should make sure that it doesn't eat away possible profits in good times. It should also protect a company against unbearable losses. A hedging strategy should also aim at minimizing transaction costs and any other overheads. A good hedge ensures that the company manages foreign exchange risk effectively and sustains the profits.

Futures and Forwards are a popular way of managing the currency risk. A futures contract is an exchange traded contract and a Forwards is an over the counter instrument. The futures contract enables a mark to market type of accounting on a daily basis and is free from counterparty risk. A US company which anticipates exchange rate risk due to adverse movements of EUR to affect its business can execute a hedging strategy which suggests shorting a futures contract of EUR/USD. A standardized EUR/USD futures contract is available on the Chicago Mercantile Exchange. It is best to short a near month contract and rollover the contract at expiry. Any foreign exchange loss due to appreciation of EUR will be offset by the profits in the futures contracts. The number of futures contract to be shorted can be decided upon based on the amount which is decided to be hedged. Forwards may be better for more flexible structuring of the deal. Futures and Forwards are widely used to manage the exchange rate risks.

Options can be another excellent tool to manage exchange rate risks. There are broadly two types of options- Call and Put. A call option entitles a buyer to buy the underlying at a particular price on or before a said date. A put option entitles a buyer to sell the underlying at a particular price on or before a said date. Buying a call option on EUR/USD contract helps a US company hedge against adverse movements of EUR against USD. Buying options has been a better way to hedge due to limited risks to the option buyer. However, since option valuation is a complex task, it requires significant expertise to trade in options sensibly. Hedges which employ option trading strategies are the best ones to manage foreign exchange risk. Some more methods are also available for large companies. A currency swap trade is also widely used for hedging currency risks. This is a trade where the cash flows are exchanged in different currencies at a particular date. A currency swap is an over the counter instrument.

Foreign exchange risk affects a variety of companies and governments. An effective hedging strategy is always recommended to manage the risks. A hedge should never aim at speculating the movement in exchange rates. A macroeconomic view while undertaking a hedging strategy can also be helpful. Foreign exchange fluctuations are caused due to a variety of factors which include Government interventions, Export-Imports, Speculation etc. The fluctuations in turn affect many decisions and hence it is impossible to speculate consistently in the foreign exchange markets. There have been many financial disasters when hedges have been executed based on speculation. A sound risk management strategy is also viewed positively in the markets and by the public. Hence foreign exchange hedging is beneficial if done correctly.