Foreign Currency Risks

Nature & Purpose

Risk Management for financial managers is concerned with the external financial risks such as interest rates and foreign exchange rates. These financial risks affect the decisions made by financial managers in investment, dividend and financing.

Foreign Currency Risks

The changes in currency affects the activities of businesses, especially international businesses, and Financial Managers have to be aware of the risks so they can use method to reduce these external effects.

Foreign currency risks are the effects on businesses that trade internationally when currency depreciates or appreciates. They can be classified as:

  • Translation risk – Note this is an accounting risk not cash-based one. This is the risk of a business making a gain/loss in the published financial statements, this happens when earnings of its foreign branches are exchanged into the home currency on consolidation of accounts. Normally the case in import/export.
  • Transaction risk – Businesses can be vulnerable to movement in exchange rates particularly the case with international traders. For example, an importer takes credit from an exporter, from the time of purchase to the time it takes to pay they both face the danger of any movement in the exchange rates. If the currency depreciates/appreciates one of the parties will benefit whilst the other suffers.
  • Economic risks – Refers to how exchange rate movements affect the international competitiveness of a company. For example, a UK company purchasing raw materials in the US dollars but selling products mainly within the EU would be vulnerable to depreciation of sterling against the dollar and this would affect its competitiveness.

Foreign currency risk hedging techniques

Hedging techniques are used to minimise the effects of currency risks.

The approaches include:

  • Leading – Try to receive payment quicker if the depreciation of currency is likely to happen. To encourage this a discount may be offered.
  • Lagging – Try to delay payment if the depreciation of currency is likely and this will make it cheaper for the business. The business can ask to exceed credit terms in this case.
  • Pay in home currency – Receive and pay only in the home currency.
  • Foreign currency bank accounts – A business may decide to have a foreign currency bank account, this would limit the exposure of exchange risk to the amount in the account.

Hedging Transaction Risk

To resolve the transaction risk several hedging methods can be employed including:

  • Forward exchange contracts – A contract set between the business and bank to agree on a certain rate of exchange today so that the business will know in advance how much it will pay/receive in local currency from import/export transactions.
  • Money Market Hedge – Involves borrowing and lending in different currencies to try and benefit from favourable exchange rate movements.