Currency risk is basically a risk that arises when a price of some country’s currency changes against the currency of some other country (Alastair, 2013). Whenever the companies or investors have their business operations or assets across their national borders, they are exposed to currency risk if they do have their positions hedged (Stephens, 2003). In these modern times of heightening currency volatility and increasing globalization, changes on the currency rates or the exchange rates causes to have a substantial influence over the profitability and operations of companies and even the government in those countries (Graham, 2014). The volatility of the exchange rates or currency rates not only affects the large corporations or multinationals, but also the medium and small sized businesses that operate only in their homeland (Horcer, 2011).
Types of currency risks or exposure
What follows is a brief account of different types of currency risks or exposure that are faced by companies and governments due to the volatility of the currency or exchange rates.
It is among the lesser discussed risks by researchers and scholars, but still is an evident one and has a substantial presence. Such a risk is basically caused by effects of unanticipated or unexpected fluctuations in currency on the future market value and cash flows of a company (Coyle, 2001). The impact of such a risk is long term is nature. It can have a substantial impact on the competitive position of a company even if the company is not making overseas sales or operating overseas. The source behind the economic risk is the change in competitive strengths of exports and imports (Plaza, 2011). This can be understood with an example.
For instance, if a company exports from UK to a country in the Eurozone and the price of the Euro weakens against the pound sterling i.e. it comes from 1.1 euros to 1.3 euros per pound sterling. This is a weak position because one would have to give 0.2 Euros more for one pound sterling. This means that a product from UK priced 100 pounds would cost 130 Euros instead of 110 Euros. This means that the goods from UK would become less competitive in the European market. On the other hand, the goods that are imported from Europe to UK would cost lesser than previously and would make them competitive in the UK market (MOguillansky, 2003).
Methods of risk mitigation for economic risk could be difficult, and especially the smaller companies which have limited international dealings (Hakala & Wystup, 2002). Some of the following approaches in general could be of importance.
- Try exporting and importing from multiple currency zones and hope that those zones do not all move together, or move together to the same extent. For example, for the six months from January 2010 to June 2010 €/US$ rate of exchange moved from €/US$0.6867 to €/US$ 0.8164. This caused to strengthen the US dollar against the Euro by 19 percent. This resulted in making it less competitive for the USA manufacturers to make exports to a country in Eurozone. However if during the same period, the value of Pound relative to the US dollar moves from 0.6263 to 0.6783, this would have strengthened the US dollar relative the pound by 8 percent. In such a case, he trade from US to United Kingdom would not have been affected so badly(Poghosyan, 2010).
- Another method here is to make the goods in the countries to which they are sold. This is something which is followed by multinationals. Though in such a case, the raw materials might need to be imported and affected by change in currency rates, but the other expenses such as electricity bills and wages in the local currency would not be subject to the currency risks(Clark & Ghosh, 2004).
The impact of currency rate fluctuations on the company’s fiscal statements results in translational risks. It is especially the case when the company features foreign subsidiaries (Matsukawa & Habeck, 2007). This risk is normally short to medium term. If the subsidiary of a company is in some country where the currency weakens, the value of assets of such subsidiary in the company’s consolidated accounts will weaken (Homaifar, 2004). The effect is not severe as it does not impact on the day to day cash flows. However, scholars and practitioners have reserved the translation risk usually for the consolidation effects (Stephen, 2003).
The exposure can be partially mitigated through funding of the foreign subsidiary through a foreign loan. For instance, take a USA subsidiary of a company which has been set up by the parent company using equity finance. The financial position statement of the company would appear something like this:
Current assets – 0.5 million US dollars
Non-current assets – 1.5 million US dollar
Equity – 2.0 Million US dollars
Now if the US dollars, the total assets of the company would have a lesser value as a result.
However, in case if the subsidiary for example was formed through using 50 % US borrowings and through 50 % equity, the financial position would be:
Current assets – 0.5 million US dollars
Non-current assets – 1.5 Million US dollars
The breakup of this position or the assets is that $ 1 million loan is used to finance the assets and the rest 1 million is equity borrowings. So the investment of the holding company is only $ 1 million US dollars and the net assets are only worth US dollars 1 million. Now if the US dollars weakens in such a case, only the net assets value of US dollars 1 million decreases (John Y, 2010).
Transaction risks are the most evident and talked about currency risks due to fluctuations in currency (Sebetian & Solnik, 2008). The exposure exists when the companies exporting and importing. This type of risk is of a short to medium term. If the rate of exchange during the time the company enters into contract and the time of actual receipt or payment of money changes, the amount of the home currency to be received or paid will alter and would make the future cash flows uncertain (Bartram & Bodnar, 2007).
Methods of currency risk mitigation and their shortcomings
Some of the most renowned and widely used risk mitigation strategies are those are used by companies to overcome transaction risks. Though in case of foreign currency transactions, there are chances of obtaining profit due to the increase in the rate of foreign currency (Ugur, 2012).
There are two obvious risk mitigation techniques for minimizing the transaction exposure.
Under this technique, the exposure or risk of the transaction is transferred to the other company. For instance, an exporter of US selling products in Germany could quote the sale price in US dollars. In such case the transaction exposure or risk for any uncertainty in exchange rate would be faced by the German importer (Ephraim & Judge, 2008).
The currency risk of transaction is minimized here by netting out. This method is of vital importance for the larger companies that are frequently involved in large amounts of currency transactions (Cavusgil, et al., 2012). Receivable of Deutsche marks of 100 million owed to some US company in 45 days is safe if the USA Company is to pay out some German suppliers Deutsche marks 75 million in about 30 days. The risk increases further if the business only has receipts on continuing basis in Deutsche marks. The risk is decreased when the receipts and payments are in various different currencies. An example has been given earlier in the exposition. Though the transaction of currency cannot be netted off fully, it may become so small that the company accepts the exposure or risks rather than incurring costs associated with hedging that are given below (Judge, 2009).
Hedging techniques for currency risk mitigation (hedging techniques or instruments)
Mitigating short term foreign exchange risks
For eliminating short term transaction exposures of currency, there are various hedging instruments available with different costs.
The most direct means to eliminate the transaction risk is by hedging the risk with forward exchange contract. For instance, suppose some USA exporter sells 50 wine cases to some Venezuelan company under sales contract, which specifies an amount of 15 million bolivars to be paid in 60 days. The exporter could eliminate the transaction exposure through the 15 million bolivars to his bank at a 60days forward exchange rate of 750 bolivars / dollar. Now it does not matter what happens to the currency rate during the next month, the company will have assurance that it will be able to convert 15 million bolivars into 20,000 US dollars (Bartram, 2008).
Now the risk or limitation with this method is that exposure could only be eliminated if Venezuelan buyer pays the obligation of 15 million bolivars. The default from the buyer would not relieve the US producer from the obligation towards the bank. Another limitation is that the forward contracts are not usually accessible for the small businesses. Banks normally quote rate that are unfavorable for the smaller businesses because the risk will be borne by the bank in case the company does not fulfill the forward contract. Creditworthy companies are also refused by banks. The non-eligible companies for forward exchange rate contracts can use the option to hedge transaction exposure through future contracts (Bartram, 2008).
The forward market hedge and future market hedge have many similarities. For instance, a US company has payable of $50,000 to be paid by the third Wednesday of September. This organization is able to purchase a Canadian dollar future contract for September. Now if value of Canadian dollar increases, the value of the payable of US Company will increase. However, value of the future contract will also increase by the same amount which would make the net value unchanged. Vice versa would be the case if the Canadian dollar value falls (Qing, et al., 2007).
The future contracts are marked by the market. The losses are to be met in cash and the offsetting currency transactions would be delayed till the transaction takes place. It might also bear the risk for insolvency for the company (Hull, 2008).
Hedging through the money market
Where future market hedge is expensive, not available, or bears large risk of insolvency, a company can use the money market hedge. Suppose a US exporter is to receive 4 million Brazilian reals in in one month time. The exposure or risk of currency fluctuation could be eliminated here through borrowing Brazilian reals at a 10 percent interest rate per month. The business can them convert them into US dollars at spot rate. When Brazilian customer after one month pays of the 4 million reals, they are utilize the settle the principle and interest on the loan.
Companies should pay out more for borrowing the funds than they could receive when they lend the funds. The interest rates charged by banks rises with risk and the requirement of collateral securities or pledge are also in place. In the situation in which the business borrows future payable, it could pledge reals deposit as the collateral security. The company’s and borrowing rate would be almost risk free when the bank has low risk. In such a case, money market hedge will be normally the least expensive option even if forwards and future contracts are available (Maurer & Valiani, 2007).
Cross hedging is another hedging method which is of importance for countries where options such as future contracts, forward rates, options or credits in the foreign currency are not available (Madura, 2012). It is a hedge that is established in currency which is related to value of currency in which the payable or receivable is denominated. In some of the cases, finding currencies that are correlated is easy because many small countries try pegging their currencies with major currencies like Euro, Dollar, or franc. However, there might not be perfect correlation among these currencies as efforts for pegging the values fail frequently (Lane & Shambaugh, 2010).
Now for instance, if there is a company that has receivables or payables denominated in the currency of some small nation that has no developed credit market or currency. In such case, it will explore possibility that the currency might be pegged to some major currency value. If not, then the company would observe the previous changes in value of that currency to determine whether such currency in correlated with the changes in value of some major currency. The company then undertakes a futures market, forward market, options or money market hedge in that major currency (Chue & Cook, 2008). A limitation with this method is that its success depends change in major currency value corresponds with the currency of the smaller country (Calamos, 2011).
For now, there is an only limited market for the currency futures options that features maturities greater than 1 year. Only a few banks render foreign exchange contracts of long term with maturities such as seven years. Only the credit worthy and the large corporations qualify for those contracts (Hull, 2008).
Back to back loans
Back to back loan arrangements are a method to reduce currency risks in long term transactions. For instance, where a company enters into a project with some company in another country, it can use parallel or back to back loan arrangements for reducing risk. Here the company will lend loan in its homeland currency to the other company if the other intends to invest in that country. Similarly the other company with whom the lending company is making investment will arrange loan in its own homeland currency for the investing company. Thus they will pay each other from the earnings they derive from their respective investments in the form of currencies of their respective countries. In such case both companies will be under bilateral arrangement which will be outside the scope of foreign exchange markets. Ultimately neither of them would be affected by fluctuations in exchange rate.
However the risk of default from either company always remains and they are not freed from their loan liabilities (Patnaik & Shah, 2010).
There are various other methods that are used for mitigating currency risks, but they vary from country to country and have their own limitations in general and in the context of specific countries.
Conclusion and recommendations
Effective legal drafting could be used to minimize substantial international transaction risk. The risk of currency fluctuation exposure could be eliminated or mitigated using the instruments or methods that have been described in this exposition. Though many of the instruments do not hedge the transaction exposure entirely, but they are more accessible for the medium and small size firms and the individuals. Though the instruments and methods increase transaction cost, but still businesses intend to minimize risks as a priority.
Individuals and companies should have an understanding of the transactions they do in terms of the risks associated with them. Similarly they should have an understanding of their financial and money market so that they can determine the risk mitigation instruments and techniques in those markets. In case the risk is higher, then the cost of mitigation techniques should never be avoided. They should have an eye on both the present and future currency risk of a transaction.
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