Question

What types of foreign exchange risks are international firms exposed to?  What commercial FX rates are available to businesses ?  How do they work the lead & lag strategies?

Answer 1

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the domestic currency of the consolidated entity.

Investors and businesses exporting or importing goods and services, or making foreign investments, have an exchange-rate risk but can take steps to manage (i.e. reduce) the risk.

Many businesses were unconcerned with, and did not manage, foreign exchange risk under the international Bretton Woods system. It wasn't until the switch to floating exchange rates, following the collapse of the Bretton Woods system, that firms became exposed to an increased risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure.The currency crises of the 1990s and early 2000s, such as the Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis, led to substantial losses from foreign exchange and led firms to pay closer attention to their foreign exchange risk.

Types of foreign exchange risk

Economic Risk:

A firm has economic risk (also known as forecast risk) to the degree that its market value is influenced by unexpected exchange-rate fluctuations, which can severely affect the firm's market share with regard to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic risk can affect the present value of future cash flows. An example of an economic risk would be a shift in exchange rates that influences the demand for a good sold in a foreign country.

Another example of an economic risk is the possibility that macroeconomic conditions will influence an investment in a foreign country.^[8] Macroeconomic conditions include exchange rates, government regulations, and political stability. When financing an investment or a project, a company's operating costs, debt obligations, and the ability to predict economically unsustainable circumstances should be thoroughly calculated in order to produce adequate revenues in covering those economic risks.^[9] For instance, when an American company invests money in a manufacturing plant in Spain, the Spanish government might institute changes that negatively impact the American company's ability to operate the plant, such as changing laws or even seizing the plant, or to otherwise make it difficult for the American company to move its profits out of Spain. As a result, all possible risks that outweigh an investment's profits and outcomes need to be closely scrutinized and strategically planned before initiating the investment. Other examples of potential economic risk are steep market downturns, unexpected cost overruns, and low demand for goods.

International investments are associated with significantly higher economic risk levels as compared to domestic investments. In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with the sale and purchase of foreign government bonds. However, economic risk can also create opportunities and profits for investors globally. When investing in foreign bonds, investors can profit from the fluctuation of the foreign-exchange markets and interest rates in different countries.^[9] Investors should always be aware of possible changes by the foreign regulatory authorities. Changing laws and regulations regarding sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect investments in foreign countries. For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted. As a result, economic risk can be reduced by utilizing various analytical and predictive tools that consider the diversification of time, exchange rates, and economic development in multiple countries, which offer different currencies, instruments, and industries.

When making a comprehensive economic forecast, several risk factors should be noted. One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment. In a macroeconomic model, major risks include changes in GDP, exchange-rate fluctuations, and commodity-price and stock-market fluctuations. It is equally critical to identify the stability of the economic system. Before initiating an investment, a firm should consider the stability of the investing sector that influences the exchange-rate changes. For instance, a service sector is less likely to have inventory swings and exchange-rate changes as compared to a large consumer sector.

Contingent risk:

A firm has contingent risk when bidding for foreign projects, negotiating other contracts, or handling direct foreign investments. Such a risk arises from the potential of a firm to suddenly face a transnational or economic foreign-exchange risk contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that, if accepted, would result in an immediate receivable. While waiting, the firm faces a contingent risk from the uncertainty as to whether or not that receivable will accrue.

Transaction risk:

Companies will often participate in a transaction involving more than one currency. In order to meet the legal and accounting standards of processing these transactions, companies have to translate foreign currencies involved into their domestic currency. A firm has transaction risk whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange, or translate, the foreign currency for domestic.

When firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market, with rates constantly fluctuating between initiating a transaction and its settlement, or payment, those firms face the risk of significant loss. Businesses have the goal of making all monetary transactions profitable ones, and the currency markets must thus be carefully observed.

Applying public accounting rules causes firms with transnational risks to be impacted by a process known as "re-measurement". The current value of contractual cash flows are remeasured on each balance sheet.

Translation risk:

A firm's translation risk is the extent to which its financial reporting is affected by exchange-rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities, or the financial statements of foreign subsidiaries, from foreign to domestic currency. While translation risk may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price.

Translation risk deals with the risk to a company's equities, assets, liabilities, or income, any of which can change in value due to fluctuating foreign exchange rates when a portion is denominated in a foreign currency. A company doing business in a foreign country will eventually have to exchange its host country's currency back into their domestic currency. When exchange rates appreciate or depreciate, significant, difficult-to-predict changes in the value of the foreign currency can occur. For example, U.S. companies must translate Euro, Pound, Yen, etc., statements into U.S. dollars. A foreign subsidiary's income statement and balance sheet are the two financial statements that must be translated. A subsidiary doing business in the host country usually follows that country's prescribed translation method, which may vary, depending on the subsidiary's business operations.

Subsidiaries can be characterized as either an integrated or a self-sustaining foreign entity. An integrated foreign entity operates as an extension of the parent company, with cash flows and business operations that are highly interrelated with those of the parent. A self-sustaining foreign entity operates in its local economic environment, independent of the parent company. Both integrated and self-sustaining foreign entities operate use functional currency, which is the currency of the primary economic environment in which the subsidiary operates and in which day-to-day operations are transacted. Management must evaluate the nature of its foreign subsidiaries to determine the appropriate functional currency for each.

Measuring risk:

If foreign-exchange markets are efficient—such that purchasing power parity, interest rate parity, and the international Fisher effect hold true -a firm or investor needn't concern itself with foreign exchange risk. A deviation from one or more of the three international parity conditions generally needs to occur for there to be a significant exposure to foreign-exchange risk.

Financial risk is most commonly measured in terms of the variance or standard deviation of a quantity such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the foreign currency spot exchange rate. A variance, or spread, in exchange rates indicates enhanced risk, whereas standard deviation represents exchange-rate risk by the amount exchange rates deviate, on average, from the mean exchange rate in a probabilistic distribution. A higher standard deviation would signal a greater currency risk. Because of its uniform treatment of deviations and for the automatically squaring of deviation values, economists have criticized the accuracy of standard deviation as a risk indicator. Alternatives such as average absolute deviation and semivariance have been advanced for measuring financial risk.

Value at risk:

Practitioners have advanced, and regulators have accepted, a financial risk management technique called value at risk (VaR), which examines the tail end of a distribution of returns for changes in exchange rates, to highlight the outcomes with the worst returns. Banks in Europe have been authorized by the Bank for International Settlements to employ VaR models of their own design in establishing capital requirements for given levels of market risk. Using the VaR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates.