Question

Illustrate the different types of exchange rate risk and ways firms manage exchange rate risk

examples as well

Answer 1

In the present era of increasing globalization and currency volatility, changes in exchange rates have a substantial influence on companies’ operations and profitability. Exchange rate volatility affects multinationals and large corporations, & also small and medium-sized enterprises also for those who operate in the domestic country only.

Firms has to manage 3 types of risk associated with exchange rates-

Transaction exposure. This arises from the effect that exchange rate fluctuations have on a company’s obligations to receive or disburse payments in FX. This type of exposure is short-term to medium-term in nature. The mitigation measure over this is to hedge its receivables & payables by appropriately entering into forward contracts considering the settlement period and FX Movement. Tools used for heding are forwards, Futures, Money market instruments, options & Swaps. Another mitigating measure could be leading (prompt settlement) & lagging (deferring the settlement)

A firm's translation risk is in which financial reporting gets affected by exchange-rate movements. As all firms having multinational operations have to prepare consolidated financial statements for reporting purposes, the consolidation process for foreign entitites entails translating foreign assets and liabilities, or the financial statements of foreign subsidiaries, from foreign to domestic currency. While translation risk does not affect a firm's cash flows, it has a impact on a firm's reported profitability & its Share price. A technique to hedge translation risk is called balance-sheet hedging, which involves speculating on the forward market in hopes that a cash profit will be realized to offset a non-cash loss from translation. This requires an equal amount of exposed foreign currency assets and liabilities on the firm's consolidated balance sheet.

Economic Risk - Market value of Firm 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. (E.g in US China Trade war led to increase in US Dollar Yuan exchange rates thus leading to exports from US to be costlier). Additionally 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 assessed in order to generate adequate revenues mitigating those risks.