Question

What is Market Risk due to currency fluctuations?

Articulate four plans to mitigate this risk in a bank.

Answer 1

exchange risk - also called FX risk, currency risk, or exchange rate risk - is the financial risk of an investment's value changing due to the changes in currency exchange rates. This also refers to the risk an investor faces when he needs to close out a long or short position in a foreign currency at a loss, due to an adverse movement in exchange rates

Foreign exchange risk typically affects businesses that export and/or import their products, services and supplies. It also affects investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency.

A firm is exposed to foreign exchange risks if it has receivables and payables whose values are directly affected by currency exchange rates. Contracts between two different firms with different domestic currencies set contracts with specific rules. This contract provides exact prices for services and exact delivery dates. However, this contract faces the risk of exchange rates between the involved currencies changing before the services are delivered or before the transaction is settled

A firm faces foreign exchange risks due to economic exposure - also referred to as forecast risk - if its market value is impacted by unexpected currency rate volatility. Currency rate fluctuations may affect the company's position compared to its competitors, its value and its future cash flow. These currency rate changes may also have good effects on firms. For example, a company from the United States with a milk supplier from New Zealand will be able to cut costs if the U.S. dollar strengthens against the New Zealand dollar. In this light, economic exposure may be managed strategically through arbitrage and outsourcing

All firms generally prepare financial statements. These statements are created for reporting purposes. They are provided for multinational partners, thus the need for the translation of important figures from the domestic currency to another currency. These translations face foreign exchange risks, as there can be changes in foreign exchange rates when the translation from the domestic currency to another currency is performed. Though translation exposure may not impact a firm's cash flow, it can change the overall reported earnings of the firm, which affects its stock price.

Firms who bid for foreign projects, negotiate contracts directly with foreign firms, or have direct foreign investments face contingent exposure. When firms negotiate with foreign firms, currency rates will continuously change before, during and after negotiations occur. For example, a firm may be waiting for a bid to be accepted by another foreign firm. As the firm waits, it faces contingent exposure, since currency rates may fluctuate and the firm will never know the status of their domestic currency in contrast with the foreign firm's currency when the bid is finally accepted.

Strategies that mitigate currency fluctuations are routinely part of a multinational company’s enterprise risk management plan. Events such as changes in interest rate policies in countries where the company does business usually trigger these ERM strategies.

Hedge the Risk with Specialized Exchange-

Traded Funds
There are many exchange-traded funds (ETFs) that focus on providing long and short exposures to many different currencies. For example, the ProShares Short Euro Fund (NYSEARCA: EUFX) seeks to provide returns that are the inverse of the daily performance of the euro. A fund like this can be used to mitigate a portfolio's exposure to the performance of the euro.

If an investor purchased an asset that is based in Europe and denominated in the euro, the daily price swings of the U.S. dollar versus the euro will affect the asset's overall return. The investor would be going "long" with the euro in this case. By also purchasing a fund like the ProShares Short Euro Fund, which would effectively "short" the euro, the investor would cancel out the currency risk associated with the initial asset. Of course, the investor must make sure to purchase an appropriate amount of the ETF, to be certain that the long and short euro exposures match 1-to-1.

ETFs that specialize in long or short currency exposure aim to match the actual performance of the currencies on which they are focused. However, the actual performance often diverges due to the mechanics of the funds. As a result, not all of the currency risk would be eliminated, but a vast majority can be. As of April 2016, there were ETFs that provide long and short exposure for the U.S. dollar, the Japanese yen, the European euro, the Australian dollar, the Swiss franc, the Chinese yuan and others.

Forward Contracts

Currency forward contracts are another option to mitigate currency risk. A forward contract is an agreement between two parties to buy or sell a specific asset on a specific future date, at a specific price. These contracts can be used for speculation or hedging. For hedging purposes, they enable an investor to lock in a specific currency exchange rate. Typically, these contracts require a deposit amount with the currency broker. The following is a brief example of how these contracts work.

As of April 1, 2016, one U.S. dollar equaled 111.97 Japanese yen. If a person is invested in Japanese assets, has exposure to the yen and plans on converting that yen back to U.S. dollars in six months, he can enter into a six-month forward contract. Imagine that the broker gives the investor a quote to buy U.S. dollars and sell Japanese yen at a rate of 112, roughly equivalent to the current rate. Six months from now, two scenarios are possible: The exchange rate can be more favorable for the investor, or it can be worse. Suppose the exchange rate is worse, at 125. It now takes more yen to buy 1 dollar, but the investor would be locked in to the 112 rate and would exchange the predetermined amount of yen at dollars at that rate, benefiting from the contract. However, if the rate had become more favorable, such as 105, the investor would not get this extra benefit because he would be forced to conduct the transaction at 112.

Currency Options

Currency options give the investor the right, but not the obligation, to buy or sell a currency at a specific rate on or before a specific date. They are similar to forward contracts, but the investor is not forced to engage in the transaction when the contract's expiration date arrives. In this sense, if the option's exchange rate is more favorable than the current spot market rate, the investor would exercise the option and benefit from the contract. If the spot market rate was more favorable, then the investor would let the option expire worthless and conduct the foreign exchange trade in the spot market. This flexibility is not free, and the options can represent expensive ways to hedge currency risk.

Money Market Hedge

A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances and commercial paper are traded.

Since there are a number of avenues such as currency forwards, futures, and options to hedge foreign exchange risk, the money market hedge may not be the most cost-effective or convenient way for large corporations and institutions to hedge such risk. However, for retail investors or small businesses looking to hedge currency risk, the money market hedge is one way to protect against currency fluctuations without using the futures market or entering into a forward contract.