Question

What is the exchange rate risk? In no more than 500 words, provide one example of a multinational firm, and explain why would the firm be concerned about it. (please don't send pictures of this answer)

Answer 1

Exchange rate risk is the possibility that the value of an investment will change when the currency is exchanged.

This occurs when there is movement in the exchange rate between placing an order and the transaction being completed. Exchange rate risk is associated with all foreign investments. This is the uncertainty that is inherent in dealing with two or more currencies.

Types of exchange rate risk

1.Transaction risk, 2.Translation risk, 3.Economic risk

1.Transaction risk.

Transaction risk occurs when a company buys products or services in a different currency or has receivables in another currency than their operating currency. Since the payables or receivables are denominated in a foreign currency, the exchange rate at the initiation of a transaction and on the date of settlement may have changed due to the volatile nature of the forex market. This can cause a gain or loss for the company depending on the direction of the movement of exchange rates and thus poses a risk to the company.

Example of Transaction Risk

A company X operating in the united states of America, buys raw material from company Y in Germany. The operational currency for Company X and Y is USD and EUR, respectively. The company buys raw material for EUR 100 Mn and needs to pay company Y 3 months down the line. At the initiation of a transaction, suppose USD/ EUR rate is 0.80; thus, if the company X had paid for the material upfront, it would have bought EUR 100 Mn for USD/ EUR 0.80 * EUR 100 Mn = USD 80 Mn.

Now suppose, after three months, USD depreciates to USD/ EUR 0.85, then the company would have to pay USD 85 Mn to buy the EUR 100 Mn to pay the company Y in Germany. Thus, company X has to pay USD 5 Mn extra due to the volatility of the USD-EUR pair. Had the dollar appreciated against the Euro, company X would have paid less to buy the EUR 100 Mn.

2.Translation risk

Translation risk occurs when a company’s financial statement reporting is affected by the exchange rate volatility. A large multinational generally has a presence in many countries, and each subsidiary reports its financial statements in the currency of the country in which they operate. The parent company typically reports the consolidated financials, which involves translating foreign currencies of different subsidiaries to the domestic currency. And this can have a significant impact on the company’s balance sheet and income statement and can ultimately affect the stock price of the company.

Example of Translation Risk

Company X operating in the United States of America, has subsidiaries in India, Germany, and Japan. To report the consolidated financials, company X needs to translate INR, EUR, and YEN, respectively, into USD. So if the INR, EUR, and YEN fluctuate in the forex market relative to USD, it can impact the reported earnings and balance sheet of company X. This can ultimately affect the share price of company X.

3.Economic risk

A company faces economic risk when the volatility in the exchange rate market can cause changes in the market value of the company. It represents the effects of exchange rates movement on revenues and expenses of a company, which ultimately affects the future operating cash flows of the company and its present value.

Example of Economic Risk

Change in the exchange rate of a pair of currency can cause changes in the demand for a product that a company produces. Since the exchange rate movement is affecting the market and revenue of the company, it can affect its present value.