Question

• What is foreign exchange risk?
• What are the causes of foreign exchange risk and what actions would you take as a financial manager to mitigate the risk?

Answer 1

Foreign exchange risk is mainly the risk of depreciation of own currency in comparison to foreign currency. For example if I am an Indian, so for me the risk would be that my currency INR depreciates against any foreign currency, let's say US dollar. Why is depreciation of my currency a risk is because if this happens, i will have to pay more units of INR for every unit of USD therefore if I have to purchase something priced in USD, I will pay more for it in my currency terms or in INR terms.

Situations when such risk can arise: Importing raw materials from a foreign country: in this case, if my local currency depreciates, my cost of production goes up and my goods become incompetitve in the foreign market.

Above is only one aspect of the coin. It shows that only depreciation of local currency causes risk. But that is not the case. At times even appreciation of local currency against foreign currency can cause foreign exchange risk. A situation that fits this explanation would be: Suppose there is a multinational company which earns revenues in many different countries. So for this company, all the earnings in foreign currencies is converted to its local currency and brought back to the home country. Now if the local currency of the MNC appreciates, the revenues earned in foreign currencies will be converted to lower amounts of revenue in the local currency of the home country. For eg. a US company earning revenue in India in INR will lose out if USD appreciates against INR because the INR revenues when converted to USD will amount to lower units of USD

Financial managers have several ways to hedge such risks:

1. Forward/Future contracts: in these contracts the rate of exchange is fixed at the time of entering into the contract and the actual exchange is made at a later date to avoid the uncertainty of facing unfavorable exchange rates later.
2. Swaps: these are another form of derivative contracts which are like a series of forward contracts for a series of exchanges to be made over a period of time
3. Options: In forwards, futures, and swaps it is an obligation to fulfill the contract but at times the anticipated risk doesn't occur, that is, the exchange rate may be favorable at the time of the exchange, so options give the buyer an option to exercise or not for which the buyer pays an upfront premium
4. Using the revenues earned in foreign countries to pay off the suppliers in that country so that the converting back situation doesn't arise at all.