In their day-to-day operations, companies encounter a lot of risks. These risks expose the company and may hinder the company from achieving its financial goals. Every financial investment is associated with risk, and you should therefore finance an investment whose risk you are ready to handle. Many factors can cause risks, and it is not possible to completely avoid risks. Risk should not deter you from investing.
The management of companies must therefore come up with ways of hedging the company against risk. A company or investment is exposed to several types of risk. This article will cover currency risk, types, and how to manage it.
Also Read: Forex Risk Management
What is Currency Risk?
Currency risk arises due to changes in the value of one currency in relation to another. It is the possibility of losing money due to adverse changes in exchange rates. Currency risk is known as exchange rate risk.
Currency risk is the possibility that currency fluctuations will adversely affect the value of financial investment or asset denominated in a foreign currency. Currency risks will also affect the value of dividends and interest related to the asset or investment.
Investors or companies with investments or assets across different countries are exposed to currency risk. Currency risk creates unpredictable losses or profits.
Types of Currency Risks
Foreign exchange risks can be divided into three categories:
- Transaction Risk
- Economic Risk
- Translation Risk
Transaction risk is the possibility that a country’s currency exchange rate will fluctuate before settling a completed foreign transaction. It is related to the delay in time between getting into a trade agreement and payment. A company or international investor making transactions between different countries is exposed to this risk.
This type of foreign exchange risk is greater if there is a long interval between entering into a contract and payment. The risk is greater because there is more time for the currencies to fluctuate. A Forward Contract is a form of hedging that can reduce exposure to this type of risk.
For example, an investor in Europe agrees to buy equipment from the U.S and pay in U.S dollars within 30 days. If the Euro fluctuates during the intervening 30 days, the investor will spend more Euros to purchase the U.S dollar to pay for the equipment.
Economic risk is also referred to as forecast risk. This is the risk that unavoidable exposure to currency fluctuations will impact the market value of a company. Multinationals and international investors are exposed to greater risk because their operations are spread over several countries. Each country has its unique economic risk.
Economic risk is long-term in nature. This risk will impact strategic decisions, for example, where to invest.
Macroeconomic conditions like political instability and government policies may cause economic risk.
Translation risk is associated with companies that deal in a foreign country’s currency. Such companies are headquartered in their home country but have assets in foreign countries. The value of these assets is denominated in a foreign currency.
Multinationals own foreign assets that are listed in their balance sheets. The relative value of such assets must be converted from the foreign currency into the home currency for accounting purposes.
Translation risk is the possibility of changes in the relative value of a company’s assets. Currency rate fluctuations between the two countries will cause changes in the relative value of the assets.
For example, a company headquartered in Europe may have a subsidiary in Canada. The assets of the subsidiary will be denominated in the Canadian dollar. For consolidated accounting purposes, the company’s management must convert the value of the assets from the Canadian dollar and have them denominated in Euros. Currency changes between the Euro and the Canadian dollar may cause a translation loss or profit.
How to Handle Currency Risk
Foreign exchange rates are volatile, exposing a lot of multinationals and investors to currency risks. Businesses must therefore come up with ways of mitigating the potential effects of currency risks.
Businesses have to do an in-depth analysis and consider the advantages and disadvantages of each model. This will enable the management to choose the best model or a combination of models that suit the investment or business.
Here is a list of the possible ways that a business can use in managing currency risk.
- Forward Contracts
- Limit Orders
- Stop-Loss Orders
Forward contracts are custom-designed agreements between two parties to sell or buy an underlying asset at a specified price at a future date. Forward contracts eliminate foreign exchange rate risk by permitting the user to hedge against unexpected foreign currency fluctuations.
Forward contracts are tailored to a specific asset, delivery date, and amount. The consideration is called a forward price. This price is calculated using the risk-free rate and the spot price. The spot price refers to the underlying asset’s current market price.
A forward contract is an over-the-counter instrument and does not trade on centralized exchanges. Financial institutions that offer forward contracts expose themselves to greater settlement and default risk. Forward contracts settlements are either on a delivery or cash basis.
By signing a forward contract, you agree to pre-determine today’s price for a future business deal. Importers and businesses paying suppliers from overseas can eliminate uncertainty by predicting and safeguarding cashflows.
Forward contracts can be fixed for up to a year. In such a case, companies have a greater assurance that unfavorable foreign exchange rate changes will not negatively affect profits. Businesses are also unaware of the sums involved when dealing with international suppliers, hence the added security of transparency.
For example, a U.S investor may import items from a European supplier in the U.S dollar with the payment due in 30 days. The investor may opt to wait and see the exchange rate on that date or use a forward contract to lock the current rate.
Advantages and Disadvantages of Forward Contracts
- Forward contracts are customizable. They can include any term and amount. The terms are at the discretion of the parties and not standardized.
- Forward contracts offer price protection. They fix the price for a future date.
- A forward contract is an over-the-counter product.
- They don’t involve an initial cost. There is no upfront premium, and margins are not paid.
- Forwards have no intermediate cash flows before they are settled.
- The risk of defaulting on the contract is very high because there are no guarantors.
- Forward contracts are difficult to cancel even when spot prices fluctuate.
The concept of a limit order describes the purchase or sale of an asset at a specified or better price. Buyers’ limit orders will be executed at the limit or lower price. On the other hand, sellers’ limit orders will be executed at a limit or higher price.
Companies and international investors use limit orders to set an ideal exchange rate for buying a specific currency. Limit orders are ideal for businesses that don’t have confined deadlines for making payments.
For example, if the current foreign exchange rate is 1 U.S dollar=0.84 Euro, an investor may not want to send 10,000 Euro to the UK until the rate is better. The investor makes a limit order targeting an exchange rate of 1 U.S dollar=0.90 Euro. A transfer is triggered once the rate is reached.
This foreign exchange risk mitigation model is ideal when there is no payment deadline to be fulfilled since it may take several months before the rate is achieved. Investors make limit orders with their financial institutions when they cannot monitor the foreign exchange rates themselves.
Advantages and Disadvantages of Limit Orders
- A limit order allows investors to pay a specific or lower price.
- Limit orders allow traders to take advantage of rate fluctuations even when they cannot monitor the markets themselves.
- A transaction may take longer to be settled since settling only happens when the set price is reached.
- Investors may lose on opportunities since the set limit may never be reached.
A stop-loss order is placed by an investor to sell or buy a specific stock when it reaches a specific price. This order is designed to hedge an investor’s loss on an investment position. A stop-loss order is simply an instruction to sell or buy a currency at a predetermined worst-case exchange rate.
Firms use stop orders to lock in deals so that the firms never trade below what they deem as acceptable foreign exchange rates. Corporations use stop-loss orders when there are potential currency fluctuations, and the currency risk to such exposure can be reduced.
Advantages and Disadvantages of Stop-Loss Orders
- Stop-loss orders effectively guarantee a minimum currency exchange rate
- There is no need to monitor your investments daily.
- Short-term price fluctuations could trigger unnecessary sales by activating the stop order.
All investors should understand the tax implications of their businesses and stocks. Most countries levy taxes on profits, dividends, and interest earned.
All corporations trading and investing in the U.S market should be aware of the following taxes on their income.
- Capital gains if you were in the U.S for less than 183 days will be levied at a default rate of 0%
- Dividends are taxed at a default rate of 30%
- Interest income is taxed at a rate of 30%
However, the tax rates may be lower if your country of residence has a Tax Treaty Agreement with the U.S.
Also Read: Forex Trading Strategies
What causes foreign exchange rate risk?
Fluctuating currency rates are the cause of foreign exchange rate risk. When a currency fluctuates, it affects a company’s market value and cash flows. Companies and investors operating internationally are exposed to foreign exchange risk.
Why do currencies fluctuate?
Currencies fluctuate because of their demand and supply. Most currencies are sold and bought based on exchange rates that are flexible. The prices of these currencies therefore change depending on their demand and supply in the foreign exchange market. These fluctuations cause foreign exchange risk.
Can foreign exchange risk be avoided?
Currency risk cannot be avoided, especially for companies investing overseas. However, you can use hedging techniques to manage currency risk.
Why do I need to manage currency risk?
Managing currency risk has a lot of potential advantages, including:
- Protecting your profit margins and cash flows.
- A better understanding of how currency fluctuations affect the business.
- Improves financial budgeting and forecasting.