Introduction to Currency Risk

Alastair Graham

• Publisher: Routledge
• Year: 2013
• Print ISBN: 9781579582173
• eBook ISBN: 9781135957254
• Topic: Business
• Subtopic: Business General
• Index: Business

The Currency Risk Management series offers readers, researchers, and financial professional a time-tested training tool for understanding and working in the increasingly complex currency markets. This series breaks new ground in simplicity, clarity, and ease of application in risk management practice.

1
Financial Risk

Risk arises from uncertainty now about what might happen in the future. The perception of risk is often defensive, anticipating negative rather than positive outcomes. For example, when preparing for a foreign business trip you might envisage

• the airplane crashing (accident risk)
• falling ill before or during the trip (health risk)
• being held up in traffic and missing the plane (traffic risk)
• flight delay (delay risk)
• having money stolen (theft risk).

This simple example illustrates the defensive attitude we take to risk, and also the tendency we have to categorize types of risk.

Commercial Risk and Financial Risk

Risk is inevitable in business, and the success or failure of its risk management will affect a company's profits. Business risk falls broadly into two categories, commercial and financial risk.

Commercial risk relates to the business environment in which a company operates and is the risk of a downturn or setback in business conditions. For example

• sales of a new product could fall short of expectation
• market share could be lost to a rival product
• the supply of raw materials could be interrupted.

Financial risk is the possibility of changes in financial conditions in the future that will affect revenues or costs. Currency risk is one type of financial risk.

Categories of Financial Risk

The term exposure that can be defined as exposure to risk, describes the existence of a financial risk for a business. There are different types of financial risk including

• country risk, sub-categorized into economic, political and regulatory risk
• price risk
• credit risk and counterparty risk
• interest rate risk
• currency risk, or exchange rate risk.

Country Risk

Country risk arises from cross-border transactions, when a business in one of the countries might suffer higher costs or lower profits because of future changes in the economic, political or regulatory environment in the other country. Risk is much greater in some countries than in others; for example, a long-term transaction in Hong Kong might be a greater risk than a long-term transaction in Singapore because it reverted to Chinese control in 1997.

Another example of country risk would be giving credit to a customer in a developing country with a foreign currency shortage. A new government might impose further foreign exchange restrictions in response to deteriorating economic conditions. A combination of economic, political and regulatory changes would have adverse financial consequences for the company granting the credit. It might not be able to receive payment from its customer, even though the customer would be able and willing to pay the debt.

Economic, political and regulatory conditions are significant factors in country risk,

Economic Risk

Fluctuations in a country's economic environment, such as wage levels, inflation and the rate of growth or recession, will affect the costs and revenues of companies operating there.

Example

XYZ Inc exports goods from the US priced in dollars and competes in world markets with German producers, who price their goods in euros.

Analysis

There might be a risk that unit costs of production in the US will increase at a higher rate than in Germany, caused perhaps by higher wage setdements or declining productivity in XYZ's industrial sector. If the euro/dollar rate remains fairly stable, XYZ would be at risk of becoming less competitive against its German rivals because of the unfavorable economic conditions in the US compared with Germany. To remain competitive, XYZ Inc would have to

• keep its dollar prices static in spite of higher unit costs, therefore reducing profitability, or
• raise its dollar prices and become less competitive than German firms.

Political Risk

Political events can disrupt a company's business and thus have an effect on its profits. For example

• wars and similar disturbances. The invasion of Kuwait by Iraq in 1990, followed by the Gulf War in 1991, affected many companies adversely, particularly those trading with customers or suppliers in the war zone. The Gulf War also discouraged international travel, and airlines suffered a sharp fall in business. On the other hand, in the dispute between NATO and Yugoslavia over Kosovo in 1999, some small airline companies benefited from a demand for their services by NATO forces to move people to and from countries near the war zone
• a political coup. For example, at the time of the break-up of the Soviet Union, there was a coup against President Gorbachev in August 1991, followed by a counter-coup several days later. These events caused a sharp fall in the value of the deutschemark, followed by an equally sharp recovery. This was because prospects for the German economy were thought at the time to be dependent on economic reforms and developments in central and eastern Europe. The deutschemark's value continued to fluctuate with the political uncertainty in Russia after the break-up of the Soviet Union
• a general moratorium on repayment of debt to foreign suppliers, declared by the government of a less developed country (LDC) or other country
• the nationalization of a company's assets by government
• elections, and the prospect of a change in government, might have an adverse effect on interest rates or exchange rates
• government-inspired measures to ban or restrict imports from particular countries. For example, trade disputes between the US and the European Union have given rise to import bans and the threat of further banning measures between the disputing governments.

Regulatory Risk

Regulatory bodies may make decisions that will have an impact on a company's profits. There is regulatory risk associated with

• listed companies on stock exchanges, new share issues, etc
• takeovers or mergers
• accounting and taxation
• other aspects of company law
• banks, the effects of which may be passed on to companies.

Economic, political and regulatory risk can exist at the same time, making business activity a high-risk operation. This has been evident, for example, in Russia since the collapse of the USSR. Foreign companies dealing with Russian customers, suppliers and joint venture partners have had to face high inflation, a weak market economy, an underdeveloped banking system, foreign exchange controls and political unrest.

Price Risk

Price risk is an exposure to a loss from the change in value of a commodity or financial instrument. Where the commodity or instrument is traded on an organized market, e.g. stocks and shares, price risk is also referred to as market risk.

For example, an investor in the shares of a public company can expect the share price to rise or fall, depending largely on

• changes in future prospects for profits and dividends
• changes in the yield available on alternative investments, e.g. a rise or fall in interest rates.

Occasionally there can be a large and unforeseen change in the level of stock market prices. In 1987 and 1989 for example, there were sudden and unforeseen falls in share prices, notably in die US and the UK. In contrast, in the late 1990s, the rise in shares on several stock markets, most notably the US, was bigger than fundamentals might seem to justify.

Credit Risk

Companies that give credit face the risk of non-payment or late payment, resulting in

• bad debt losses
• interest costs, or cost of carry, having to fund debtors for a longer time than intended
• administrative costs of chasing up late payers.

Counterparty Risk

A counterparty is the other party to a contract. I here could be a risk that the counterparty will fail to honor his/her contract obligations. The risk of non-payment of money owed, i.e. credit risk, is a common form of counterparty risk.

Interest Rate Risk

When a company borrows or lends funds it is exposed to financial risks associated with the volatility of interest rates.

Interest rate risk is the risk from changes in market interest rates of either

• paying more in interest charges for borrowed funds than need have been paid, or
• receiving less interest income from deposits or loans in the case of banks than could have been earned.

Interest rate risk also arises from borrowing or investing in different currencies. Market rates of interest vary between currencies. You might borrow in one currency and then find in retrospect that it would have been cheaper to borrow in another. This currency of denomination exposure combines interest rate risk and currency risk.

Currency Risk (Exchange Rate Risk)

Currency risk, also referred to as exchange rate risk and foreign exchange risk, is the risk from adverse movements in exchange rates. When a company has assets or liabilities denominated in a foreign currency, or contracts to receive or pay in a foreign currency, it has an exposure to that currency.

An adverse movement in the exchange rate can affect a company by

• reducing its cash income
• increasing its cash expenditures
• reducing its reported profits
• reducing the reported value of its foreign assets
• increasing the value of its foreign currency liabilities
• damaging its competitive position in its domestic and foreign markets to the advantage of foreign rivals.

Cash flows are at risk from adverse exchange rate movements because

• companies that receive income in foreign currency often will wish to exchange it into domestic currency. For example, a French company that receives $50,000 for selling equipment to Saudi Arabia might wish to convert the dollars into euros
• companies with debts in a foreign currency will have to convert domestic currency into the foreign currency, i.e. buy currency, to pay what they owe

Currency risk to cash flows arises because of movements in the prices, or exchange rates, at which foreign currency is converted.

Profits also are at risk if they are earned by foreign subsidiaries. A UK company, for example, might earn annual profits of $600,000 from a US subsidiary. If the sterling/dollar exchange rate moves from £1 = $1.50 to £1 = $2.00, the value of the annual profits will slide from £400,000 to £300,000. In much the same way, the value of the assets of foreign subsidiaries, expressed in the parent company's domestic currency, is at risk from adverse exchange rate movements.

A company's competitiveness in both domestic and international markets can be under threat from currency risk.

Example

There are two producers of radios, one based in the EU and one in Singapore. The European company's production costs are €10 per unit and the Singapore company's S$20. The product sells for $15.

If current exchange rates are €1 = $1, €1 = S$2 and $1 = S$2, the two companies will be equally cost-competitive in world markets. Each company would incur the equivalent of $10 in costs and earn the equivalent of $5 profit per unit. The European company's profit would be €5 per unit and the Singapore company's profit would be S$10 per unit.

Analysis

Suppose, however, that the euro increased in value to €1 = $1.2 and €1 = SS2.4. The European company would ...

Table of contents

• Cover
• Title
• Copyright
• Contents
• 1 Financial Risk
• 2 Currency Risk
• 3 Transaction Exposures
• 4 Translation Exposures
• 5 Economic Exposures
• 6 Gains and Losses from Exposures
• 7 Identifying and Quantifying Exposures
• 8 Risk Management Strategies
• Glossary
• Index