Currency Risk

11 Key excerpts on "Currency Risk"

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  eBook - ePub

  Essentials of Financial Risk Management

  • Rick Nason, Brendan Chard(Authors)
  • 2018(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 6 Currency Risk Management Introduction

  Currency Risk arises from the fluctuations in exchange rates between currencies. Currency trading is the largest trading market with an estimated $3 to $5 trillion being exchanged on a daily basis. Although exchange rate fluctuations are somewhat controlled by central banks, the control has at best a dampening effect and is a secondary factor. Thus, we see wild variations in exchange rates and exchange rate crises such as the Thai Baht crisis in the late 1990s.

  Currency Risk arises in many different forms. It can be transactional—such as repatriating sales achieved in a foreign currency or paying expenses in a foreign currency, or it can be translational—adjustments to the financial statements based on accounting for foreign currency transactions, or it can be strategic—such as changes in relative price competitiveness to a competitor whose cost structure is based in a different currency.

  Relatively few companies will hedge translational exposure. Although it affects the earnings of a company for a cycle, it is not related to cash flows. Most analysts understand the effects of translational exposure and thus are not concerned by the effects on earnings. Most analysts consider that attempting to hedge translational exposure is actually just introducing costs and economic exposure to deal with the cosmetic effects on earnings.

  Currency Risk affects virtually all companies of a certain size. This is irrespective if a company even has foreign operations or sales. The world operates on a global scale and the relative competitiveness of a company is based in large part on their cost base, which in turn is directly affected by exchange rates. Entire countries, and by extension, entire industries can see their relative competitiveness change quickly as exchange rates tend to be one of the more volatile financial variables. With a robust Currency Risk management plan, companies can find their competiveness being severely compromised in a hurry.

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  International Financial Operations

  Arbitrage, Hedging, Speculation, Financing and Investment

  • I. Moosa(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  CHAPTER 4 Hedging Exposure to Foreign Exchange Risk: The Basic Concepts 4.1 DEFINITION AND MEASUREMENT OF FOREIGN EXCHANGE RISK Foreign exchange risk arises because of uncertainty about the exchange rate prevailing in the future (after a decision involving exchange rate expectations has been taken, such that the outcome depends on the materialisation or otherwise of the expectations). It refers to the variability of the base currency value of assets, liabilities and cash flows (contractual or otherwise) resulting from the variability of the exchange rate. Therefore foreign exchange risk arises when a firm indulges in international operations involving currencies other than the base currency, including importing, exporting, investing and financing. As a result, the firm will be exposed to assets, liabilities and cash flows denominated in currencies other than the base currency. We have to remember that foreign exchange risk is associated with unanticipated changes in exchange rates, since anticipated changes are discounted and reflected in the value of the firm. The concept of foreign exchange risk will be illustrated by referring to an investment decision. Assume that an investor with a base currency x takes up an investment in a y-denominated asset at time t, maturing at time t + 1. If V x and V y are the x and y values of the asset respectively, then V x = S(x/y)V y (4.1) In what follows, we will for simplicity drop (x/y) from the symbol representing the spot exchange rate, but it is crucial to bear in mind that the exchange rate in this analysis is measured as the x price of one unit of y. The rate of return on the asset between t and t + 1 in terms of x is given by 65 ( ) , , , , 1 1 1 1 + = = + + + R V V S V S V x t x t t y t t y t (4.2) or ( ) ( )( ) 1 1 1 + = + + R S V y (4.3) where S and V y are respectively the percentage changes in the exchange rate and the y-denominated value of the asset between t and t + 1.

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  eBook - PDF

  Multinational Financial Management

  • Alan C. Shapiro, Paul Hanouna(Authors)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Thus, any accounting measure that focuses on the firm’s past activities and decisions, as reflected in its current balance sheet accounts, is likely to be misleading. Although exchange risk is conceptually easy to identify, it is difficult in practice to determine what the actual economic impact of a currency change will be. For a given firm, this impact depends on a great number of variables including the location of its major markets and competitors, supply and demand elasticities, sub- stitutability of inputs, and offsetting inflation. Finally, we concluded that since Currency Risk affects all facets of a company’s operations, it should not be the concern of financial managers alone. Operating managers, in particular, should develop marketing and production initiatives that help ensure profitability over the long run. They should also devise anticipatory or proactive, rather than reactive, strategic alternatives in order to gain competitive leverage internationally. SUMMARY AND CONCLUSIONS 317 The key to effective exposure management is to integrate currency considerations into the general manage- ment process. One approach that many MNCs use to develop the necessary coordination among executives responsible for different aspects of exchange risk management is to establish a committee for managing foreign currency exposure. Besides financial executives, such committees should—and often do—include the senior officers of the company such as the vice president-international, top marketing and production executives, the director of corporate planning, and the chief executive officer. This arrangement is desirable because top executives are exposed to the problems of exchange risk management, so they can incorporate currency expectations into their own decisions.

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  Global Corporate Finance

  Text and Cases

  • Suk H. Kim, Seung H. Kim(Authors)
  • 2009(Publication Date)
  • Wiley-Blackwell

    (Publisher)

  These results underline the impact of the high yen on Japanese exporters such as Sony. In fact, these days many companies are at the mercy of foreign-exchange rates. So long as we do not have a single world currency, some degree of exchange risk will exist, no matter what the system. Fluctuations in the value of currency had been quite fre-quently pronounced even under the fixed exchange rate system. A study by DeVries (1968), for example, shows that during the 20-year period from 1948 to 1968, 96 countries devalued their currencies by more than 40 percent, and 24 countries devalued their currencies by more than 75 percent. This problem has become more complicated in the past three decades, because most countries have permitted their currencies to float since 1973. Daily currency fluc-tuations and frequent currency crises have become a way of life since then. Daily currency fluc-tuations and the increasing integration of the world economy are two major reasons why multinational companies (MNCs) consider exchange rate risk as the most important among many risks. This chapter has four major sections. The first section describes the basic nature of foreign-exchange exposure. The second section explains how transaction exposure can be measured and hedged. The third section explains how economic exposure can be measured and hedged. The fourth section covers the use of exchange risk management instruments by MNCs. In addition, this section explores the possibility that a hedge can be risky, by using the maturity mismatch in a German firm’s oil futures hedge as an example. 9.1 The Basic Nature of Foreign-Exchange Exposures Foreign-exchange exposure refers to the possibility that a firm will gain or lose because of changes in exchange rates. Every company faces exposure to foreign-exchange risk as soon as it chooses to maintain a physical presence in a foreign country.

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  International Financial Management

  • Alan C. Shapiro, Peter Moles(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Bleakley, “How U.S. Firm Copes with Asian Crisis”, Wall Street Journal (December 26, 1997): A2. 11.7 SUMMARY AND CONCLUSIONS In this chapter, we examined the concept of exposure to exchange rate changes from the perspective of the economist. We saw that the accounting profession’s focus on the bal- ance sheet impact of currency changes has led accountants to ignore the more important effect that these changes may have on future cash flows. We also saw that to measure expo- sure properly, we must focus on inflation-adjusted, or real, exchange rates instead of on nominal, or actual, exchange rates. Therefore, economic exposure has been defined as the extent to which the value of a firm is affected by currency fluc- tuations, inclusive of price-level changes. Thus, any account- ing measure that focuses on the firm’s past activities and decisions, as reflected in its current balance sheet accounts, is likely to be misleading. Although exchange risk is conceptually easy to identify, it is difficult in practice to determine what the actual eco- nomic impact of a currency change will be. For a given firm, this impact depends on a great number of variables includ- ing the location of its major markets and competitors, supply and demand elasticities, shifting the sourcing of inputs, and offsetting inflation. Finally, we concluded that since Currency Risk affects all facets of a company’s operations, it should not be the con- cern of financial managers alone. Operating managers, in par- ticular, should develop marketing and production initiatives that help ensure profitability over the long run. They should also devise anticipatory or proactive, rather than reactive, strategic alternatives in order to gain competitive leverage internationally. The key to effective exposure management is to inte- grate currency considerations into the general management process.

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  Derivatives

  • (Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  So does the hedging 1 2013 Triennial Survey, Bank for International Settlements (2013). Chapter 7 Currency Management: An Introduction 341 of foreign currency assets and liabilities. It is unusual for market participants to engage in any foreign currency transactions without also managing the Currency Risk they create. Spot trans-actions typically generate derivative transactions. As a result, understanding these FX deriva-tives markets, and their relation to the spot market, is critical for understanding the Currency Risk management issues examined in this reading. 2.1. Spot Markets In professional FX markets, exchange rate quotes are described in terms of the three-letter cur-rency codes used to identify individual currencies. Exhibit 1 shows a list of some of the more common currency codes. EXHIBIT 1 Currency Codes USD US dollar EUR Euro GBP British pound JPY Japanese yen MXN Mexican peso CHF Swiss franc CAD Canadian dollar SEK Swedish krona AUD Australian dollar KRW Korean won NZD New Zealand dollar BRL Brazilian real RUB Russian ruble CNY Chinese yuan INR Indian rupee ZAR South African rand An exchange rate is the number of units of one currency (called the price currency ) that one unit of another currency (called the base currency ) will buy. For example, in the notation we will use a USD/EUR rate of 1.3650, which means that one euro buys $1.3650; equivalently, the price of one euro is 1.3650 US dollars. Thus, the euro here is the base currency and the US dollar is the price currency. The exact notation used to represent exchange rates can vary widely between sources, and occasionally the same exchange rate notation will be used by different sources to mean completely different things. The reader should be aware that the notation used here may not be the same as that encountered elsewhere.

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  eBook - ePub

  Airline Finance

  • Peter S. Morrell(Author)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  Chapter 9 Risk Management: Foreign Currency, Fuel Prices and Interest Rates

  This chapter will look at how airlines deal with three risks that stem from decisions on foreign exchange, fuel contracts and interest rates. These arise from the dayto-day running of an airline, rather than ones such as terrorist threats or epidemics that occur on a periodic or cyclical basis. No airline can disregard them, although foreign Currency Risks would be relatively less important to, say a domestic US airline, than one selling and buying in a large number of currencies worldwide. The focus here will be on the first two risks and the responses from airlines to minimise their impact on profitability or profit volatility over time. However, interest rate risk will also be addressed in the last section.

  It should be noted that airlines flying to/from and within Europe are required to submit an allowance for the amount of CO2 they emit during 2012 and subsequent years. Most of these allowances will initially be handed out without charge and some auctioned, but any difference between these and actual emissions will need to be purchased in the market. There is a risk that the market price of allowances might increase as the submission date approaches, so some airlines have already purchased some in advance to reduce this risk. This is similar to an add-on to the fuel price and will not be discussed further below.

  9.1 Exchange Rate Volatility

  International airlines sell tickets in many different countries and currencies, even in places where they do not have their own operations. They also incur operating expenses in the currencies of the countries they serve, and buy capital equipment from the major aerospace exporting countries such as the US, Canada, the UK, France, Brazil and Germany.

  It would be impossible for there to be a perfect match in both amounts and timing of foreign currency receipts and expenses. An airline may achieve some sort of balance over the year as a whole in receipts and expenses in a certain currency, but there will be weeks and months of surpluses followed by periods of shortfall. This can be managed by borrowing and lending in this one currency, and thus not involving conversion into another currency or any exchange risk. But net surpluses in a foreign currency would have to be exchanged into the local currency, which is the currency in which most costs are incurred and ultimately any profits would be retained or distributed. Here, there will be a time lag between income and expenditure which involves a risk of a movement in the exchange rate, and therefore a foreign exchange loss or gain. An airline’s treasury has the task of managing revenues, expenditures, assets and liabilities in both local and foreign currencies, and thus minimising the risks of exposure to large currency movements.

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  eBook - PDF

  Airline Finance

  • Peter S. Morrell(Author)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  Chapter 9 risk Management: Foreign Currency, Fuel Prices and Interest Rates this chapter will look at how airlines deal with three risks that stem from decisions on foreign exchange, fuel contracts and interest rates. these arise from the day-to-day running of an airline, rather than ones such as terrorist threats or epidemics that occur on a periodic or cyclical basis. No airline can disregard them, although foreign Currency Risks would be relatively less important to, say a domestic US airline, than one selling and buying in a large number of currencies worldwide. the focus here will be on the first two risks and the responses from airlines to minimise their impact on profitability or profit volatility over time. However, interest rate risk will also be addressed in the last section. It should be noted that airlines flying to/from and within Europe are required to submit an allowance for the amount of Co 2 they emit during 2012 and subsequent years. Most of these allowances will initially be handed out without charge and some auctioned, but any difference between these and actual emissions will need to be purchased in the market. there is a risk that the market price of allowances might increase as the submission date approaches, so some airlines have already purchased some in advance to reduce this risk. this is similar to an add-on to the fuel price and will not be discussed further below. 9.1 Exchange Rate Volatility International airlines sell tickets in many different countries and currencies, even in places where they do not have their own operations. they also incur operating expenses in the currencies of the countries they serve, and buy capital equipment from the major aerospace exporting countries such as the US, Canada, the UK, France, Brazil and Germany. It would be impossible for there to be a perfect match in both amounts and timing of foreign currency receipts and expenses.

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  Available until 4 Dec |Learn more

  International Finance

  Contemporary Issues

  • Maurice D. Levi, Dilip Das(Authors)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  20 For example, if Aviva can negotiate the price of its imported denim cloth in terms of US dollars, it need not face any foreign exchange risk or exposure on its imports. Indeed, in general, when business convention or the power that a firm holds in negotiating its purchases and sales results in agreement on prices in terms of the home currency, the firm that trades abroad will face no more receivables and payables exposure than the firm with strictly domestic interests. However, even when trade can be denominated in the importer’s or exporter’s local currency, only part of the risk and exposure is resolved. For example, an American exporter who charges for his or her products in US dollars will still find the level of sales dependent on the exchange rate, and hence faces operating exposure and risk. This is because the quantity of exports depends on the price the foreign buyer must pay, and this is determined by the rate of exchange between the dollar and the buyer’s currency. Therefore, even when all trade is in local currency, some foreign exchange exposure – operating exposure – will remain.

  Of course, only one side of an international deal can be hedged by stating the price in the importer’s or exporter’s currency. If the importer has his or her way, the exporter will face the exchange risk and exposure, and vice versa.

  When there is international bidding for a contract, it may be wise for the company calling for bids to allow the bidders to state prices in their own currencies. For example, if Aviva invites bids to supply it with denim cloth, Aviva may be better off allowing the bids to come in stated in pounds, euros, and so on, rather than insisting on dollar bids. The reason is that the bidders cannot easily hedge because they do not know if their bids will succeed (they can use options, but options contracts from options exchanges are contingent on future spot exchange rates rather than the success of bids for orders, and so are not ideally suited for the purpose). When all the foreign-currency-priced bids are in, Aviva can convert them into dollars at the going forward exchange rates, choose the cheapest bid, and then buy the appropriate foreign currency at the time it announces the successful bidder. This is a case of asymmetric information, where the buyer can hedge and the seller cannot, and where the seller may therefore add a risk premium to the bid. When the seller is inviting bids, as when equipment or a company is up for sale, the seller knows more than the buyer, and so bidding should be in the buyer’s currency. The seller can convert the foreign-currency bids into their own currency, choose the highest bid, and then sell the foreign currency forward at the same time as they inform the successful bidder.

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  eBook - PDF

  Managing Currency Risk

  Using Financial Derivatives

  • John J. Stephens(Author)
  • 2003(Publication Date)
  • Wiley

    (Publisher)

  Should one of the currencies be subject to exchange controls, the deviations can become much greater. As will appear more fully, this disequilibrium is a factor that use can be made of in managing costs and return cash flows. managing long-term operating fx exposure Long-term operating exposure comes from doing business continuously in a foreign country. The exposure can then not be linked to particular transactions, but rather to the exposure created by the continuing presence of the business. Examples of this type of exposure are Toyota and Volkswagen. A very substantial part of both these company’s revenues are in US dollars from sales in the US and Canada, while most of their costs is in yen and Deutsche mark respectively. MANAGING COST/RETURN CASH FLOWS ON LONG-TERM CURRENCY EXPOSURES 197 the measure of long-term exposure The first problem that is encountered when trying to manage the risk concomitant upon long-term operating exposure, is the measure of that risk. No risk can be managed or hedged if it is a quantitative unknown. Future sales, for example, are always uncertain quantitatively, although it is certain that there will be sales. Companies are thus forced to resort to forecasting future sales when planning and budgeting ahead. Similarly, future exposure to foreign exchange risk must also be forecast. Since capital expenditure is regularly motivated on the basis of sales forecasts, it would be inconsistent, if not downright dangerous, if these same forecasts were ignored for the purposes of hedging against future currency exposure. Thus, the basis of the measure of long-term operating currency exposure must be the same sales forecasts that are used for other elements of future planning and budgeting within a company.

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  Managing Global Financial and Foreign Exchange Rate Risk

  • Ghassem A. Homaifar(Author)
  • 2004(Publication Date)
  • Wiley

    (Publisher)

  OPERATING EXPOSURE The exposure to the multiperiod future cash flows arising due to an unexpected change in exchange rate is referred to as an economic or operating exposure. In this scenario the present value of the future cash flows is affected as a result of an unexpected change in the exchange rate. The transaction exposure is the effect of unexpected change in the nominal exchange rate on the cash flow asso- ciated with the monetary assets and liabilities and is usually short term and hedged with financial derivatives traded over the counter or on organized exchanges. The operating exposure, however, is related to the impact of the unexpected change in the exchange rate on future cash flows associated with the real assets and liabilities. Therefore, it is long term in nature. The party with exposure to foreign exchange rate risk may wish to manage its exposure using: Exchange-traded financial derivatives such as futures or options Forward contracts, money market hedges, caps, floors, collars, and swaps in the over-the-counter (OTC) market A multinational corporation (MNC) identifies its exposure to foreign ex- change risk on a particular transaction on a currency-by-currency basis and nets out its aggregate inflows and outflows from various subsidiaries for a particu- lar currency and time. Next the MNC determines how much of the exposure to manage — that is, whether to hedge or not to hedge. Finally, it identifies which hedging instrument is to be used based on cost/benefit analysis for managing and mitigating risk. HEDGING IN PRACTICE: NIKE AND DUPONT Nike markets its products in over 140 countries with foreign sales revenue account- ing for 46 percent of its total revenue in fiscal 2001. 4 Given its huge presence in the foreign market, Nike’s annual report states: It is the company’s policy to utilize derivative financial instruments to reduce foreign exchange risks where internal netting strategies cannot be effec- tively employed.

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