BBK3253 | Risk Management
Prepared by Dr Khairul Anuar
L6 – Currency Risk
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1. Currency Risk
• Currency Risk - is a form of financial risk that occurs
from the potential change in the exchange of one
currency in relation to another.
• Investors or businesses face an exchange rate risk
when they have assets or operations across national
borders or if they have loans or borrowings in a
foreign currency.
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2. Exchange Rate and Exchange Risk
• Exchange rate: the ratio that exchanges one currency
into another
 Example: exchange rate A$1.00 = US$0.80,
so 1 tonne of Australian coal @ A$160/metric
= US$128/metric
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3. Exchange Rate and Exchange Risk
• What is exchange risk?
– Exchange risk arises in an international transaction
when buyer and seller use different currencies, and
time elapses between sale and payment
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3. Exchange Rate and Exchange Risk
Example –
•
Assume Exchange rate today: A$1.00 = US$0.80.
In 30 days: A$1.00 = US$0.85
•
Australian coal sold today 10,000mt @ $160/metric = A$1,600,000
•
Exporter sells in US$, so selling price is A$1,600,000 x US$0.80 =
US$1,280,000
•
Payment terms are 30 days from date of shipment
•
Payment received in 30 days: US$1,280,000/US$0.85 =
A$1,506,000
•
Outcome: exporter LOSES A$1,506,000 – A$1,600,000 = -A$94,000
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4. International Business’ Dilemma
• International business’ dilemma: Do I sell in my own currency to
avoid risk (e.g. A$), or in buyer’s currency (e.g. US$, Yen, Euro)?
• If own currency, may lose sales due to lack of customer
orientation, foreign country regulations, lack of convertibility etc.
• May be contrary to industry norms (some world markets are
denominated in US$, e.g. oil)
• If foreign currency, may be benefits, e.g. lower interest rates in
foreign country, profits from astute currency management
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5. Sources of Risk from Exchange Rate
Fluctuations
1. Transaction risk: e.g. foreign transaction sales currency
depreciates reduced return to exporter.
2. Competitive risk: exporter’s own currency is appreciating,
disadvantaging exporter’s manufactures from home market,
(e.g. A$ = US$0.52 in 2001 to US$0.90 in 2008 = 73%
increase).
3. Market portfolio risk: MNE is limited to a narrow range of
markets, i.e. is not diversified, so cannot balance exchange
rate via multi-country operations.
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6. Types of foreign exchange risk
1. Transaction risk
2. Economic risk
3. Translation risk
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6. Types of foreign exchange risk
1. Transaction risk
• This us the risk of an exchange rate changing between the
transaction date and the subsequent settlement date, i.e. it is
the gain or loss arising on conversion.
• This type of risk is primarily associated with imports and
exports.
 If a company exports goods on credit then it has a figure for
debtors in its accounts. The amount it will finally receive
depends on the foreign exchange movement from the
transaction date to the settlement date.
• As transaction risk has a potential impact on the cash flows of a
company, most companies choose to hedge against such
exposure. Measuring and monitoring transaction risk is
normally an important component of treasury risk management.
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6. Types of foreign exchange risk
2. Economic risk
• Transaction exposure focuses on relatively short-term cash
flows effects; economic exposure encompasses these plus the
longer-term affects of changes in exchange rates on the market
value of a company. Basically this means a change in the
present value of the future after tax cash flows due to changes
in exchange rates.
• There are two ways in which a company is exposed to
economic risk: directly and indirectly.
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6. Types of foreign exchange risk
2. Economic risk
• Directly: If your firm's home currency strengthens then foreign
competitors are able to gain sales at your expense because
your products have become more expensive (or you have
reduced your margins) in the eyes of customers both abroad
and at home.
• If your firm's home currency strengthens then foreign
competitors are able to gain sales at your expense because
your products have become more expensive (or you have
reduced your margins) in the eyes of customers both abroad
and at
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6. Types of foreign exchange risk
2. Economic risk
• Indirectly: Even if your home currency does not move vis-a -vis
your customer's currency you may lose competitive position.
For example suppose a South African firm is selling into Hong
Kong and its main competitor is a New Zealand firm. If the New
Zealand dollar weakens against the Hong Kong dollar the
South African firm has lost some competitive position.
 Economic risk is difficult to quantify but a favoured strategy to
manage it is to diversify internationally, in terms of sales,
location of production facilities, raw materials and financing.
Such diversification is likely to significantly reduce the impact of
economic exposure relative to a purely domestic company, and
provide much greater flexibility to react to real exchange rate
changes.
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6. Types of foreign exchange risk
3. Translation risk
• The financial statements of overseas subsidiaries are usually
translated into the home currency in order that they can be
consolidated into the group's financial statements. Note that this
is purely a paper-based exercise - it is the translation not the
conversion of real money from one currency to another.
• The reported performance of an overseas subsidiary in homebased currency terms can be severely distorted if there has
been a significant foreign exchange movement.
•
If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then
the UK parent company will anticipate a balance sheet value of £500,000 for the subsidiary. A
depreciation of the US dollar to $/£2.00 would result in only £250,000 being translated.
•
Unless managers believe that the company's share price will fall as a result of showing a translation
exposure loss in the company's accounts, translation exposure will not normally be hedged. The
company's share price, in an efficient market, should only react to exposure that is likely to have an
impact on cash flows.
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7. Hedging transaction risk - internal techniques
1. Invoice in home currency
• One easy way is to insist that all foreign customers pay in your home
currency and that your company pays for all imports in your home
currency.
• However the exchange-rate risk has not gone away, it has just been
passed onto the customer. Your customer may not be too happy with
your strategy and simply look for an alternative supplier.
• Achievable if you are in a monopoly position, however in a competitive
environment this is an unrealistic approach.
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7. Hedging transaction risk - internal techniques
2. Leading and lagging
• If an importer (payment) expects that the currency it is due to pay will
depreciate, it may attempt to delay payment. This may be achieved by
agreement or by exceeding credit terms.
• If an exporter (receipt) expects that the currency it is due to receive
will depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for
immediate payment.
• The problem lies in guessing which way the exchange rate will move.
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7. Hedging transaction risk - internal techniques
3. Matching
• When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against each
other.
• It is then only necessary to deal on the forex markets for the
unmatched portion of the total transactions.
• An extension of the matching idea is setting up a foreign currency
bank account.
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7. Hedging transaction risk - internal techniques
4. Decide to do nothing?
• The company would "win some, lose some".
• Theory suggests that, in the long run, gains and losses net off to leave
a similar result to that if hedged.
• In the short run, however, losses may be significant.
• One additional advantage of this policy is the savings in transaction
costs.
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8. Hedging transaction risk – external techniques
1. Forward contracts
• The forward market is where you can buy and sell a currency, at a
fixed future date for a predetermined rate, i.e. the forward rate of
exchange. This effectively fixes the future rate.
2. Money market hedges
 The basic idea is to avoid future exchange rate uncertainty by making
the exchange at today's spot rate instead. This is achieved by
depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur. This effectively fixes the future rate.
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8. Hedging transaction risk – external techniques
3. Futures contracts
• Futures contracts are standard sized, traded hedging instruments.
• The aim of a currency futures contract is to fix an exchange rate at
some future date, subject to basis risk.
4. Options
 A currency option is a right, but not an obligation, to buy or sell a
currency at an exercise price on a future date. If there is a favourable
movement in rates the company will allow the option to lapse, to take
advantage of the favourable movement. The right will only be
exercised to protect against an adverse movement, i.e. the worst-case
scenario.
 A call option gives the holder the right to buy the underlying currency.
 A put option gives the holder the right to sell the underlying currency.
 Options are more expensive than the forward contracts and futures but result in an
asymmetric risk exposure.
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8. Hedging transaction risk – external techniques
5. Forex swaps
• In a forex swap, the parties agree to swap equivalent amounts of
currency for a period and then re-swap them at the end of the period
at an agreed swap rate. The swap rate and amount of currency is
agreed between the parties in advance. Thus it is called a fixed
rate/fixed rate swap.
• The main objectives of a forex swap are:

To hedge against forex risk, possibly for a longer period than is
possible on the forward market.

Access to capital markets, in which it may be impossible to
borrow directly.

Forex swaps are especially useful when dealing with countries
that have exchange controls and/or volatile exchange rates.
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9. What determines exchange rate levels
1. Main traded currencies are ‘floating’, i.e. free from
Government intervention (e.g. US$, A$ since 1983, GBP).
Some others are ‘fixed’, i.e. the Gov’t decides the
exchange rate.
2. Fixed currencies are subject to occasional devaluations (or,
rarely, revaluations) sudden big drop in currency value.
Speculators often make a killing (e.g. George Soros in
1992, £1bn profit). Nontrade currencies priced on ‘cross
rates’.
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9. What determines exchange rate levels
3. Floating currencies’ exchange rates are determined by
forces of supply & demand as in ratio of exports to imports,
interest rates, inflation, Gov’t economic policy, even forex
market sentiment (e.g. A$ value is seen in part as linked to
commodity prices).
4. In the long term, exchange rates reflect the economic
success of a country.
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10. How do international marketers manage exchange risk
• Risk shifting (short term) e.g. hedging:
• Immediate currency conversion is a ‘spot’ transaction
• Conversion in the future uses a ‘forward exchange
contract’:
>>a bank agrees to fix an exchange rate at a set date in
the future (expressed as a premium or discount on the
spot rate, equal to the interest rate differential between
the two countries), thus giving the exporter certainty in
their exchange rate.
• Generally, exporters want to sell goods, not speculate
on currencies.
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10. How do international marketers manage
exchange risk
2. Risk modifying (long term, strategic):
•
Involves marketer manipulating prices or other
elements of their marketing strategy.
•
Export prices may be adjusted or not depending
on market conditions (‘passthrough’ vs.
‘absorption’).
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11. Strategic Risk Modifying Behavior
Scenario:
• Holden is selling its new Monaro to the US (rebadged the
Pontiac GTO). A$ rises against US$ from US$0.60 to US$0.90
(= 50% increase in cost of your product to GM USA). What do
you do?
1. ‘Pass-through’: you keep your price unchanged forcing the
buyer to pay more
loss of competitiveness
loss of
market share? Depends on buyer’s level of preference for
product (demand).
2. ‘Absorption’: you reduce your export price correspondingly as
the A$ appreciates
your sales revenue correspondingly
reduces, even to a loss. Goal of long-term market share
maintenance?
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11. Strategic Risk Modifying Behavior
• In the 1990s the US Dollar appreciated hugely
making imports cheaper to US consumers. Foreign
car companies found they had windfall gains.
• Keep gains as extra profit, or pass to consumer as
cheaper prices?
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12. Strategic marketing considerations to
exchange rate movements
1. Short-term:
• Pricing-to-market: varying your trading terms for each
market depending on conditions there.
– Considerations: is market price-sensitive?, local
competitors’ reactions, value placed on price stability
(e.g. Harley Davidson), alternatives to discounts.
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12. Strategic marketing considerations to
exchange rate movements
2. Long-term:
– Market refocus
– Streamline operations/seek efficiencies
– Shift production e.g. offshore via FDI
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