Definition of Foreign Exchange Risk
Foreign exchange risk is the risk associated with the risk of unfavorable fluctuation in the exchange rate. Financial institutions have to incur losses in their foreign currency transactions. This risk is also called exchange rate risk, FX risk, or currency risk. Foreign exchange risk impacts the people or businesses dealing with foreign currency transactions.
As explained in the definition, the foreign exchange risk arises when a company or an institution deals with financial transactions that are not in base currency, i.e., they are in foreign currency. And suppose there are any unfavorable changes in the exchange risk due to which the final settlement value in base currency goes down. In that case, it will directly impact the company or financial institution as it will have to bear the losses.
The payment in a foreign currency will be the same. Still, due to the fluctuation in the conversion rate, the amount when settled and converted into base currency is less than what was expected, which leads to foreign exchange risk losses. The transaction value can result in profit and losses depending upon the favorable/unfavorable fluctuation in conversion rate.
How to Manage Foreign Exchange Risk?
A company can adequately manage its foreign exchange risk by proper planning, implementing, and employing different hedging techniques. This would require the below usual steps:
- The company must thoroughly analyze the operating cycle to identify where FX risk exists.
- Then it needs to do a proper calculation to analyze the exposure to the foreign exchange risk.
- Different techniques for hedging the FX risk need to be applied.
- It is better to create a policy for managing the FX risk and follow it.
- Periodic review and monitoring of the complete process.
Example of Foreign Exchange Risks
An import/export dealer went into a contract to buy 100 units of a commodity for €20 per unit. The base currency was US dollars. At the time of the agreement, the exchange rate between both currencies was €1 = $1. The dealer was expecting to pay $2000 at the delivery time.
But due to some fluctuation, the exchange rate became €1 =$1.5; now, due to this adverse movement, the dealer will have to pay $3000 and bear the loss of $1000 due to foreign exchange conversion.
Types of Foreign Exchange Risks
The different types of Foreign exchange risk are as follows:
- Transaction Risk: The risk arising from dealing in transactions other than the base currency, i.e., foreign currency transactions. The risk of potential losses due to the downward movement of the exchange rate. This risk is also known as transaction risk.
- Translation Risk: Translation risk occurs when the business has a subsidiary with a reporting currency other than the home currency. The risk will happen when the company reports the consolidated financial statements.
- Economic Risk: This type of risk happens when the market forecast of the company business and future cash flow is impacted due to exchange rate fluctuations. The risk is also known as forecast risk.
How Could Foreign Exchange Risk be Prevented?
It cannot be prevented entirely, but it can instead be minimized. The following strategies can be applied to reduce the risk:
- Different hedging techniques can be applied to protect the business from foreign currency risk.
- Currency ETS, i.e., exchange-traded funds, can be used to mitigate the potential risk.
- Diversification of the foreign securities globally, i.e., everything should not be invested in one region, do not put all the eggs in one basket.
- Forward and options contracts can help in protecting from foreign risk.
Measuring Foreign Exchange Risks
In the current scenario, It is measured with the help of VaR methodology, i.e., the value at risk calculation. The value at risk model is the total value of loss or maximum losses for a given exposure over a given period with z% confidence. It is calculated based upon the below parameters:
- The period for which the business will hold the foreign currency or exchange position.
- The estimation’s confidence level is usually 95 or 99 percent.
- Unit of currency in the denomination of value at risk calculation.
Foreign Exchange Risk Exposure
Foreign exchange risk exposure is the company’s total exposure or financial institution due to the potential losses because of change in the exchange rates, i.e., the degree to which the fluctuation would impact the company in the foreign exchange rate.
The primary difference between foreign exchange risk and exposure is that exchange risk refers to the movement in settlement value of a transaction in foreign currency. In contrast, foreign risk exposure refers to the degree to which these changes impact the organization.
- It gives the opportunity of gaining from the favorable exchange rate movement.
- Managing foreign exchange risk will better understand the new and innovative products for hedging the risk.
- Managing exchange risk helps protect the cash flow and profit margin.
- It serves for improvement in financial forecasting and budgeting.
Different limitations are mentioned below:
- Even the tiny foreign exchange movement would result in huge losses if not managed properly.
- Hedging of risk leads to an increase in the cost and a margin requirement when a change occurs in the exchange rate.
- It is a complex process and not always understandable by the layman.
It is an important phenomenon. In layman’s terms, it is a risk and thus a negative. But as a whole, it allows the companies to hedge this risk and protect their business from potential losses. If managed successfully, companies can also reap benefits from the exchange rates’ positive movement.
This is a guide to Foreign Exchange Risk. Here we also discuss the definition and how to manage foreign exchange risk with advantages and limitations. You may also have a look at the following articles to learn more –