Foreign Exchange Risk

Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately.

Translation Exposure

A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign asset]s and liabilities or the financial statements of foreign subsidiary / subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments. Contingent exposure A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.

Transaction Exposure

A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency.

Economic Exposure

A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's market share and position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good.

 

Measurement

If foreign exchange markets are efficient such that purchasing power parity, interest rate parity, and the international Fisher effect hold true, a firm or investor needn't protect against foreign exchange risk due to an indifference toward international investment decisions. A deviation from one or more of the three international parity conditions generally needs to occur for an exposure to foreign exchange risk.

Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. Variance represents exchange rate risk by the spread of exchange rates, whereas standard deviation represents exchange rate risk by the amount exchange rates deviate, on average, from the mean exchange rate in a probability distribution. A higher standard deviation would signal a greater currency risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations, be they positive or negative, and for automatically squaring deviation values. Alternatives such as average absolute deviation and semivariance have been advanced for measuring financial risk.

Value at Risk

Practitioners have advanced and regulators have accepted a financial risk management technique called value at risk (VAR), which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Banks in Europe have been authorized by the Bank for International Settlements to employ VAR models of their own design in establishing capital requirements for given levels of market risk. Using the VAR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates.

Management

Managers of multinational firms employ a number of foreign exchange hedging strategies in order to protect against exchange rate risk. Transaction exposure is often managed either with the use of the money markets, foreign exchange derivatives such as forward contracts, futures contracts, options, and swaps, or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting.

Firms may exercise alternative strategies to financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange risk exposure.

Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards. For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods such as the temporal method and current rate method. Firms can manage translation exposure by performing a balance sheet hedge. Since translation exposure arises from discrepancies between net assets and net liabilities on a balance sheet solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure.

Foreign exchange hedge

A foreign exchange hedge (FOREX hedge) is a method used by companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies (see Foreign exchange derivative). This is done using either the cash flow or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP).

Currency risk

When companies conduct business across borders, they must deal in foreign currencies. Firms must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.

Hedge

A hedge is a type of derivative, or a financial instrument, that derives its value from an underlying asset. This concept is important and will be discussed later. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forwards and options. A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.

Accounting for Derivatives

Under IFRS

Guidelines for accounting for financial derivatives are given under IFRS 7. Under this standard, “an entity shall group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. An entity shall provide sufficient information to permit reconciliation to the line items presented in the balance sheet”. Derivatives should be grouped together on the balance sheet and valuation information should be disclosed in the footnotes. This seems fairly straight forward, but IASB has issued two standards to help further explain this procedure. The International Accounting Standards IAS 32 and 39 help to give further direction for the proper accounting of derivative financial instruments. IAS 32 defines a “financial instrument” as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”.

Therefore, a forward contract or option would create a financial asset for one entity and a financial liability for another. The entity required to pay the contract holds a liability, while the entity receiving the contract payment holds an asset. These would be recorded under the appropriate headings on the balance sheet of the respective companies. IAS 39 gives further instruction, stating that the financial derivatives be recorded at fair value on the balance sheet. IAS 39 defines two major types of hedges. The first is a cash flow hedge, defined as: “a hedge of the exposure to variability in cash flows that:

(i)              is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction, and

(ii)            could affect profit or loss”.

In other words, a cash flow hedge is designed to eliminate the risk associated with cash transactions that can affect the amounts recorded in net income.

The second is a fair value hedge.

Again, according to IAS 39 this is “a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss”.[3] More simply, this type of hedge would eliminate the fair value risk of assets and liabilities reported on the Balance sheet. Since Accounts receivable and payable are recorded here, a fair value hedge may be used for these items.

Under US GAAP

The US Generally Accepted Accounting Principles also include instruction on accounting for derivatives. For the most part, the rules are similar to those given under IFRS. The standards that include these guidelines are SFAS 133 and 138. SFAS 133, written in 1998, stated that a “recognized asset or liability that may give rise to a foreign currency transaction gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or payable) not be the hedged item in a foreign currency fair value or cash flow hedge”.[4] Based on the language used in the statement, this was done because the FASB felt that the assets and liabilities listed on a company’s books should reflect their historic cost value, rather than being adjusted for fair value. The use of a hedge would cause them to be revalued as such. Remember that the value of the hedge is derived from the value of the underlying asset. The amount recorded at payment or reception would differ from the value of the derivative recorded under SFAS 133. As illustrated above in the example, this difference between the hedge value and the asset or liability value can be effectively accounted for by using either a cash flow or a fair value hedge. Thus, two years later FASB issued SFAS 138 which amended SFAS 133 and allowed both cash flow and fair value hedges for foreign exchanges. Citing the reasons given previously, SFAS 138 required the recording of derivative assets at fair value based on the prevailing spot rate.

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