A company’s currency risk is a critical component of its overall business risk and can have a material impact on the bottom line.
Companies can mitigate foreign exchange risk through a variety of tools. They can include simple hedging techniques, market-based options and derivatives.
Transaction Risk
International trade is a key part of growth and scale for many companies. But it also brings new risks that must be addressed in order to ensure business success.
Transaction risk is one of the major sources of FX risk management that businesses face when conducting business outside their domestic markets. This is due to the fact that currency exchange rates can change significantly over a period of time.
In order to minimize the effects of this risk, companies can use hedging strategies that take into account their specific business needs. These can include the use of money market instruments, forward contracts, options and futures.
Exchange Rate Risk
Exchange rate risk involves the possibility of a change in the exchange rate between two currencies before a transaction is settled. This risk can be mitigated by using forward contracts and options to lock in a predetermined exchange rate.
Companies that deal with suppliers and customers in foreign currencies face a variety of FX risks. These include transactions that take place in different currencies, currency depreciation and changes in the value of a company’s assets or liabilities.
A company may also have exposure to a number of other FX risks, including translation risk or structural risk, which occur when a company’s cash inflows and outflows react differently to currency changes. For example, a company that generates sales in dollars but incurs costs in euros might experience a large impact on its net cash flow from US operations if the dollar depreciates by 5 percent.
Market Risk
Market risk includes interest rate, equity, commodity and currency risks. It is primarily associated with fixed-income securities but can also affect stock investments.
Managing this kind of risk relies heavily on financial models, which provide critical information about the potential impact on prices and sensitivities. They also help portfolio managers assess how much the value of their portfolio would change if a particular market risk factor changed.
A number of strategies can be used to mitigate this type of risk, including diversification and hedging. One common approach is to use a forward contract, which “locks in” the exchange rate of future payments.
Economic Risk
When companies buy or sell goods and services abroad, they expose themselves to economic risk. It can arise from changes in interest rates, exchange rates or even the timing of a contract.
Economic risk also includes a company’s future cash flows, foreign investments and earnings. This is especially true for multinational companies with many subsidiaries in different countries.
The best way to mitigate economic risk is through hedging. This involves a simple strategy of matching currency flows.
It’s also essential to understand how the accounting impact of a change in currency values affects a company. For instance, if the value of an asset rises or falls due to exchange rate fluctuations, it can result in negative impacts to the net assets of the asset, its book values and even earnings per share.
Nontransparent External Risk
Nontransparent external risk is a broad category of risks that cannot be forecasted with reliability and, therefore, are difficult to manage. They often arise from natural events or changes in government legislation and are unpredictable and can occur without warning.
This type of risk is often associated with large infrastructure projects or long-term contracts that involve a significant foreign exchange element. These contracts may last a number of years and any changes in exchange rates could jeopardize the company’s profitability.
This risk can be mitigated by building clauses into sales and supply agreements that allow for revenue to be recouped in the event of exchange rate deviance. However, the clauses must be negotiated thoroughly and regularly reviewed to ensure they are effective. They must also include clear indices against which the exchange rates are measured.
