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Foreign Exchange Risk

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Foreign Exchange Risk

Uploaded by

jkdigitalcreator73
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Foreign Exchange Risk

Foreign exchange risk, also known as currency risk, arises from the possibility that fluctuations in
exchange rates can impact the value of financial transactions involving foreign currencies. This
risk affects nations, businesses, banks, and individuals engaged in international trade,
investments, or asset management.

Causes of Foreign Exchange Risk

Exchange rates do not remain static; they fluctuate in response to various economic forces. The
primary reasons for this volatility include:

1. Demand and Supply Shifts in Foreign Exchange Markets: Nations’ demand for
foreign exchange changes based on shifts in domestic and international tastes,
trade balances, and import-export activity. For instance, if the U.S. public’s demand
for European Union (EU) goods increases, the demand for euros rises, depreciating
the dollar.
2. Differential Inflation Rates: Countries with lower inflation rates tend to see their
currency appreciate. Lower inflation means domestic goods are cheaper on the
international market, boosting exports and demand for the currency. Conversely,
higher inflation rates can lead to currency depreciation due to reduced demand for
overpriced goods.
3. Interest Rate Differentials: Higher interest rates in a country attract foreign
capital due to higher returns, thus increasing demand for its currency and leading to
appreciation. A fall in interest rates can lead to depreciation as foreign investments
exit the market.
4. Speculative and Expectational Factors: Market expectations about future
currency performance significantly influence demand and supply. For example,
speculation of a stronger dollar may drive demand for dollars, raising its value.
Conversely, if market participants expect the dollar to weaken, they may shift assets
to other currencies, triggering depreciation.
5. Political and Economic Stability: Stable countries with sound economic policies
are more attractive to investors, leading to currency appreciation. Uncertainty or
economic instability, however, may lead to currency outflows and depreciation.

Types of Foreign Exchange Risk

1. Transaction Exposure: This risk arises when firms need to settle transactions in
foreign currencies. As exchange rates fluctuate, the amount a firm owes or receives
can vary significantly, affecting its cash flow and profitability.
• Example: A U.S. importer purchasing €100,000 worth of goods faces the risk that
the euro might strengthen against the dollar by the payment date, increasing the
dollar cost. If the exchange rate moves from $1/€ to $1.10/€, the importer would
need to pay $110,000 instead of the initially anticipated $100,000. As a result, the
importer will usually want to insure against an increase in the dollar price of the euro
(i.e., an increase in the spot rate) in three months.
2. Translation Exposure (Accounting Exposure): Multinational corporations with
assets or liabilities in foreign currencies need to consolidate their financial
statements in the home currency. Translation exposure can impact the valuation of
foreign subsidiaries’ assets and liabilities, affecting the parent company’s reported
earnings.
• Example: Suppose a Japanese subsidiary of a U.S. firm holds assets worth ¥10
million. A depreciation of the yen would reduce the dollar value of these assets
when consolidated, impacting the firm’s balance sheet.
3. Economic Exposure: This refers to the longer-term impact of exchange rate
changes on a firm’s future cash flows, profitability, and market position in foreign
markets.
• Example: A U.S.-based exporter of agricultural machinery may experience reduced
demand abroad if the dollar appreciates, making its products more expensive for
foreign buyers.
4. Contingent Exposure: This type of risk arises from uncertain, future
commitments. For instance, if a U.S. firm has submitted a bid on a project in Japan,
any change in the yen-dollar exchange rate before the bid is finalized may impact
the project’s profitability.

Historical Examples of Exchange Rate Fluctuations

Exchange rates are highly volatile, influenced by global economic conditions, crises, and
monetary policies. Historical trends illustrate this:

• Japanese Yen: In the 1970s, the yen was relatively weak, trading at 360 yen per
dollar. However, by the mid-1990s, it had strengthened to approximately 80 yen per
dollar, primarily due to Japan’s economic growth and trade surplus with the U.S.
• Euro: The euro’s exchange rate against the dollar has seen notable fluctuations
since its introduction in 1999. Initially pegged at $1.17/€, it dropped to $0.85/€ in
2000, but then surged to $1.58/€ in 2008. This volatility reflects differing economic
conditions, including the eurozone crisis and varying interest rate policies between
the EU and the U.S.
• Effective Dollar Exchange Rate: The U.S. dollar has seen significant swings due to
changes in trade policies, interest rates, and economic crises. From the early 1980s
to 1985, the dollar appreciated sharply, driven by high U.S. interest rates, but
depreciated just as quickly from 1985-1987 as the U.S. sought to correct trade
imbalances.

These fluctuations illustrate the dynamic nature of exchange rates and the risks
they pose to international financial transactions.

Impact on Businesses and Risk Management

Foreign exchange risks create uncertainties that can lead to unexpected financial losses.
Businesses engaged in international trade face increased costs if their currency depreciates
before they make payments in foreign currency. Similarly, exporters risk receiving lower revenues
if their home currency appreciates, reducing the foreign currency’s value.

Businesses use various risk management techniques to hedge against currency fluctuations:

1. Forward Contracts: Agreements to buy or sell a currency at a predetermined rate


on a future date. Forward contracts help lock in exchange rates, protecting
businesses from adverse movements.
2. Options Contracts: Currency options give businesses the right, but not the
obligation, to buy or sell a currency at a specific rate, providing flexibility in risk
management.
3. Currency Swaps: Firms exchange debt or interest payments in different
currencies, allowing them to manage long-term currency exposures.

Conclusion
In sum, foreign exchange risk is inherent to global trade and investment. Effective
risk management is essential for firms to stabilize cash flows and protect
profitability amidst the volatility of exchange rates.

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