Exchange Rate Risk

Exchange rate risk

Transaction risk:

• Accrues when:
  - purchasing/selling goods at previously agreed prices
  - borrowing/lending funds in foreign currencies
• How much the income from individual transaction is affected by fluctuation of the rates

Economic risk:

• Firm’s future of international earning affected by changes in exchange rates
• Long term effect of changes in rates → different prices

Translation (Accounting) risk:

• Impact of exchange rate changes on financial statements of a company
• Concerned with present measurement of past events
• Gains/losses are unrealized = paper losses

Hedging:
Operating hedge:

• Cash management along a company through intracompany accounts

Possibilities:

• Reduce cash to a minimum by purchasing inventories or other assets
• Try to delay payments (extended trade credit)
• Avoid giving extended trade credit
• Borrow the local currency

Meaning in examples:

• Cash netting of obligations among units (same currency)
• The bigger the hedged amount the “cheaper” (per unit) it is to hedge

Financial hedge:

       Derivate securities:

• Traded on spot market, prices set by forces of demand and supply
• Can hedge risk, but can also give more risk

Forward contracts:

• Agreement to trade at a specified price a specified quantity on a specified place on a specified date in the future
• On maturity date the buyer takes delivery, the seller receive agreed payment
• Amount will be paid regardless of the actual spot exchange rate on the date of maturity

→ More flexible

Future contracts:

       Same as futures but:

• Traded on organized exchanges
• Highly standardized
• Highly traded volumes → good liquidity
• Can only be concluded for delivery in pre-specified months (usually 4years)
• Guaranteed by stock exchanges

→ lower risk, ease of trade

• Short future hedge: selling a future contract, when you make delivery of an asset at a future date → minimize risk of a drop in price
• Long future hedge: buying a future contract, used when buying an asset at a future date → minimize the risk of a increasing price

Swaps:

       Exchange one financial contract for another

• Interest-rate swaps: convert an asset held at a floating rate of interest to a fixe rate and backward → Change of interest flows, no change of principal
• Currency swaps: exchange debt obligations in different currencies, each agrees to pay the other’s interest obligation → Only cash-flow differences are paid, no exchange of principal