FOREIGN EXCHANGE RISK Also known as exchange rate risk or currency risk. 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.
TRANSACTION EXPOSURE Involves the possible exchange on loss or gain on existing foreign currency-denominated transactions. To realize the domestic value of its foreign- denominated cash flows, the firm must exchange foreign currency for domestic currency. Exchange rates may move by up to 10% within any single year, which can significantly affect a firms cash flows, meaning a 10% decline in the value of a receivable or a 10% rise in the value of a payable. Such outcomes could be troublesome as export profits could be negated entirely or import costs could rise substantially.
ECONOMIC EXPOSURE Also known as operating exposure. The degree that the market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firms position with regards to its competitors, the firms future cash flows, and ultimately the firms value. A firm’s economic exposure depends on the structures of the input and the output markets.
TRANSLATION EXPOSURE A firms translation exposure is the extent to which its financial reporting is affected by exchange rate movements. The exchange gain or loss occurring from the difference in the exchange rates at the beginning and the end of the accounting period. A firm is exposed to translation loss, if it uses current exchange rate to translate its assets and liabilities.
METHODS USED IN TRANSLATING ASSETS AND LIABILITIES Current Monetary or Temporal Current rate or non- non- method method current monetary
HEDGING FOREIGN EXCHANGE RISK 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 . This is done using either the cash flow or the fair value method.
ALTERNATIVES Three alternatives available to companies to hedge against the foreign exchange exposure: Forward contract Foreign currency option Money market operations