Foreign Exchange Risk Management http://trade.gov/media/publications/pdf/tfg2008ch12.

pdf F oreign exchange (FX) is a risk factor that is often overlooked by small and mediumsized enterprises (SMEs) that wish to enter, grow, and succeed in the global marketplace. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy foreign buyers today are increasingly demanding to pay in their local currencies. From the viewpoint of a U.S. exporter who chooses to sell in foreign currencies, FX risk is the exposure to potential financial losses due to devaluation of the foreign currency against the U.S. dollar. Obviously, this exposure can be avoided by insisting on selling only in U.S. dollars. However, such an approach may result in losing export opportunities to competitors who are willing to accommodate their foreign buyers by selling in their local currencies. This approach could also result in the non-payment by a foreign buyer who may find it impossible to meet U.S. dollar-denominated payment obligations due to the devaluation of the local currency against the U.S. dollar. While coverage for non-payment could be covered by export credit insurance, such what-if protection is meaningless if export oppor tunities are lost in the first place because of the payment in U.S. dollars only policy. Selling in foreign currencies, if FX risk is successfully managed or hedged, can be a viable option for U.S. exporters who wish to enter and remain competitive in the global marketplace. Key Points

Most foreign buyers generally

prefer to

trade in

their

local currencies to avoid FX risk exposure. U.S. SME exporters who choose to trade in foreign

currencies can minimize FX exposure by using one of the widely-used FX risk management techniques available in the United States. The volatilenature of the FX market poses a great risk

of sudden and drastic FX rate movements, which may cause significantly damaging financial losses from otherwise profitable export sales. The primary objective of minimize potential currency FX risk management is to

losses, not to make a profit from FX rate movements, which are unpredictable and frequent.

A variety of options are available for reducing short-term FX exposure. The following sections list FX risk management techniques considered suitable for new-to-export U.S. SME companies. The FX instruments mentioned below are available in all major currencies and are offered by numerous commercial lenders. However, not all of these techniques may be available in the buyers country or they may be too expensive to be useful. Non-Hedging FX Risk Management Techniques The exporter can avoid FX exposure by using the simplest non-hedging technique: price the sale in a foreign currency. The exporter can then demand cash in advance, and the current spot market rate will determine the U.S. dollar value of the foreign proceeds. A spot transaction is when the exporter and the importer agree to pay using todays exchange rate and settle within two business days. Another non-hedging technique is to net out foreign currency receipts with foreign currency expenditures. For example, the U.S. exporter who exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a differ-

ent Mexican trading partner. If the companys export and import transactions with Mexico are comparable in value, pesos are rarely converted into dollars, and FX risk is minimized. The risk is further reduced if those peso-denominated export and import transactions are conducted on a regular basis. FX Forward Hedges The most direct method of hedging FX risk is a forward contract, which enables the exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a delivery date from three days to one year into the future. For example, suppose U.S. goods are sold to a Japanese company for 125 million yen on 30-day terms and that the forward rate for 30-day yen is 125 yen to the dollar. The U.S. exporter can eliminate FX exposure by contracting to deliver 125 million yen to his bank in 30 days in exchange for payment of $1 million dollars. Such a forward contract will ensure that the U.S. exporter can convert the 125 million yen into $1 million, regardless of what may happen to the dollar-yen exchange rate over the next 30 days. However, if the Japanese buyer fails to pay on time, the U.S. exporter will be obligated to deliver 125 million yen in 30 days. Accordingly, when using forward contracts to hedge FX risk, U.S. exporters are advised to pick forward delivery dates conservatively. If the foreign currency is collected sooner, the exporter can hold on to it until the delivery date or can swap the old FX contract for a new one with a new delivery date at a minimal cost. Note that there are no fees or charges for forward contracts since the lender hopes to make a spread by buying at one price and selling to someone else at a higher price. FX Options Hedges If there is serious doubt about whether a foreign currency sale will actually be completed and collected by any particular date, an FX option may be worth considering. Under an FX option, the exporter or the option holder acquires the right, but not the obligation, to deliver an agreed amount of foreign currency to the lender in exchange for dollars at a specified rate on or before the expiration date of the option. As opposed to a forward con-

tract, an FX option has an explicit fee, which is similar to a premium paid for an insurance policy. If the value of the foreign currency goes down, the exporter is protected from loss. On the other hand, if the value of the foreign currency goes up significantly, the exporter can sell the option back to the lender or simply let it expire by selling the foreign currency on the spot market for more dollars than originally expected, but the fee would be forfeited. While FX options hedges provide a high degree of flexibility, they can be significantly more costly than FX forward hedges.

Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an [1][2] 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 [3][4] are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately.
Contents
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1 Types of exposure

o o o o

1.1 Transaction exposure 1.2 Economic exposure 1.3 Translation exposure 1.4 Contingent exposure

2 Measurement

2.1 Value at Risk

3 Management 4 History 5 Project finance 6 References

[edit]Types

of exposure

Foreign currency exposures are generally categorized into the following three distinct types: transaction exposure, economic exposure, and translation exposure. These exposures pose risks to firms' cash flows, competitiveness, [5][2][6] market value, and financial reporting. [edit]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 [5][2] between the foreign and domestic currency. Firms generally become exposed as a direct result of activities such [7] as importing and exporting or borrowing and investing. Exchange rates may move by up to 10% within any single year, which can significantly affect a firm's 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 [6] import costs could rise substantially. [edit]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 position with regards to its competitors, the firm's future cash flows, and ultimately the firm's [5][2] 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 [6] economic exposure for a firm that sells that good. [edit]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 assets and liabilities or the financial statements of [5][2] foreign subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm's cash [6] 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. Translation gives special consideration to assets and liabilities with regards to foreign exchange risk, whereas exposures to revenues and expenses can often be managed ex ante by managing [8] transactional exposures when cash flows take place. [edit]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, [5][8] so a firm may prefer to manage contingent exposures. [edit]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 [9] 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 [4] absolute deviation and semivariance have been advanced for measuring financial risk. [edit]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 [4] period of time with a given probability of changes in exchange rates. [edit]Management See also: Foreign exchange hedge

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 [5] 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 [5] 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. [5] Foreign exchange derivatives may also be used to hedge against translation exposure. [edit]History Many businesses were unconcerned with and did not manage foreign exchange risk under the Bretton Woods system of international monetary order. It wasn't until the onset of floating exchange rates following the collapse of the Bretton Woods system that firms perceived an increasing risk from exchange rate fluctuations and began trading [10][11] an increasing volume of financial derivatives in an effort to hedge their exposure. The outbreak of currency crises in the 1990s and early 2000s, such as the Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis, substantial losses from foreign exchange have led firms to pay closer attention [12] to foreign exchange risk. [edit]Project

finance

Foreign exchange risk has been shown to be particularly significant and particularly damaging for very large, one-off investment megaprojects. Such projects are typically financed by very large debts denominated in foreign currencies. Megaprojects have been shown to be prone to ending up in debt traps where, due to cost overruns, schedule delays, unforeseen foreign currency and interest rate increases, the costs of servicing debt become larger than the revenues [13] available to do so. Financial restructuring is typically the consequence and is common for megaprojects.