EXCHANGE RATE RISK

Risk Management in Foreign Exchange

 LEARNING OBJECTIVES

• What is Exchange Rate Risk?

• Why is it important to understand Exchange Rate Risk?
• What are the types of Exchange Rate Risk?
 WHAT IS EXCHANGE RATE RISK

• Foreign exchange risk arises from fluctuations in the exchange rates between different
currencies.
• It is also known as FX risk or currency risk
• When a company or individual engages in international transactions involving multiple
currencies, they expose themselves to potential financial losses if the exchange rate moves
against them.
 IMPORTANCE OF EXCHANGE RATE RISK

Protect Financial Stability

• Exchange rate fluctuations can significantly impact the profitability of businesses operating in the global market. By understanding and managing exchange rate risk,
companies can safeguard their financial stability and avoid unexpected losses that could jeopardize their operations.

Enhanced Profitability
• Effective exchange rate risk management strategies can help businesses maintain a predictable cost structure and protect their profit margins from the volatility of exchange
rates. This predictability allows businesses to make informed decisions and pursue growth opportunities with greater confidence.

Improved Competitiveness
• Managing exchange rate risk can enhance a company's competitiveness in international markets. By mitigating the impact of exchange rate fluctuations, companies can
maintain competitive pricing and ensure that their products and services remain attractive to global customers.

Reduced Uncertainty
• Understanding exchange rate risk helps businesses make informed decisions about investments, financing, and international expansion. By anticipating potential risks,
companies can reduce uncertainty and make strategic decisions that align with their long-term financial goals.

Sound Financial Planning

• Exchange rate risk management is an integral part of sound financial planning for businesses engaged in international trade or investments. By incorporating exchange rate
risk assessment into their financial models, businesses can make informed decisions about resource allocation, risk diversification, and hedging strategies.

Informed Decision-Making for Individuals

• Individuals involved in international transactions, such as travel, remittances, or overseas investments, can also benefit from understanding exchange rate risk. By making
informed decisions about currency conversion and hedging options, individuals can protect their financial interests and manage their personal finances effectively.
TYPES OF EXCHANGE RATE RISKS

Transaction Risk Translation Risk Economic Risk

 TRANSACTION RISK

• This risk arises whenever a firm or

individual enters a Transaction which
involve Foreign Exchange.
• A firm has transaction risk whenever it has
contractual cash flows (receivables or
payables) whose values are subject to
unanticipated changes in exchange rates due
to a contract being denominated in a foreign
currency.
 TRANSACTION RISK – EXAMPLE

• A Pakistani exporter agrees to sell goods to a US customer for $10,000. The exporter expects to
receive the payment in three months. If the Pakistani rupee strengthen against the US dollar
during this period, the exporter will receive fewer rupees upon conversion, resulting in a
financial loss.
• Suppose Rate at the time of contract USD/PKR = 280; and rate at the time of payment USD/PKR
= 250
• So, in essence in this example and underlying assumption the exporter will receive 2.5 million
PKR instead of 2.8 million PKR due to rate movement
 TRANSLATION RISK

This risk arises when a subsidiary

This risk is associated with converts (translates) its financial
multinational firms only statements to foreign currency of its
parent company

Translation risk does not impose any

loss of cashflows as in case of other
types of risks, but it greatly impact It may impact the Goodwill and stock
the overall position of consolidated prices of the parent company
financial statements of parent
company
Suppose Unilever Pakistan registers Rs.
1,828 million Profit for FY-2022. Let’s
suppose at the time of announcement of this
figure the USD Rate was USD/PKR = 240
but after 2 months the USD rate is USD/PKR
= 280

So due to change in Forex Rate Unilever

TRANSLATION
Pakistan will register ~$6.52 million instead
of ~$7.62 million in consolidated Financial RISK –
Statement.
EXAMPLE
Thus, Unilever’s overall position will show a
decrease of about $1 million, and it will
impact its share price in NYSE and other
major exchanges
This risk stems from changes in macro-
economic conditions that can affect a
company's competitiveness and
profitability in foreign markets.
ECONOMIC
RISK
Macroeconomic conditions include
exchange rates, government regulations,
and political stability as well.
 ECONOMIC RISK – EXAMPLE

• Suppose due to the high inflation rates in Pakistan the prices of raw milk has increased
substantially. Therefore, it has become increasingly difficult for Nestle Pakistan to keep its
profitability and competitiveness intact with respect to its sister concerns or the competitors.
 CONCLUSION

• It is paramount for any business organization involved in

International Business to understand Forex Risks and
have a well-placed policy to safeguard against these risks.
• A good Forex Risk Policy can be a difference between a
thriving business in International market or a huge
failure.
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Thanks for your attention!