Risk Management: Currency (Transaction Risk (Risk that the home currency…
Risk Management: Currency
Currency or exchange rate risk arises due to potential losses from adverse exchange rate movements
Level of exposure depends on exchange rate volatility and the volume of foreign trade
UK multinational firms may be highly exposed to currency risk due to location of subsidiaries and foreign transactions
First stage in exchange rate risk management is to identify and measure exchange rate exposures.
First stage in exchange rate risk management is to identify and measure exchange rate exposures
Real risk only when real cash is converted.
Risk that the home currency value of foreign currency transactions may change due to exchange rate.
Caused by exchange rate changes between transaction date and settlement date
Transaction risk is a real cash flow exposure
Transaction exposure is most typically created when purchases and sales are made on credit and stated in foreign currency
Transaction exposure is also created from borrowing and lending when payments and receipts (and debt) are stated in foreign currency
Balance sheet values of foreign currency-denominated assets and liabilities are converted to home parent or group value
Arises on consolidation of accounts and hence also called "accounting exposure"
No real cash flow exposure but can affect market sentiment and accounting ratios
Share price also affected
Risk of change is business value or in international competitiveness due to long-term changes in exchange rates
Economic risk cannot be avoided, it is general in its nature, unpredictable, and is difficult to hedge against
Exchange rate fluctuations can impact companies even though they have no foreign transactions.
Managing Currency Risk
Leading and lagging
Money market hedging
Forward Exchange Contracts
Reduces bankruptcy risk
Reduces volatility of corporate cash flow
Reduces overall risk profile of the firm
Hedging instruments can be complicated
Costs associated with derivatives
Complexity of using and accounting for derivatives and their tax treatment
Shareholders already manage risks through holding an internationally diversified portfolio (extent then of risk reduction?)