The Risks Underlying Foreign Exchange Transactions - Example

Evaluate the risks underlying foreign exchange transactions Your name:   Course name:         Professors’ name: Date: Introduction Foreign exchange risk is the risk that a business’s position or financial performance will be affected by fluctuations in the exchange rates between currencies (Kotler, Li, & Su, 2005). In other words, a business that deals in more than one currency is the one affected with Foreign exchange risk. However, a business can be indirectly exposed to foreign exchange risk if, the business rely on imported goods or services. The risk should be managed if fluctuations in exchange rates have an impact on the profitability of the business. While, in businesses where the core operations is not financial services, foreign exchange risk should be managed in such a way that it focus on the core goods or services without exposing the business to risks (Kotler, Li, & Su, 2005). If a business deals with imports or exports of goods or services, the business need to be protected against changes in the exchange rate. A fluctuation in the exchange rate could cost the business thousands of dollars (Case, 2005). Foreign exchange has either harmful or beneficial effects on a business. The effect on the business may be on its cash flows, profits, or its market value. In other words, foreign exchange exposure may be used to measure the potential for a company’s net cash flow, market value, and profitability to change because of fluctuation in the exchange rates (Guo & Meng, 2008). Foreign Exchange Risks Analysis In analyzing risks involved in foreign exchange exposure three types of risks should be considered: transaction exposure, operating exposure, and translation exposure. i. Transaction exposure For Australian businesses that sell their products and services in other countries and get their payment in a foreign currency, foreign exchange risk is likely to occur, and a change in the exchange rated may make the firm to receive lower amount of Australian dollars than originally anticipated. But for firms that import its products and services, it is the likelihood that a foreign exchange rates fluctuation on an upper side will means the firm will pay more than anticipated. Transaction exposure will measure the change in the value of outstanding financial obligations incurred Prior to a change in foreign exchange rates but not due to be settled until after the exchange rates change (Case, 2005). ii. Operating exposure Operating risks, also called, strategic exposure, economic exposure, or competitive exposure, measures Operating exposure is all about unexpected changes that may be experience in the company’s future cash flows (Guo & Meng, 2008). In other words, it is the degree of risk that a firm is exposing itself to when there is a fluctuation of value of currency that are relevant to the operation of the firm (Guo & Meng, 2008). The fluctuation of exchange rates on a downward side or upward side will have a negative or positive effect on the value of certain assets of the firm and thus have either positive or negative impact on the overall profitability of the firm. It is important to note that strategic exposure is a projection of what is going to happen in the future (Guo & Meng, 2008). Therefore, assessing this risk is a constant process. This way will help a business minimize losses and also help to create a position for growth at some point in the future. When a business fails to do so it means it will lose value to key of its assets, and this may hamper the productivity of the business in the future (Guo & Meng, 2008). iii. Translation exposure This risk involves the possibility of a change in the equity section (equity reserves, retained earnings, and common stocks) of a multinational organization’s consolidating its balance sheet that has been caused by a change in foreign exchange rates (Guay, 2006). “Foreign currency translation will occur during the conversion of foreign subsidiary firm’s balance sheet denominated, and profit and loss account in foreign currency to the reporting currency on consolidating group accounts” (Munya 2010). “Foreign currency exposure in a group account will occur if; for example, the profit and loss account and balance sheet of Australia firm’s Malaysian subsidiary are converted into Australian dollars” (Munya 2010). In real sense, “foreign currency transaction exposure will not affect cash flows of a firm hence some will call it as an imaginary exposure rather than real exposure as transaction exposure is a function of the accounting system” (Munya 2010). Under the Australia AASB 121 there are two type of translation risk that is: Balance sheet exposure and Profit and loss exposure. “Balance sheet exposure will occur when the subsidiary firm converts its balance sheet to the reporting currency” (Munya 2010). For the subsidiary which has its assets denominated in foreign currency, the exposure will affect the strength of the balance sheet being reported. “Foreign currency transaction exposure will be reported on the profit or loss account when the foreign currency is converted into the reporting currency or home currency” (Munya 2010). Techniques and Instrument for Managing Foreign Exchange Rate Exposure There are two techniques that can be used to manage foreign exchange exposures or risk: natural hedging and financial hedging. Many multinational organizations use both methods. i. Natural hedging Natural hedging is used to reduce the difference between payments and receipts in foreign currency (Kotler, Li, & Su, 2005). For example, an Australia exports to china and expects payment of 5 million Yuan after one year. If the company is expected to make payments of 500,000 Yuan at that time, the company’s exposure to the Chinese Yuan is 4.5 million Yuan. The Australian company is able to reduce this exposure through borrowing 1 million Yuan and increase its procurement from Chinese company by 1.5 million Yuan. This will reduce the company’s exposures to 2 million Yuan. Alternatively, the Australian company could decide to buy or build a production facility in China to reduce most of the transaction risks or exposure (Chance, 2007). ii. Financial Hedging Financial hedging is another method used to mitigate foreign exchange exposure. Financial hedging involves buying foreign exchange instruments that are typically sold by financial institutions (such as banks) and foreign exchange brokers. The ones common instruments are: forward contracts, currency swaps and options (Chance, 2007). ii (a). Forward contract Many international firms have been found to use forward contract as an instrument to manage exchange rate risk. By definition, forward contracts are agreements that will help a firm to fix the exchange rate for future dealing or transaction (Chance 2007). Forward contract allow an organization to set its own exchange rate at which it will purchase or sell foreign currency in the future. For example, if an organization expects to receive 350,000 dollars more than it needs to pay every month (Chance, 2007). The organization can decide to enter into a forward contract to sell, at a predetermined foreign exchange rate, this of U.S. dollars each month. When a company enters into a forward contract, it will be able to eliminate most of its transaction exposures it may face. ii (b) Currency options Currency option is another tool that can be used to mitigate financial exposure (Guay, 2006). This tool gives a company the right to sell or buy foreign exchange at a pre-determined exchange rate in the future. Because currency option does not force the company to buy or sell its foreign currency, it mostly used by organization that bid on foreign contracts (Guay, 2006). This tool allows organizations to reap maximum benefits from favorable movement in foreign exchange rates. For example, an Australian company has bought a currency option giving the company the right to sell American dollars at a foreign exchange rate of 0.9745 USD/AUD five months from now. But, if the exchange rate is pegged at 0.9855USD/AUD, then the organization may exercise its rights to sell its foreign currency at an exchange rate of 0.9745 USD/AUD. iii (c) Interest Rate Swap Interest Rate Swap is also another form of hedging that can be used by the firm (Kotler, Li, & Su, 2005). This arrangement involves two firms that are in different countries agreeing to swap or exchange debt-servicing obligations. This exchange will help the firm to avoid the risks in fluctuation in the currency (Kotler, Li, & Su, 2005). In other words, this method involves the simultaneous buying and selling of foreign currency, can help organization match payments and receipt in a foreign currency (Chance, 2007). For example, if today an organization receives payment of 300,000 US dollars, but the organization knows it will make a payment of 300,000 US dollars in 30 days. The organization can enter into a swap arrangement whereby it sells 300,000 US dollars today (in exchange for Australia dollars) and commits to buy the same amount of U.S. dollars in 30 days at a foreign exchange rate that is pre-determined. Swap will allow the organization to have access to the Australian dollars equivalent of 300,000 US dollars for the next 30 days. In addition, it will help the firm to eliminate foreign exchange exposure during this time. Conclusion Hedging is a financial strategy that will help companies to reduce the risk of its investment. Similar to insurance, hedging will help a company to avoid making losses. Foreign exchange plays an important role in international business and dealings. Foreign exchange rates fluctuations will have an impact on the company’s outcomes and decisions. Many firms that deal with import have become unworthy or shelved due to the effect of exchange rate risk rooted in them. References Case W 2005, Politics in Southeast Asia: democracy or less, Curzon Press, Richmond Surrey Chance, Don M 2007, An Introduction to Derivatives, 4th edition, Dryden, London. Guay, W 2006, ‘How much do firms hedge with derivatives?’ Journal of Financial Economics, vol 70, 423-461. Guo, L. & Meng, X 2008, ‘Consumer Knowledge and its Consequences: an International Comparison’, International Journal of Consumer Studies vol 32:3, pp.260-268. Kotler, P., Li, J. & C. Su 2005, Principes van marketing: Derde editie (The Principles of Marketing:Third European edition), Pearson Education Benelux, London. Munya, M 2010, ‘What is translation exchange exposure’, Biz610 Newsletter, Retrieved from http://biz610.com/what-is-translation-exchange-exposure/ Read More