Exchange rate risk refers to the risk of loss due to adverse movements in exchange rates. Currency exposure refers more broadly to the possibility that exchange rate changes will result in either a gain or a loss. These gains or losses can affect individuals, firms, or investors and reflect the impact of exchange rate changes on cash flows, on assets and liabilities, on profits, and on stock market values. Exchange rate risk is thus commonly divided into three categories, reflecting the nature of their financial impact: “transaction” (or contractual) risk, “translation” (or accounting) risk, and “economic” (or operating) risk.
Transaction (or contractual) risk arises when there is a time difference between the establishment of a transaction and its financial settlement. Any change in the exchange rate between the agreement and settlement dates will affect the value of the cash flows that are either received or paid. Many foreign exchange transactions arise from the import or export of goods or raw materials, from the payment of interest on foreign currency debt, and from the receipt of dividends on foreign investments.
Translation (or accounting) risk arises from the need to translate financial statements denominated in foreign currencies into the home currency of the reporting entity. The greater the percentage of business conducted by subsidiaries, the greater is the translation risk. In consolidating financial statements, the translation can be done using either the prevailing exchange rate or the average exchange rate over the reporting period, depending on the accounting standard applicable to the parent company. Thus, while income statements are usually translated at the average exchange rate over the period, balance sheet exposures of foreign subsidiaries are often translated at the prevailing exchange rate at the time of consolidation. Many companies apply International Accounting Standard 21, “The Effects of Changes in Foreign Exchange Rates,” to translate the financial statements of foreign subsidiaries.
Economic (or operating) risk refers to the possibility that the present value of future operating cash flows, and thus the economic value of the firm, will vary in home currency terms as a result of changes in exchange rates. It measures the effect that unanticipated exchange rate changes have on firm value since expected changes should already be reflected in share prices.
Economic risk is similar to transaction risk in that both are concerned with cash flows. However, in the case of economic risk the timing and amount of the cash flows are uncertain; once a potential cash flow becomes a financial commitment, it no longer represents an economic risk but a transaction risk. The main determinants of economic risk are the structure of the markets in which a firm sells its products and sources its inputs, such as labor and raw materials, and also its ability to mitigate the effect of currency changes by adjusting its markets, its product mix, and its sourcing.
A widely used method of measuring transaction exchange risk is the calculation of value-at-risk (VaR). Broadly, VaR is defined as the maximum loss for a given currency position over a specified time horizon for a given confidence interval. For example, if a bank’s U.S. dollar position has a one-day VaR of $10 million at the 99 percent confidence interval, it should expect the value of this position to decrease by no more than $10 million on 99 out of 100 trading days, if normal conditions prevail.
In theory, exchange rate risk is not a problem if purchasing power parity (PPP) exists because changes in exchange rates simply offset prior price-level changes. However, the evidence suggests that PPP only exists in the long run. Firms can mitigate exchange rate risk by entering into financial hedges using forward contracts or other derivative instruments. Such hedging may be unnecessary for shareholders holding diversified portfolios, as they may find that the negative effect of exchange rate changes on one firm is offset by gains on another. However, the exact nature of currency risk is not known to investors, so it may not be fully diversifiable. Even so, firms may actively manage currency risk to avoid the costs associated with financial distress. Although the findings of empirical studies are mixed, the bulk of the evidence suggests that exchange rate risk affects shareholder wealth, and thus that there is value in hedging.
- Laurence Copeland, Exchange Rates and International Finance (Prentice Hall/Financial Times, 2008);
- Craig Doidge, John Griffin, and Rohan Williamson, “Measuring the Economic Importance of Exchange Rate Exposure,” Journal of Empirical Finance (v.13/4, 2006);
- Maurice D. Levi, International Finance (Routledge, 2009);
- Aline Muller and Willem C. Verschoor, “Foreign Exchange Risk Exposure: Survey and Suggestions,” Journal of Multinational Financial Management (2006);
- S. Tai, “Asymmetric Currency Exposure and Currency Risk Pricing,” International Review of Financial Analysis (v.17/4, 2008).
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