Exchange Rate Risk In Forex Market

The impact that unexpected exchange rate changes have on the value of the corporation is known as exchange rate risk.

Currency risks in exchange rate are quite crucial for a corporation as it can have a major impact on its cash flows, assets and liabilities, net profit. The corporation needs to have a robust management plan in order to safeguard itself from various types of exchange rate risks. It should focus on the following defined priorities in case it has foreseen and accepted the exchange rate risks.

1. Clearly define the kind of exchange rate risk, the corporation is exposed to.

2. Design a suitable strategy to deal with these risks in exchange rate.

3. Specify which financial instruments it allows itself to use for this purpose.

Currency exchange rate risks seem to be simple in concept; however the reality is that they are really complex. In simple words, risks in exchange rate are the possible gain or loss resulting from an exchange rate move. It can have a huge impact on the value of a corporation directly as a result of an unheeded exposure or more indirectly. Different kind of exchange rate risk can offset each other. For example, consider a US citizen who owns stock in a British auto manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the face of it the individual sees the US dollar value of their holding decline.

However, the British auto exporter should in fact benefit from a weaker Euro as this makes the company’s exports to the US cheaper, allowing them the choice of either maintaining US prices to maintain margin or cutting them further to boost market share. Sooner or later, the stock market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the currency translation, but gain on the higher stock price.

This is quite a simple example and life unfortunately is rarely that simple. Therefore in order to manage successfully the currency exchange rate risks, the first step is to admit that such risk actually exists and that it has to be managed in the general interest of the corporation and the corporation’s shareholders business into the speculative world of currency markets. The general trend within the corporate world has however been in favor of admitting the existence of and the need to manage currency risk.

The main types of exchange rate risks are defined below. Let us take a look:

Transaction Risk:

This exchange rate risk is associated with the cash flow risk and can be related to any kind of transactions like, receivables, payables or dividends. These are also the most common types of risks in exchange rate, which are faced by the multinational companies and corporations. Economic Risk: Economic types of exchange rate risk focus on how exchange rate moves change the real economic value of a company, keeping an eye on the present value of future operating cash flows and how this changes in line with exchange rate changes. Like with the translation risk in risks in exchange rate, calculating economic risk is also complex. It is important to calculate economic risk in exchange rate to be able to assess how exchange rate changes can affect the present value of foreign subsidiaries.

Translation Risk:

These types of risks in exchange rate exist because of the integration of parent company and foreign subsidiary financial statements. This combination means that exchange rate impact on the balance sheet of the foreign subsidiaries is translated to the parent company’s balance. The three most common methods used by large companies for translating balance sheet risk in currency exchange, how they separate assets and liabilities between those that need to be translated at the current exchange rate at the time of integration and those that are translated at the historical exchange rate are- the all current method, the monetary/non-monetary method and the temporal method.