International Financial Management
Foreign Exchange Risk Analysis
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A currency exposure is any business operation whose profitability can be impacted by a currency exchange rate fluctuation.
Currency exposures assume many forms: they can be assets or liabilities; current or committed; contracted or merely forecast; they can be for trade, investment or balance sheet purposes. Cases of currency exposure can emerge at any point along the value chain, with various repercussions. Each requires a transfer of funds, and for each the rate of exchange is uncertain. Examples of different types of currency exposures are presented below.
FIGURE 1: CURRENCY EXPOSURES ACROSS THE VALUE CHAIN
Project planners calculate profitability based upon competitiveness in the target market.
Thereafter, a competitor in a third country benefits from favorable exchange rates between its currency and the currency of the target market. The exchange gap makes the competitor’s product more competitive. The product loses market share and ceases to be profitable.
Product manufacture relies on components or machinery purchased in foreign-denominated currency. A shift in exchange rates renders these purchases more expensive—in terms of home-country currency—and the product loses profitability.
|Development |Manufacture |Marketing |Sale |Accounting & | | | | | | |Reporting | | | | | | | | |
An unfavorable exchange rate movement renders products relatively more expensive in terms of the foreign currency.
The vendor must either maintain the nominal price level— at the risk of losing market share—or lower prices and erode the profit margin.
Any adverse exchange rate movement that takes place between the times of price quote, bid offer, sale confirmation, invoice receipt or payment deposit may render the sale undesirable, unprofitable or void.
A foreign subsidiary may post a satisfactory profit in terms of its base currency, however a negative exchange rate movement makes these figures less impressive upon profit repatriation. While this is a superficial incident, it may strongly impact stakeholder opinion or debt repayment schedules.
TYPES OF CURRENCY EXPOSURE
The currency exposures presented on the previously can be classified into three categories, according to the type of activity they impact. The three types of currency exposure are as follows:
• Transaction Exposure—Vulnerability to exchange rate movements between the base currency and a foreign currency in the course of trading
• Translation Exposure—Vulnerability to exchange rate movements between the base currency and a foreign currency in the course of accounting
• Economic Exposure—Vulnerability to exchange rate movements between two foreign currencies, or vulnerability resulting from indirect effects on product competitiveness
A transaction exposure is an exchange of goods between two currencies. Such an exchange presents the risk that, during the delay between planning the necessary currency exchange and executing it, the rate of exchange might change.
The source of vulnerability of a transaction exposure is the time lapse between the point of pricing and the actual point of currency transaction (i.e., settling of the account). This lapse allows for a change in exchange rates, altering the premises on which pricing was determined. Such situations arise when a company anticipates or commits to a trade of goods denominated in a foreign currency....
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