The exchange risk or exchange risk (also known as currency risk, currency risk, or foreign exchange risk), is a financial risk associated with the fluctuation in the exchange rate of one currency with respect to another. This risk must be assumed by those investors and companies whose investments and businesses involve an exchange between currencies.
Currency risk can result in a negative or positive balance (in profit or loss) depending on whether the exchange rate has changed in favor or against the interests of the investor or company. Often, companies such as “oanda.com” that carry out commercial operations provides the best foreign exchange data services that involve exchange between currencies use hedging strategies to neutralize or reduce the risk of exposure to fluctuations in exchange rates, in this way possible gains from this exposure will also be neutralized. It is also common to use futures contracts to carry out the commercial transaction in the future at an exchange rate agreed upon in the present.
Types of Exposure to Currency Risk
Currency risk can be classified according to the type of exposure. This exposure to currency risk in a company affects the flow of capital, market value, competitiveness and financial information.
- Trade Exposure: There is a risk that the exchange rate will change unfavorably when a trade involving currency-to-currency conversion is performed.
- Conversion Exposure: This is an accounting concept. This exposure is proportional to the amount of assets denominated in foreign currency. Changes in the foreign exchange data will lead to inaccurate financial or accounting reports over time.
- Operational or economic exposure: Refers to the degree to which currency risk affects the market value of a company or investments.
- Contingent exposure: A company has contingent exposure when it makes an offer or negotiates a contract abroad and refers to the ability to face economic and / or transaction exchange risk.
Currency risk exists regardless of whether investors invest in the country of origin or abroad, it exists as long as there is a transaction with exchange between currencies. If they invest in the home country, and the local currency devalues, investors have lost money.
All investments in the stock market are subject to FX payments risk, regardless of the nationality of the investor or investment, and whether they are in the same or different currency. Some people argue that the only way to avoid currency risk is to invest in commodities (such as gold), which have a value independent of the monetary system.
Consequences of Currency Risk
The exchange risk associated with an instrument denominated in foreign currency is an important factor in foreign investment. For example, if a US investor owns shares in Canada, the performance that will take place is affected by both the change in the share price and the change in the value of the Canadian dollar against the US dollar. Suppose that the shares the investor owns in Canada appreciated 15%.
If the Canadian dollar has depreciated 15% against the US dollar, the exchange rate movement would have canceled out the profit made on the sale of the shares. If a company buys or sells in another currency, then revenues and costs may increase or decrease based on fluctuations in exchange rates and their effect on currency conversions between the foreign currency and the domestic currency.
Similarly, if a business receives funds in another currency, debt payments could vary in domestic currency terms, and if the business has invested abroad, returns on investment may vary with exchange rates. Currency risk has proven to be particularly significant and damaging especially for large one-time investment projects, the so-called megaprojects.
This is because these types of projects are normally financed by credits denominated in currencies other than the currency of the country of origin of the owner of the debt. Megaprojects have been shown to be prone to ending up in what has been termed a ‘debt trap’ which can lead to the costs of paying off debt higher than the income available to do so. That is why it is so frequent that financial restructuring is carried out in megaprojects.
How to Avoid Currency Risks Protection Against Currency Risks
As a beginner, you should know that the risks and benefits of any investment are simultaneous and that the higher the return, the greater the likelihood of risks arising. How do you protect currency newbies against currency risks? Give examples of protection against currency risks.
Among the risks of foreign exchange operations, the most important are foreign exchange and interest rate risks, therefore, protection against foreign exchange risks consists mainly of protection against both types of risks, which can only be avoided to the extent possible. Today I present a case of prevention of the risks of investing in foreign currencies with fx corporate payments.
Analysis of an example: A German Company, a subsidiary of a transnational company in the United States, assumed currency risk with an item of DM 3 million on its balance sheet for a given year with a net cash flow as of March 31. Below is a detailed explanation of how the company is protected against currency risks, both in terms of exchange rates and interest rates:
Protection Against Currency Risks
Due to Mark’s estimated appreciation trend, two measures could be taken in relation to currency risk:
No hedging, converting DM 3 million into US dollars would increase from US $ 1.5 million to US $ 1.76 million, and the company would have to pay an additional debt of USD 260,000
Hedging measures The cost of hedging is borne by the parent company, i.e. US $ 30,000, Ascension transfers are purchased, the exchange rate is DEM 1.7 per dollar in At the time of delivery, the hedge benefit is $ 26 minus US $ 30,000, representing a gain of $ 230,000, or a cash flow of $ 230,000, which compares , the cost of non-refoulement is 0 and the cash flow is 0; hedging expenses were $ 30,000 and cash flows were $ 230,000, indicating that the hedging measures were more favorable.
The type of risk related to exchange interest rates is very varied and can directly or indirectly generate a risk of loss of the value of the investment or of the profits, mainly in five points:
Portfolio investments at fixed interest rates in fx corporate payments, when market interest rates rise, share prices fall, resulting in a loss of interest; when companies issue new bonds, market and new bond interest rates rise, and holders of crude oil bonds suffer losses. Increase in market interest rates to increase the risk that companies incur financial costs.