What Is Foreign Exchange Risk?
Foreign exchange risk refers to the losses that a business conducting international transactions can incur due to fluctuations in currency rates. Currency fluctuations can alter business costs and investment values.
Foreign exchange risk occurs when a company makes financial transactions in a foreign currency. Any appreciation or depreciation of the currencies involved will alter the cash flows emanating from that transaction. It can also affect investors who trade in international markets and businesses engaged in the import/export of products or services to multiple countries — proceeds of a closed trade, profit or loss, are in the foreign currency and must be converted back to the investor's home currency, and exchange rate fluctuations can lower the amount received on conversion. An import/export business is exposed to foreign exchange risk through account payables and receivables affected by currency exchange rates. This risk arises when a contract specifies exact prices and delivery dates for goods or services — if currency values change between signing and delivery, one party will incur a loss.
Exploring the Three Types of Foreign Exchange Risk
There are three different types of foreign exchange risk:
- Transaction risk — This is the risk a company faces when it buys/sells a product from/to a company located in another country. It is an adverse movement of the exchange rate from the time a transaction is budgeted till its completion. If an Indian company buys a product from a company outside India, and the selling company's currency appreciates versus the Indian Rupee, the Indian company will have to make a larger payment in Rupees to meet the contracted price.
- Translation risk — This arises from the need to "translate" foreign currency assets/liabilities into the home currency for the purpose of finalising accounts for any given period. A parent company might face losses when converting a foreign subsidiary's financial statements back to its own currency.
- Economic risk — Also called forecast risk, this occurs when a company's market value is continuously impacted by unavoidable exposure to currency fluctuations. A change in the exchange rate also affects a company's competitive position in the market.
Hedging Instruments
Companies that are subject to FX risk can implement hedging strategies to mitigate that risk. Foreign exchange risk is managed through two means: (a) internal techniques — tools internal to the firm such as netting, matching, price variation, asset-liability management, leading and lagging, also known as passive hedging; and (b) external techniques — contractual means such as forward contracts, futures, and options, to insure against potential exchange losses, also known as active hedging. Usage of internal tools among group companies may at times be difficult to practice owing to local exchange control regulations.
A forward contract is a right to buy or sell foreign currency at an agreed price for a future date. A forward rate is calculated by adding the current exchange rate (the spot rate) of the currency and the forward premium for the forward date. The forward premium is simply the interest differential between two currencies, and is freely quoted in the currency market for up to 12 months. All assets/liabilities can be hedged by purchasing/selling a forward contract in the OTC (Over the Counter) market.
| Period | Premium (in INR) | Forward Rate (in INR) |
|---|---|---|
| 1 Month | 0.18 / 0.20 | 91.68 / 91.72 |
| 2 Months | 0.38 / 0.40 | 91.88 / 91.92 |
| 3 Months | 0.57 / 0.58 | 92.07 / 92.10 |
Assuming a spot rate of USD/INR at 91.50/91.52 — an importer or exporter can today fix a price for future payment obligations depending on maturity. If an exporter has to receive payment in USD after 3 months, they can take a forward cover for three months today and freeze a rate of 92.07 from the table above. As a result, after three months when the payment comes in USD, conversion to INR will be on the basis of 92.07, irrespective of whether the USD has appreciated or depreciated in those three months.
A futures contract is similar to the forward contract but is traded in an organized exchange rather than only OTC. It is an agreement to buy and sell a standard quantity of a specific financial instrument at a future date and price agreed between the parties. Futures contracts have specific, non-customizable details, including the number of units traded, delivery and settlement dates, and minimum price increments. The exchange acts as counterpart to the trader, providing clearance and settlement. A buyer of the futures contract has both the right and the obligation under the contract.
Hedging through a futures contract is almost akin to hedging with a forward contract — an exporter with a receivable can hedge by selling futures, while a payable is hedged by buying a futures contract. However, since amounts and delivery dates are standardized, a perfect hedge through futures is not always possible. There is also a difference in that intermediate cash flows exist under futures contracts owing to the "mark-to-market" mechanism, which can be positive or negative.
Options are financial instruments in which the buyer of the option has the right to buy or sell foreign currency at a pre-determined price (the strike rate) for a specified date — but there is no obligation for them to do so. The option buyer can simply let the right lapse by not exercising the option. Globally there are two types of options:
There are two basic types of options — Call Option and Put Option.
In either type of option, the buyer has to pay a cost called the "upfront premium" whether they exercise their right or not.
Consider an Indian exporter who has to receive a payment after three months and wants to make sure they do not receive less than INR 93.00 per dollar. The exporter can buy a Put option on USD at a strike price of 93.00, paying the upfront premium to the bank as cost. When the actual payment comes after three months, if the USD/INR exchange rate moves to 94.00, the exporter can sell the USD at the ongoing market rate of 94.00 and let the option expire. However, if the exchange rate moves to 91.00, the exporter can exercise the option and sell the receivables in USD at the strike price of 93.00 as per the contract. With options, one can protect against losses while leaving room for unlimited gains — though pricing of the option (upfront premium) plays an important role in determining its viability.
Under a currency swap, two counterparties agree to exchange specific amounts of two different currencies at the outset, and repay these over time in instalments, reflecting interest and principal. A swap is a contract to exchange cash flows over the life of the contract — essentially a combination of forward contracts for a longer maturity. Parties exchange principal amounts at the start, pay interest on the swapped amounts during the term, and re-exchange principal at the end, often at the same rate, to eliminate risk.
An American company may be able to borrow in the United States at 6%, but requires a loan in Mexican Peso for an investment in Mexico, where the relevant borrowing rate may be 13%. At the same time, a Mexican company wishes to finance a project in the United States, where its direct borrowing rate is 9%, compared to a rate of 10% in Mexico. Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap: the American company borrows USD at 6% and lends the funds to the Mexican company at 6%. The Mexican company borrows Mexican Peso at 10%, then lends the funds to the U.S. company for the same amount. Currency swaps can also involve exchanging two variable rate loans, or fixed rate borrowing for variable rate borrowing.
Other Types of Swaps
An agreement between two counterparties where one stream of future interest payments is exchanged for another, based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.
Company A is currently paying a floating rate of interest on its USD loan but wants to pay fixed. Company B is currently paying a fixed rate but wants to pay floating. By entering into an interest rate swap, each party can "swap" their existing obligation for their desired one. Here, B makes periodic interest payments to A based on a variable rate of LIBOR + 70 basis points. Company A in return makes periodic interest payments based on a fixed rate of 8.65%, calculated over the notional amount. Normally the parties do not swap payments directly, but each sets up a separate swap with a financial intermediary such as a bank, which takes a spread from the swap payments. By doing the IRS, Company A gets fixed rate funds at an effective cost of 9.60% (paying 8.65% to B, plus a differential of 0.95% over Libor), while Company B gets floating rate funds at Libor + 0.70%.
Similar to an IRS, where the rates are determined by the participants themselves. This could be used as a cost-reduction strategy.
Similar to a currency swap, except that in a currency swap both principal and interest are exchanged between the parties, whereas in a POS only principals are exchanged on pre-decided maturities.
An Indian company, ABC Ltd., whose cash flows are in Dollars, has taken a loan in Japanese Yen to finance capital goods imports. The company is now exposed to fluctuation in the USD/JPY exchange rate. To eliminate this risk, the company would want to assume a dollar liability, since it has cash flows in dollars — a currency swap can facilitate this. Assuming the Yen loan is repayable in 10 equal half-yearly instalments of JPY 150 million each, and the prevailing spot rate of USD/JPY is 150 yen to a dollar, the swap would involve receiving Yen 150 million and paying out USD 1 million every six months for the next 5 years.
Forward Rate Agreement (FRA)
This is an agreement between two parties — typically a bank on one hand and a borrower/depositor on the other — where the former guarantees the latter a fixed rate on an agreed future date. This instrument is used to freeze or defreeze interest payments from fixed to floating (or vice versa) on the basis of LIBOR, which can be fixed in advance. One can thus mitigate LIBOR risk by freezing future LIBOR rates today by adding some cost, in case a view is taken for rising or falling LIBOR. This is a similar product to forward contracts — the IRS explained above is essentially a combination of a series of FRAs.
Suppose the current month is February. Company ABC needs $5,000,000 in April, which it can repay back in May. To hedge against the risk that interest rates may be higher in April than in February, the company enters into an FRA with Bank Z at a 6% FRA rate. This would be a 2×3 FRA — meaning a 1-month loan to begin in 2 months, with a notional principal of $5,000,000. In April, if the interest rate rises to 8%, Bank Z would pay Company ABC the increased interest arising from the higher rate (2%). If instead the interest rate falls to 5%, Company ABC would pay Bank Z the differential of 1%.
- No exchange of principal.
- Only the interest differential on the notional amount is exchanged.
FRAs trade over the counter (OTC) and, because they are not exchange traded, both the notional amount of the loan and the FRA rate can be negotiated and customized. Since the contract is cash settled, no loan is actually given or received — the contracts are settled on the first day of the underlying loan. FRAs are quoted in the format A×B, with (A) representing the number of months until the loan is set to begin, and (B) representing the number of months until the loan ends.
Hedging instruments for exchange rate risk allow businesses to lock in currency rates, mitigating losses from volatility. If done properly, these strategies can protect a company from adverse foreign exchange moves. Managing foreign exchange risk is crucial for companies engaged in import/export activities, to avoid unexpected costs and protect profit margins. An ongoing awareness and proactive financial planning are vital for minimizing the impact of currency fluctuations on business operations and investments.