Managing Foreign Exchange Risk

The nature of foreign exchange risk was discussed in Chapter 9. There we described how changes in exchange rates alter the profitability of trade and investment deals, how forward exchange rates and currency swaps enable firms to insure themselves to some degree against foreign exchange risk, and how relative inflation rates determine exchange rate movements. In this section, we focus on the various strategies international businesses use to manage their foreign exchange risk. Buying forward, the strategy most discussed in Chapter 9, is just one of these. We will examine the types of foreign exchange exposure, the tactics and strategies firms adopt in attempting to minimize their exposure to foreign exchange risk, and things firms can do to develop policies for managing foreign exchange risk.

Types Of Foreign Exchange Exposre

When we speak of foreign exchange exposure, we are referring to the risk that future changes in a country's exchange rate will hurt the firm. As we saw in Chapter 9, changes in foreign exchange values often affect the profitability of international trade and investment deals. Foreign exchange exposure is normally broken into three categories: transaction exposure, translation exposure, and economic exposure. Each is explained here.

Transaction Exposure

Transaction exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. Suppose a US company has just contracted to import laptop computers from Japan. When the shipment arrives in 30 days, the company must pay the Japanese supplier ¥200,000 for each computer. The dollar/yen spot exchange rate today is $1 = ¥120. At this rate, each laptop computer would cost the importer $1,667 (i.e., 200,000/120 = 1,667). The importer knows it can sell each computer for $2,000 on the day the shipment arrives, so as the exchange rate stands, the US company expects to make a gross profit of $333 on every computer it sells (2,000 - 1,667). If the dollar depreciates against the yen over the next 30 days, say to $1 = ¥95, the U.S. company will still have to pay the Japanese company ¥200,000 per computer, but in dollar terms that would be $2,105 per laptop computer--more than the computers could be sold for. A depreciation in the value of the dollar against the yen from $1 = ¥120 to $1 = ¥95 would transform this profitable transaction into an unprofitable one.

Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported consolidated results and balance sheet of a company. This issue was discussed in Chapter 19 when we looked at currency translation practices. Translation exposure is basically concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized--they are "paper" gains and losses--but they are still important. Consider a US firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar, as it did during the early 1990s, this would substantially reduce the dollar value of the Mexican subsidiary's equity. In turn, this would reduce the total dollar value of the firm's equity reported in its consolidated balance sheet. This would raise the apparent leverage of the firm (its debt ratio), which could increase the firm's cost of borrowing and restrict its access to the capital market. Thus, translation exposure can have a very negative impact on a firm.