Currency risk is something you need to be aware of and be able to manage as it may result in the depreciation of your assets. Today will elaborate on what it is why it is important to understand and ways to avoid the risk or manage it.
What is currency risk?
Currency risk is also known as exchange rate risk and is the risk that comes about when there are changes in currency value; it is the risk of a currency’s depreciation affecting an individual’s assets or investments negatively, more so for those securities that are denominated in foreign currency. Companies that operate in foreign markets are also vulnerable to currency risks as the foreign financial conclusion needs to firms into the organisation’s home currency.
Why currency risk knowledge is important
When dealing with currencies especially foreign currency, it is vital to understand what currency risk is because; the foreign currency exchange rates have the ability to extremely shift the returns on a foreign investment no matter how well the investment has been doing.
Nevertheless, it is not all bad, as it opens up an opportunity for investors to gain when two countries interest rates show the predicted exchange rates changes. When a country's interest rates
go up a lot of other countries, come in to take advantage of higher yields thereby creating an international flow of currencies in that country, and hence the currency of that country gains value.
Types of currency risk
The three major types are as follows;
1. Economic risk
This type of currency risk is the most important of them all as it has the most impact.
Economic risk affects a firms' value directly, meaning that a company’s market value is influenced heavily by sudden changes in the exchange rate. This type of currency risk can affect the current value of the company’s future cash flows and those transactions that leave the firm exposed to foreign exchange risk exposes the firm economically as well.
However, there are other business activities as well as investments apart from international transactions that can cause economic risk; these include future cash flows from any fixed assets, changes in exchange rates in a country that influences the demand for particular goods or services.
International investments vs. domestic investment
Economic risk is more present in international investments than in domestic investments
In international businesses, economic risk affects investors as well as bondholders and shareholders; this is mostly when dealing with foreign government bonds sales and purchases. Investors must always analyze and calculate thoroughly the possible changes foreign regulatory authorities make. Changes in laws and regulations on types, timing, sizes, credit quality, as well as to disclosures of bonds
directly and immediately affects investments in foreign countries.
2. Transaction risk
This type of currency risk is the simplest one of all of them as it is merely risk incurred in an actual business transaction in foreign currency.
As companies carry out their transactions setting prices and delivery dates in a volatile foreign exchange market where exchange rates are constantly fluctuating; they are vulnerable to the risk of exchange rate changes that may occur between the foreign currency and the domestic currency. Therefore the currency risk in transactions refers to the risk related to changes in the exchange rate from the time a company initiates a transaction to when it settles it.
Most times, companies carry out transactions in more than one currency; and to meet the transaction’s processing standards, the parties involved must send the foreign currencies involved back to their country. Companies may see delays in the high profits that any company expects from a transaction; and this is because the currency market is always changing and moving in different directions. The transaction occurs on a market exchange rate in a short period; therefore, fluctuations may occur.
The time lag that is between the time of execution and settlement of a transaction can cause companies to incur several losses. The time lag occurs after the foreign exchange transaction is executed; therefore the risk comes in on the fact that the relevant exchange rate might fluctuate vastly
Currency risk – Hedging transaction risk
There are several ways to reduce the volatility that comes from transaction risk through fluctuations. The extremity of transaction risk comes when currencies in large amounts are exchanged in foreign countries from a warehouse. In that case, a company can purchase Foreign Exchange hedging documents like options
and forward contracts, to protect themselves.
With forward contracts, a company can set a currency rate for a specific date in the future. If a firm goes with buying an option; then it can specify a rate which is “at-worst” for the transaction. Natural hedging, also known as ‘netting Foreign Exchange exposures’ is also a very good option; as it is efficient and helps reduce the margin taken by banks as businesses exchange currencies.
3. Translation risk
This currency risk in a firm refers to; the extent to which the company’s financial reports are affected by exchange rate movements. Generally, all companies are required to make consolidated financial statements as reports of the business activities. Therefore this process for multinationals deals with; the translation of foreign liabilities and assets or converting the foreign subsidiaries financial statements from foreign currency to domestic currency. During the translation process, there is a risk that can significantly affect a firms reported earnings; which will also affect its stock price.
Translation risk is present when a company denominates part of its equities, liabilities, income, or assets in a foreign currency. Ultimately, any company that is doing business within a foreign country has to exchange the related foreign country's currency back to their domestic currency.
Moreover, the value of the foreign currency can change drastically when exchange rates increase or decrease; as they are constantly fluctuant by nature. Therefore, the significant value changes bring about translation risk; because it becomes more difficult to evaluate the fluctuation of the currencies compared to other foreign currencies.
Currency risk – how to hedge translation risk
The balance sheet hedging is one of the most common methods to hedge translation risk. Speculation is the core of balance sheet hedging as it involves; gambling with the forward market ‘so to speak’ and hoping that there will be a cash profit that will offset the non-cash loss from the translation. To carry out this method; the company’s consolidated balance sheet has to have equal amounts of assets and liabilities in exposed foreign currency. Once that happens, net translation exposure becomes zero.
Other ways in which companies can try to hedge translation risk include; buying future contracts or currency swaps,
or asking customers to make payments in the currency of the company’s home country; which gives the client responsibility and risk instead.
Hedging currency risk with ETFs
Using currency-focused ETFs is a flexible, more liquid, and a simple way to manage currency risk. Many established financial institutions offer a variety of currency-focused ETFs. Some of the most well-known institutions with these provisions are WisdomTree and CurrencyShares. The two institutions both offer a diverse pool of ETFs
that support most of the world’s currencies; including those from investment destinations like Canada, China, and Brazil. Check out our article on the most used currencies in the world here
Investors must purchase put options against the ETFs; so that they can profit from declines in the value of the currency; thereby offsetting losses upon conversion. Investors can also purchase currency-hedged ETFs, that carry built-in hedges over currency fluctuations in relation to the U.S. dollar.
It must be clear now how important it is to understand currency risk and how to manage it. Here’s hoping that this article was helpful, stay tuned for the next one.