How to protect your foreign investment from currency risk
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Exchange rate fluctuations are common. From someone on vacation planning a trip abroad and wondering when and how they can get local funding to an international organization that buys and sells in multiple countries, the consequences of a bad deal can be substantial.
Types of currency risk
There are three types of currency risk that companies face: transaction risk, transfer risk, and financial (or operational) risk. We’ll take a closer look below.
Transaction currency risk
As the name suggests, this is the simplest form of currency risk and occurs in actual currency trading. This is due to, for example, the time difference between the customer’s right to receive money and the actual physical receipt of the money or, in the case of payment, the time difference between the purchase order and the invoice.
Translation currency risk
This implies the conversion or translation of financial statements for foreign subsidiaries (e.g., income statements and balance sheets) from the local currency to the parent company’s reporting currency. This is because the parent company has reporting obligations to shareholders and supervisory authorities that require it to provide a set of online trading accounts linked in a reporting currency for all subsidiaries.
Following the example above, suppose an American company decides to establish a subsidiary in Germany to manufacture equipment. The subsidiary reports economic development in Euros, and the US parent company converts these statements into US dollars.
The example below shows the financial results of a subsidiary in local euros. Between the first and second years, the company saw a 10% increase in revenue and achieved productivity, keeping costs at 6%. This, in turn, represents an impressive 25% increase.
However, due to the effects of exchange rate fluctuations, financial results look very different in the parent company’s reporting currency, the US dollar. In this example, the dollar has risen over two years, and the euro/dollar exchange rate has fallen from an average of 1.2 in the first year 1 to 1.05 in the second year. The financial development of the US dollar looks much worse. Sales are reported to have declined 4% while net income is still growing, but only up 9%, not 25%.
Of course, the reverse can also happen. Therefore, when reporting financial results, you will often hear companies reporting “reported” and “local currency” on specific key metrics, such as revenue.
Economic or operational risk
This type of currency risk arises from the impact of unexpected exchange rate fluctuations on a company’s future cash flows and market value and is of a long-term nature. These kinds of impacts can influence long-term strategic decisions, such as where to invest in manufacturing facilities. Even if you do not operate or sell overseas, exchange rate fluctuations can have a significant impact on your competitiveness. For example, a US manufacturer that sells only local furniture must compete with imports from Asia and Europe, which become more competitive as they become cheaper when the dollar strengthens significantly.
How to reduce currency risk in the international market
The first question is whether it’s worth trying to minimize the risk. Perhaps a company is prepared to accept currency risk as a business expense and deal with potential earnings volatility. A company may have a high enough margin to provide a buffer against exchange rate volatility, or it may have a strong brand/competitiveness that may raise prices to compensate for adverse changes. In addition, the company may trade with countries whose currencies are pegged to US dollars (except Saudi Arabia, with its currency pegged to dollars starting in 2003). However, the list of countries officially linked is small and unimportant in terms of volume).
For companies that prefer to mitigate risk in foreign currencies actively, the tools available range from very simple and inexpensive to more complex and expensive.
Trade in your currency
Companies with substantial competitive advantages cannot sell branded products or services but can negotiate in currency. For example, a US company may require you to bill and pay in US dollars even when working abroad. This transfers the online currency exchange risk to the local buyer/supplier.
In practice, this can be difficult because there are expenses that must be paid in local currency, such as taxes and salaries, but it can be possible for companies that do business primarily over the Internet.
Business relationship/contract protection
Many companies dealing with major infrastructure projects, such as oil and gas, energy, or mining, often have long-term contracts that can cover a significant portion of the currency exchange. These contracts can last for many years, and fluctuating exchange rates during contract negotiations and valuations can jeopardize profitability. The contract may include a currency clause that will reimburse the income if the exchange rate deviates by more than the agreed-upon amount. This obviously eliminates any currency risk to the buyer/supplier and, like all other provisions of the contract, requires consent.
In my experience, this can be a very effective way to protect against volatility in exchange rates, but the legal language of contracts is strict, and the indicators measuring exchange rates must be clearly accurate. These provisions should also be reviewed regularly by financial and commercial groups to ensure that procedures are in place to recover damages when monetary provisions are triggered.
Finally, these provisions can lead to complex deals if commercial negotiations with a customer are initiated, especially when the time merges with the time of negotiations for a new contract or its extension. Companies usually do not enforce rules to protect customer relationships when this happens.
Hedging currency risk
Natural currency hedging occurs when a company can match foreign currency income and expenses to reduce or eliminate net currency risk or exposure. For example, a US company that operates in Europe and earns in Euros may find European products to supply to its domestic business in the United States to use those Euros. This is an example of somewhat simplifying the supply chain for most companies, but we’ve seen how this can be used effectively when a company has departments in multiple countries.
However, this puts additional strain on PSAs as tracking net exposures requires multi-currency P&L data and balances to be processed alongside traditional ledgers.
Hedge with financial instruments
The most complex and perhaps well-known way to hedge currency risk is to use a hedging mechanism with financial instruments. The two main hedging methods are currency futures and exchange rate options.
1. Forward Contract.
A forward contract is a contract in which a company agrees to buy or sell a specified amount of foreign currency on a specified date in the future. The company can protect itself from subsequent exchange rate fluctuations by entering into this agreement with a third party (usually a bank or other financial institution).
The purpose of this contract is to hedge currency positions to avoid losses in specific trades. In the example of the equipment contract discussed earlier, a company may acquire a forex hedge at a fixed rate of 1.1€/US$ at the point of sale. Hedging costs include transaction fees paid to third parties and adjustments to reflect the difference in interest rates between the two currencies. Hedging is usually available for up to 12 months, but some of the most important currency pairs can be hedged for more extended periods.
Forward contracts can be very effective. But only if the company has a solid working capital process. The security benefit is only visible if the transaction (customer receipt or payment to the supplier) occurred on the expected date. This requires close liaison between the collection department and the collection/invoicing team.
2. Currency options
Currency options give the company the right, but not the obligation, to buy and sell currency at a given exchange rate on or before a specific date. This is similar to a futures contract, but the company is not obligated to perform a trade when the contract is terminated. The investor will exercise the option and benefit from the contract if the option price is more favorable than the spot market price. If spot market interest rates were less favorable, investors would close the value in the spot market and allow the opportunity to conduct currency trades. This flexibility is not free, and companies must pay an option premium.
Good to know!
When the dollar weakens from €1.1 to €1.2, the company will exercise the option and avoid a $10,000 exchange rate loss (but still increase the $5,000 option).
In a scenario where the dollar price is €1.1 to €0.95, the company lets the option expire and maintains a $15,000 exchange rate return, resulting in a net profit of $10,000 after considering the option’s value.
In practice, the value of the option premium depends on the currency being traded and the option’s duration. Many companies think the cost is too unreasonable.
FAQ – The most asked questions about Currency risk protection:
Is currency risk protection important?
Yes, currency risk protection is essential. Due to the economic changes that take place constantly in the market, the currency of any economy must stay protected. It will offer the economy a competitive edge and a streamlined investment source. If the currency is unstable and fluctuates frequently, it can pose a risk for investors. Thus, currency risk protection is essential to promote investments in the long run.
What are some steps in currency risk protection?
If you are a forex trader, you might often expose yourself to currency risk. Thus, currency risk protection is essential to minimize forex trading losses. A few decisions can help a forex trader in currency risk protection. For instance, a forex trader can make it a priority to trade in his local currency. Trading in the local currency will minimize or make the losses minimal for any trader. Thus, it is a desirable step in currency risk protection.
Should a trader trade without considering currency risk protection?
No trader should think of trading without currency risk protection. After all, he can encounter significant losses if he moves forward without including some currency risk protection in his trading strategies. A trader can include currency risk hedging in his trading decisions to minimize the risks the currency fluctuations pose.
Last Updated on February 17, 2023 by Andre Witzel