CURRENCY RISK
July 1st, 2009
So, what precisely is currency risk? There is no point in focusing on an issue if one cannot first define it. Although definitions vary within the academic community, a practical description of currency risk would be:
The impact that unexpected exchange rate changes have on the value of the corporation
Currency risk is very important to a corporation as it can have a major impact on its cash flows, assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation has accepted that currency risk needs to be managed specifically and separately, it has three initial priorities:
1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose
Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible gain or loss resulting from an exchange rate move. It can affect the value of a corporation directly as a result of an unhedged exposure or more indirectly.
Different types of currency risk can also offset each other. For instance, take a US citizen who owns stock in a German auto manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the face of it the individual sees the US dollar value of their holding decline. However, the German auto exporter should in fact benefit from a weaker Euro as this makes the company’s exports to the US cheaper, allowing them the choice of either maintaining US prices to maintain margin or cutting them further to boost market share. Sooner or later, the stock market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the currency translation, but gain on the higher stock price.
This is of course a very simple example and life unfortunately is rarely that simple. For just as a weaker Euro makes exports from the Euro-zone cheaper, so it makes imports more expensive. Thus, an exporter may not in fact feel the benefit of the currency translation through to market share because higher import prices force it to raise export prices from where they would otherwise would be according to the exchange rate.
The first step in successfully managing currency risk is to acknowledge that such risk actually
exists and that it has to be managed in the general interest of the corporation and the corporation’s shareholders. For some, this is of itself a difficult hurdle as there is still major reluctance within corporate management to undertake what they see as straying from their core, underlying business into the speculative world of currency markets. The truth however is that the corporation is a participant in the currency market whether it likes it or not; if it has foreign currency-denominated exposure, that exposure should be managed. To do anything else is irresponsible. The general trend within the corporate world has however been in favour of recognizing the existence of and the need to manage currency risk. That recognition does not of itself entail speculation. Indeed, at its best, prudent currency hedging can be defined as the elimination of speculation:
The real speculation is in fact not managing currency risk
The next step, however, is slightly more complex and that is to identify the nature and extent of the currency risk or exposure. It should be noted that the emphasis here is for the most part on non-financial corporations, on manufacturers and service providers rather than on banks or other types of financial institutions. Non-financial corporations generally have only a small amount of their total assets in the form of receivables and other types of transaction. Most of their assets are made up of inventory, buildings, equipment and other forms of tangible “real” assets. In order to measure the effect of exchange rate moves on a corporation, one first has to define the type and then the amount of risk involved, or the “value at risk” (VaR). There are three main types of currency risk that a multinational corporation is exposed to and has to manage.
Filed under: Risk