There are three main types of currency risk as detailed below.
The source of economic risk is the change in the competitive strength of imports and exports. For example, if a company is exporting (let’s say from the UK to a eurozone country) and the euro weakens from say €/£1.1 to €/£1.3 (getting more euros per pound sterling implies that the euro is less valuable, so weaker) any exports from the UK will be more expensive when priced in euros. So goods where the UK price is £100 will cost €130 instead of €110, making those goods less competitive in the European market.
Similarly, goods imported from Europe will be cheaper in sterling than they had been, so those goods will have become more competitive in the UK market.
The following approaches might be used to mitigate economic risk :
- Try to export or import from more than one currency zone and hope that the zones don’t all move together, or if they do, at least to the same extent.
- Make your goods in the country you sell them. Although raw materials might still be imported and affected by exchange rates, other expenses (such as wages) are in the local currency and not subject to exchange rate movements.
This affects companies with foreign subsidiaries. If the subsidiary is in a country whose currency weakens, the subsidiary’s assets will be less valuable in the consolidated accounts.
It does not affect its day-to-day cash flows. However, it would be important if the holding company wanted to sell the subsidiary and remit the proceeds. It also becomes important if the subsidiary pays dividends.
The following approach might be used to mitigate translation risk :
It can be partially overcome by funding the foreign subsidiary using a foreign loan.
For example , US subsidiary that has been set up by its holding company providing equity finance.
There are the following two cases.
Case 1: the subsidiary were set up using 100% equity
Its statement of financial position would look something like this:
If the US$ weakens then all the US$2m total assets become less valuable.
However, if the subsidiary were set up using 50% equity and 50% US$ borrowings, its statement of financial position would look like this:
This arises when a company is importing or exporting. If the exchange rate moves between agreeing the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or received will alter, making those future cash flows uncertain.
For example, in June a UK company agrees to sell an export to Australia for 100,000 Australian $ (A$), payable in three months. The exchange rate at the date of the contract is A$/£1.80 so the company is expecting to receive 100,000/1.8 = £55,556. If, however, the A$ weakened over the three months to become worth only A$/£2.00, then the amount received would be worth only £50,000. Of course, if the A$ strengthened over the three months, more than £55,556 would be received.