Foreign exchange risks

Transaction risk

Transaction risk is the risk that an exchange rate moves unfavourably between the date you agree to a transaction and the date you actually pay (or receive) the money.

For example:

• If you’re based in South Africa and you agree to buy goods from a retailer such as Amazon, with payment due in six months, the ZAR/$ exchange rate could move against you before the payment date. That would make the goods cost more in your domestic currency than you expected.
• If you’re paying your CIMA subscription fees in British pounds, you might convert the amount today to estimate how much you need to save. If the exchange rate changes before you pay, you may end up paying more (or less) than your original estimate.

Hedging tools are available to deal with transaction risk

Several hedging tools can reduce (or manage) transaction risk.

Forward exchange rate agreement

A forward exchange rate agreement is a legally binding contract between two parties in different countries (using different currencies). It fixes an exchange rate today for a currency exchange that will take place on a specified future date.

A key point is that a forward contract is not flexible:

• If the exchange rate moves in your favour, you still must use the pre-agreed forward rate.
• If the exchange rate moves against you, the forward rate protects you from that adverse movement.

Because a forward contract removes both downside risk and upside potential, it’s most suitable when forecasts suggest the exchange rate is likely to move adversely.

Futures

Futures contracts have similar hedging characteristics to forward contracts, but they are standardised (fixed contract sizes and terms). They can also be traded (bought and sold) in the money market, which was introduced in the previous chapter.

These will be explored in more detail in F3 at strategic level.

Currency options

Currency options are more flexible than forwards and futures. They give the holder the right, but not the obligation, to exchange currencies at a pre-agreed rate.

This flexibility means:

• If the exchange rate moves against you, you can use the option rate to limit your loss.
• If the exchange rate moves in your favour, you can choose not to exercise the option and benefit from the favourable market rate.

Options are typically more expensive than forwards because they protect against downside risk while still allowing upside potential. They’re often used when it’s unclear whether the exchange rate will move favourably or unfavourably, and the organisation wants protection in either case.

Economic risk

Economic risk is the risk of unfavourable exchange rate movements caused by longer-term economic or cyclical factors (as discussed in chapter 3). These factors include inflation, recession, and other macroeconomic conditions.

Economic risk is usually long term. For example, if the British pound remains strong relative to other currencies over time, exports priced in pounds may be consistently expensive for overseas customers.

Dealing with economic risk

Economic risk can’t usually be removed using the same short-term hedging tools used for transaction risk, because it reflects long-term currency movements.

Instead, organisations often respond by changing how and where they operate. For example:

• A company may open a factory or warehouse in the country where it sells its products, so it can price in the local currency and reduce exposure to exchange rate movements.
• If domestic production costs rise because imported inputs become more expensive, the company may relocate some manufacturing to a country where production is cheaper.

At the time these notes were written, Amazon was working on opening a warehouse in South Africa and pricing products in the local currency. This helps reduce the impact of long-term currency differences between its home currency (the $US) and the ZAR.

Translation risk

Translation risk arises when a company converts (translates) the financial statements of overseas operations into the reporting currency at the reporting date. The value of overseas assets and liabilities can change purely because exchange rates have moved.

Some economists argue this is not a “real” risk because:

• The movements are accounting gains or losses on translation dates.
• They are not realised gains or losses unless the assets are actually sold.

However, translation movements can still matter in practice. They may affect:

• gearing levels
• the company’s risk profile
• key financial ratios

So organisations can’t always ignore translation risk. Hedging techniques such as currency swaps may be used, and this will be explored further in F3 at strategic level.