Currency risk

From CEOpedia | Management online

Business activity often poses a high risk. For enterprises that conduct settlements in foreign currencies, one of the many risks is the exchange rate risk. It mainly concerns importers, exporters, entities taking out loans in foreign currency or financing investments with such funds and international corporations. In order to understand the date of the exchange rate risk, it is necessary to start with the significance of the overall risk. Therefore, it is a situation in which the decision that has been taken is connected with the possibility of obtaining effects incompatible with our expectations. The risk is usually defined as the possibility of incurring a loss or lower profits or actions that may fail. The very notion of risk should not be confused with the concept of uncertainty. At risk, it is possible to estimate the probability of its occurrence, while with uncertainty we are dealing when it is not possible to estimate the probability of negative effects of a given event. Uncertainty is the lack of available information, and the risk can both be valued and calculated as a result of a financial effect.

Foreign exchange risk, also known as currency or exchange rate, can be defined as the possibility of a decrease in a given receivable or an increase in such receivables as a result of changes in exchange rates. The occurrence of exchange rate risk means that a given company that is settled in foreign currencies must face a different type of threat. The lack of a stable exchange rate level may affect the enterprise in various ways. Such fluctuations in the exchange rate have a significant impact on the revenues the exporter obtains from the sale of services and goods, the prices charged to the importer for purchasing goods on the international market or raw materials necessary for the production of the goods that are imported. Currency risk affects the possibility of smaller claims or larger liabilities. Foreign exchange risk is often associated with the cost of credit that enterprises are required to pay back. Differences in interest rates on loans denominated in zlotys and denominated in foreign currencies contributed to the fact that many enterprises use foreign currency loans.

Foreign exchange risk includes

  1. purchase and sale transactions of future periods
  2. items of a given balance sheet denominated in a foreign currency
  3. physical, actual purchases and sales of services and goods that have not yet been invoiced
  4. bills and payments in foreign currencies that appear when a commercial transaction is made

Exchange rate risk depending on the situation may occur in three forms; as economic, transactional and conversion risk. The most important of them are: conversion and transactional; the third type of risk, i.e. the economic exposure, also called strategic or competitive, depends on many factors, including the geographical location of competitors and the hedging strategies adopted by them. It is subject to quantification, which is why most companies decide to manage it.

In broad terms, economic risk is a measure of market sensitivity of a given entity to future exchange rate changes. The economic exposure arises in many ways, but each of them is related to the position of the company in relation to its competitors, it may be direct or indirect. Direct economic exposure occurs when the exporting company sets prices in a foreign currency, which is also the domestic currency of the enterprises with which it competes. Indirect exposure occurs when two or more companies from the same country compete against each other on the foreign market, or when a group of exporters from different countries compete for market shares in another country.

The economic exposure results therefore from many factors such as:

  • geographical location of the company branch,
  • the currency in which the enterprise incurs costs,
  • geographic location of competition,
  • relative exchange rate movements.

On the other hand, conversion risk can be defined as changes in the value of assets and liabilities expressed in a foreign currency after they are converted according to exchange rates from the balance sheet date. It often occurs during the consolidation of financial statements of branches of foreign enterprises, which requires the conversion of all balance sheet and profit and loss account items to the currency of the country in which the parent company is located. The exchange rate on the day the balance is created differs from the one at which the individual items were previously posted. The difference affects the carrying amount of the subsidiary expressed in the currency of the parent company's country, and thus the balance sheet total of the consolidated balance sheet of the capital company. It should be noted that the conversion exposure affects only the book value, does not affect the company's financial flows or its actual financial situation. The transactional risk associated with trade between participants of the international market has a definitely greater impact on the company's operations.

Transaction risk can be defined as a threat that the value of commercial transactions expressed in the domestic currency will change as a result of changes in exchange rates in the period between the conclusion of a transaction and the moment of conversion of a foreign currency into a domestic currency. They are exposed to companies exporting or importing services and goods that are active on international markets, carrying out not only commercial transactions but also investment and credit transactions in foreign currencies. Changes in rates can significantly reduce the profitability of the contract, affecting the deterioration of the company's financial results. In the case of the appreciation of the national currency in relation to the foreign currency, the exporter will incur a loss resulting from a reduction in the level of receivables converted into domestic currency; the situation is similar in the case of an importer whose domestic currency depreciates.

The main factors causing the creation of the exposure are not only the actual contracted receipts and payments, but also orders and offers, and thus transactions that will come about with a high degree of probability. Each enterprise should therefore apply an individual approach, securing its transactional exposure, taking into account its market position and the credibility of its contractors.

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