Foreign-Exchange Risk

When investing in foreign countries you must consider the fact

that currency exchange rates can change the price of the asset as
well. Foreign-exchange risk applies to all financial instruments
that are in a currency other than your domestic currency. As an
example, if you are a resident of America and invest in some
Canadian stock in Canadian dollars, even if the share value
appreciates, you may lose money if the Canadian dollar
depreciates in relation to the American dollar.

This risk usually affects businesses that export and/or import, but
it can also affect investors making international investments. For
example, if money must be converted to another currency to
make a certain investment, then any changes in the currency
exchange rate will cause that investment's value to either
decrease or increase when the investment is sold and converted
back into the original currency.

Exchange Rate System

US Dollar, Yen, Pound, Euro float against each other, however,

only a minority of currencies use this system. Other systems
include:

Fixed Exchange Rates

This involves publishing the target parity against a single

currency or a basket of currencies and a commitment to use
monetary policy (interest rates) and official reserves of foreign
exchange to hold the actual spot rate within some trading band
around this target.

Fixed against a single currency:

This is where a country fixes its exchange against the currency of

another country’s currency. More then 50 countries fix their rates
in this way, mostly against the US Dollar. Fixed rates are not
permanently fixed and periodic revaluations and devaluations
occur when the economic fundamentals of the country concerned
strongly diverge (e.g., inflation rates)

Fixed against a basket of currencies:

Using a basket of currencies is aimed at fixing the exchange rate

against more stable currency base then would occur witha a
single currency fix. The basket is often devised to reflect the
major trading links of the country concerned.

Freely Floating Exchange rates

Also called the clean float. A genuine free float would involve
leaving exchange rates entirely to the vagaries of supply and
demand on the foreign exchange markets and neither intervening
in the market using official reserves of foreign exchange not
taking exchange rates into account when making interest rate
decisions.
Managed Floating Exchange Rates (also called dirty float)

The central bank of countries using a managed float will attempt

to keep currency relationships within a predetermined range of
values (not usually publically announced) and will often intervene
in the foreign exchange markets by buying or selling their
currency to remain within the range.

Reasons for Currency Risk

Changes in exchange rates result from changes in the demand for

and supply of the currency. These changes may occur for a
variety of reasons e.g., due to changes in international trade or
capital flows between economies.

Since currencies are required to finance international trade,

changes in trade may lead to changes in exchange rates. In
principle:

• Demand for imports in the US represents a demand for

foreign currency or a supply of dollars.

• Overseas demand for US exports represents a demand for

dollars or a supply of the currency.

The a country with a current account deficit where improts

exceed exports may expect to see its exchange rate depreciate,
since the supply of the currency (imports) will exceed the demand
for the currency (exports).
Purchasing Power Parity Theory

See separate sheet.

Interest Rate Parity Theory

See separate Sheet.

Types of Currency Risk

Since firms regularly trade with firms operating in countries with

different currencies and may operate internationally themselves,
it is essential to understand the impact that foreign exchange rate
changes can have on the business.

Transaction Risk

The risk of an exchange rate changing between the transaction

date and the subsequent settlement date i.e., it is the gain or loss
arising on conversion.

Arises primarily on imports and exports.

See example on separate sheet.

Economic Risk
The variation in the value of the business (i.e., the present value
of future cash flows) due to unexpected changes in exchange
rates. It is the long term version of transaction risk.

For an export company it could occur because:

• The home currency strengthens against the currency in

which it trades

• A competitor’s home currency weakens against the currency

in which it trades

See example on separate sheet.

Translation Risk

Where the expected performance of an overseas subsidiary in

home based currency terms is distorted in consolidated financial
statements because of a change in exchange rates.

This is an accounting risk rather than a cash based one. ONLY on

paper.

See example on separate paper

Managing Foreign Currency Risk

Taking measures to eliminate or reduce a risk is called Hedging

the risk or hedging the exposure.

Practical Approaches
See separate sheet

Trading in Currencies

The foreign exchange market

The Spot Market

The Forward Market

Hedging with forwards

Money Market Hedge

Hedging a Payment

Hedging a Receipt