Magazine article Business Credit

Coping with Exhange Rate Risk

Magazine article Business Credit

Coping with Exhange Rate Risk

Article excerpt

The growth in international business has forced large and small businesses to access their exposure to exchange rate risk. Many large businesses have a division that measures exposure and makes hedging decisions. While small businesses generally do not devote as much attention to foreign exchange management, they are allocating more resources to insulate against exchange rate risk.

The first step in the management of exchange rate risk is to measure the exposure to exchange rates. If a firm's exposure is negligible, there is no reason to devote resources toward managing risk. Firms recognize their so-called transaction exposure, which reflects exposure resulting directly from foreign transactions, such as exporting or importing.

However firms are commonly exposed indirectly to exchange rate risk. For example, small companies that have no international business should be concerned about exchange rate risk because the pricing by their competitors may be influenced. First, foreign competitors that export to the U.S. tend to increase market share when the dollar strengthens, as the dollar prices on their products decline. Second, local competitors that purchase most of their supplies from foreign countries incur lower import costs when the dollar strengthens, allowing them to reduce prices and increase market share.

Exposure Degree Varies

The potential effects of a given degree of exposure vary with the foreign currency. For example, the Italian lire's value has been much more volatile than the Canadian dollar from a U.S. perspective. Thus, the possible dollar cash flows resulting from exposure in lire is much more uncertain than the possible dollar cash flows resulting from the equivalent exposure in Canadian dollars. U.S. firms would normally be much more concerned with hedging the exposure in lire because of the high volatility.

In some cases, the exposure of a U.S. firm to one currency can offset another, thereby reducing the net exposure. The most obvious example is a firm that has end-of-month payables in one European currency and end-of-month receivables worth the same dollar equivalent in another European currency. Since the currencies of industrialized European currencies move together (as they are linked through Europe's Exchange Rate Mechanism, ERM) any effects by the inflow (receivables) currency should be offset by opposite effects of the outflow (payables) currency.

Yet, firms must recognize that as currencies are revalued within the European Monetary System, their movements against the dollar are not as highly correlated as is normally expected, so that effects of inflow and outflow currencies may not be offsetting. Further more, since other currencies such as the Asian currencies and the Canadian dollar do not move in tandem, inflow and outflow currencies will not have offsetting effects.

Offsetting Exposure Is Vital

Once a firm recognizes its exposure to exchange rate risk, it can use the information in its cash budgeting projections. For example, if a U.S. firm is a heavy exporter of goods denominated in dollars, and does not have offsetting exposure, it is likely to be adversely affected by a stronger dollar. The firm may develop a separate set of monthly sales forecasts based on that possible scenario. Of course, this would have an effect on all other income statement items included in the cash budget. A precise estimate of the dollar's strength and of its impact on sales is nearly impossible. However, the firm can still benefit from preparing a schedule of forecasted cash balances if the dollar does strengthen by some amount.

Hedging Heads Off Potential Losses

A firm should also decide whether to hedge its exposure to exchange rate risk. It is easier to hedge transaction exposure than indirect exposure because the actual impact of exchange rate movements resulting from indirect exposure is uncertain. …

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