When a company has cash flows that are denominated in a foreign currency, it becomes exposed to foreign exchange risk, or in other words, has foreign exchange exposure. Foreign exchange exposure can also arise when a firm has assets denominated in a foreign currency, because the value of those assets will fluctuate with the exchange rate.
Currencies have always changed value against one another. Even at the time of the gold standard, currencies rose and fell, though by much less than today (the gold supply changed from time to time, and countries often decreased the amount of gold a paper currency was worth).
However, it wasn't until 1970s that many countries, as a result of the collapse of the Bretton Woods system, switched to floating exchange rates. In a floating exchange rate system, the exchange rate is determined by supply and demand. A government interferes in the foreign exchange market only in exceptional situations, such as to stem a speculative attack on its currency.
Floating exchange rates can be very unstable. In periods of high volatility in the financial markets, currency fluctuations are especially profound, with one currency rising or falling by as much as 10 percent or more against another.
Even pegged currencies (those that have a fixed exchange rate against another currency) pose exchange rate risk since the peg can come under severe pressure as money is quickly withdrawn from a country because of a financial crisis.
A number of factors influence foreign exchange risk, They include political and social instability (wars, revolutions, street riots), demographics, economic growth, fiscal policies (taxes and tax breaks) and especially monetary policies (interest rates).
The policies of central banks are probably of greatest importance, however. It is the central bank of a country that is responsible for foreign exchange market interventions, keeping price stability and ensuring the smooth functioning of the foreign exchange system.
The more cash flows a company has denominated in a foreign currency, the greater its foreign exchange exposure is, especially if the exchange rates of the currencies in question are not correlated--that is, if they do not move together (such as the euro and the Swiss frank).
To calculate its foreign exchange exposure, a company needs to measure how much money it would lose if foreign exchange rates that it has cash flows or assets denominated in moved unfavorably.
The best strategy to reduce foreign exchange exposure is to link a firm's inward and outward cash flows denominated in a foreign currency. That is, a firm can denominate its costs and revenues in the same currency, so if revenues fall because of currency depreciation, the costs will fall as well.
Firms can also mitigate their exchange rate risk by hedging--giving up a possible gain in exchange for reduced risk. A firm can go into long-term currency exchange contracts, widely known as futures, that will allow it to get a specified amount of foreign currency at a certain price at a certain time in the future. Or it can buy the needed amount of foreign currency long before it will be used.
- exchange fluctuations image by Raimundas from Fotolia.com