In a global economy, foreign exchange (FX) exposure is something many businesses face, regardless of their size. From a multinational corporation with millions in assets in 12 countries to a website owner selling t-shirts and coffee mugs from his basement, any time you make a transaction in a different country, you expose yourself to some risk due to shifting currency values.
TL;DR (Too Long; Didn't Read)
Foreign exchange exposure is the financial risk that is associated with changes in foreign exchange rates, typically when a company makes transactions, holds assets or has debts in another country's currency rather than its own country's.
The Basics of Foreign Exchange
Exchange rates are the value of a foreign currency compared to your domestic currency. For example, a Canadian dollar may be worth 0.75 American dollars, or expressed as 1 $CAN = 0.75 $US. If you exchanged $100 CAN, you would get $75 in U.S. funds.
The value of one currency compared to another can appreciate or depreciate. A depreciated currency is one that becomes less valuable and therefore less expensive to buy. An appreciated currency is one that becomes more valuable and costs more to buy.
For example, if the Canadian dollar depreciated by one cent tomorrow, you would only get back 74 cents per dollar, compared to the 75 cents you would have gotten today. If it appreciated by one cent, you would get back 73 cents per Canadian dollar.
The Meaning of Foreign Exchange Exposure
Imagine someone gave you a check for $10,000 in Canadian dollars. For as long as you hold that check, you are at risk of foreign exchange fluctuations. Suppose the exchange rate was exceptionally volatile this week and the Canadian dollar compared to the American dollar began to slide before rising at the end of the week. The amount of money you would get would depend on which day you exchanged it.
- Monday: $7,500 (even)
- Tuesday: $7,400 ($100 loss)
- Wednesday $7,300 ($200 loss)
- Thursday $7,450 ($250 loss)
- Friday $7,550 ($50 gain)
This is, of course, a simple example and the Canadian/U.S. dollar exchange rate does not really fluctuate this much, but it should demonstrate the risk — and potential gains — involved when you deal with foreign currencies.
There are two types of foreign exchange exposure. Transaction exposure, like the one above, and translation exposure.
Identifying FX Transaction Exposure
Transaction exposure arises when a company sends or receives payments in a foreign currency on a different day than when it is processed. This is a common risk for companies that export or import products and either make payments or receive payments in a foreign currency.
The level of risk depends on three factors: the amount of money being transferred, the length of time that your cash flow is affected and the exchange rate fluctuations during that time period. A $10 purchase from a customer using a credit card would represent very little risk, whereas a $100,000 purchase using a wire transfer would represent much more risk.
It's not uncommon for a wire transfer to take several days to be processed. During that time, if the vendor is waiting for the deposit before shipping, the customer is without either the goods or the money. Likewise, if the vendor shipped the goods immediately, the vendor is without the money, which could be problematic if their funds are already low. During that time, of course, the currency exchange rates could go up or down.
Identifying FX Translation Exposure
This risk arises if your company has assets in a different currency and you need to translate them for accounting and reporting purposes. Any changes in the exchange rate can affect the value of these assets and must be reported.
Under GAAP (Generally Accepted Accounting Practices), when this translation is calculated depends on whether one currency is deemed to be highly-inflationary or not. There are specific criteria for making this determination.
If neither currencies are highly-inflationary, a change from a foreign currency to your currency is translated at the end of the previous accounting period. Otherwise, changing from your currency to any foreign currency, or changing to a high inflation currency to your own, is accounted for prospectively from the date of the actual change.
Measurement of Foreign Exchange Exposure
Value-At-Risk (VAR) is perhaps the most common way companies measure how they may lose or gain money under normal currency market conditions over a specific period of time. It applies to assets or investments that are valued in foreign currencies and helps to determine the potential loss in market value during a specific period based on a confidence interval.
VAR is usually used for liquid assets over short periods of time, based on possible exchange changes during that period. For example, a VAR model might analyze the variability in exchange rates over a period of 10 days. Additional metrics for measuring exposure risk are:
Cash-Flow-At-Risk (CFAR) estimates how your future cash flows will be affected by foreign exchange changes in a set period of time.
Earnings-At-Risk (EAR) estimates how income can change over a specific period of time due to changes in FX rates.
Profit-At-Risk (PAR) estimates a potential fall in future profits based on FX rate changes.
Currency Risks in Emerging Markets
Emerging markets can represent a great opportunity for companies, as well as a great deal of risk, especially when currency exchange rates are concerned. It may be tempting to treat all emerging markets as the same amount of risk, however, this would be a mistake.
In 2018, Nomura, an Asia-based financial services group with a global network in over 30 countries, made headlines when it launched Damocles, a statistical analysis tool for assessing foreign exchange risk in emerging markets. Damocles, said the company, had predicted 67% of the past 54 emerging market exchange rate crises since 1996.
In September 2018, Damocles identified six countries at risk of an exchange rate crisis, with scores above 100. Two of those countries were already in the midst of a crisis that month, while one country experienced a crisis the following month and four turned to the International Monetary Fund (IMF) for assistance. However, 14 other countries had scores between 17 and 62, representing much less risk, and the remaining eight countries analyzed scored zero, representing almost no currency exchange risk at all as emerging markets.
Foreign Currency Management for Small Businesses
If you own a small business with transactions in foreign countries, there are two easy ways to manage your exposure to risk without it becoming a full-time job.
The first way is to simply pass the cost of foreign exchange on to your customers by adding a small markup to your prices. If this markup is minimal and you offer superior products or services compared to what local companies offer, an increase in price may not affect your sales. In a competitive market, however, this could backfire with a loss in sales.
A second way is to accept payment only in U.S. dollars. This is a huge benefit for businesses located in the United States, as the U.S. dollar is highly regarded and is usually used as the basis of comparison for other currencies. This is particularly popular in e-commerce transactions, where a customer's credit card automatically makes the currency exchange for the customer at the time of purchase, paying the vendor in American money. You can make the process easier by informing the customer what the current exchange rate is.
If you are buying products from other countries, you can also negotiate with them to pay only in U.S. currency. It's likely that the supplier will charge a small fee for this to reduce their risk of changes in exchange rates, but it will give you one less thing to worry about if the currency markets do shift overnight.
- Cambridge FX: What Are the Main FX Risk Types and FX Risk Metrics Used to Measure Them?
- Nomura: Damocles Update: Who Is at Risk?
- Deloitte: A Roadmap to Foreign Currency Transactions and Translations 2018
- Risk.net: Other Alternatives to VAR
- Investopedia: Spot Rate
- Investopedia: Forex Algorithmic Trading: Understanding the Basics
- Nomura: Damocles: Our Early Warning Indicator of Exchange Rate Crises
- EML UC Berkeley: Exchange Rates and the Foreign Exchange Market: An Asset Approach
- Magnetic Trading: How to Manage Currency Risk in a Small Business