Foreign Exchange Exposure

Overview

America Creations is a company based in America and has manufacturing companies across American states. The company specializes in complete home furnishes and interior designs for wealthy clients in the Caribbean, Miami, Los Angles, and other states. However, the company intends to expand its operations internationally, and Zircon cars plc will be advising them on whether to take the expansion project depending on the risk factors involved.

In this paper, we are going to look at the foreign exchange aspects or risks that a global firm dealing with foreign exchange can encounter. We will further examine how these risks and exposures can be mitigated, and finally, advise the company whether it can continue with the projects.

Introduction

Foreign exchange exposure is the risk that a company dealing with exchange transactions will incur. It is also the unexpected exchange rate that goes against an enterprise’s expectations that can be termed as a risk. Foreign currency can move to an unanticipated direction which is detrimental to the firm. Most global firms that deal with currency exchange are at high risks of losing their investments (Henry, 2003). However, the riskier the business, the more the returns. Global investments of American Creations projects will deal with interior design and furnishes for the wealthy across the world.

An exchange risk can be a gain or loss that will occur as a result of risk exchange occurrence. For example, the company could be trading at the Japanese Yen, but when the value of the Japanese yen falls, the overall value of the exchange rate will be a loss to the American Creations investment projects. The shareholders’ value of the currency is difficult to access, so, they use proxies instead to ascertain the value held by currency. However, an investor who has diversified his investments will have the losses incurred by one company offset by the gains in another investment. In the exchange market, a risk is not a risk if it is known or anticipated.

When the value of future cash flows is dependent on the exchange rate, the firm will experience a loss in its investments. For instance, when the American Creations Investments Company has its money held in the oil industry which is dependent on the exchange rate, a fall in the exchange rate will cause a loss to its investments. Such situations call for more measures in anticipation of the exposure effects because the movement of the exchange rate will affect the wealth of the American Creations investment projects (Henry, 2003).

Types of foreign exchange exposure

When expanding internationally to other markets, the firm is most likely to meet the following types of exposures in its daily businesses.

Transaction Risk

When the exchange rate changes from the date of the transaction to another subsequent time of the transaction, the risk involved is called transaction risk. From the risk the company can gain or lose from the currency conversion. Transaction risk mostly affects the people who deal with imports and exports. When the company imports or exports goods, it will have creditors and debtors in its list who are going to pay on specific dates in the future. However, the amount to be paid will depend on the value of the currency (Henry, 2003). Mostly, it will affect the cash flows of the company.  The level of exposure of the transaction will depend on the value of money involved or the hedge period set before the cash flows are expected.

Economic Risks

Economic Risks focusses on short exposure of currencies and cash flows and the long-term effects of the exchange value that will affect the value of the company. The firm can be affected directly or indirectly by the change in currency. For instance, if the company’s money becomes strong competitors will gain an advantage over the firm because the products have become cheaper both in the eyes of the competitors and also the customers at home. In such a scenario, the firm will be affected directly (Andersen, 2007). However, if the dollar strengthens against the New Zealand dollar, the company will lose because a competitor in Hong Kong will take advantage of the high price and sell at a relatively lower price. If the New Zealand dollar loses its value to the Hong Kong dollar, the firm will also lose it competitive position in the market. Either way, the firm has been affected indirectly. Subsequently, it is a challenge to quantify the exposure as a result of foreign exchange. However, such risks can be avoided if appropriate measures are taken.

Translational Risk

This risk is as a result of sending a financial statement to subsidiaries of the company overseas. The subsidiary company has to convert the currencies in the financial statement into their home currency. It is this translation that brings the disparities in the final income. If the country had experienced a major foreign exchange movement, the accounts would be distorted. If the translation will cause a fall in the company shares, it is hedged to prevent company losses (Henry, 2003). The gains or losses do not affect the company’s performance or its financial position. However, due to the translation, currencies will be lost in between the translations.

How Foreign Exchange Exposure Can Occur

As the American Creations Investment project kicks off, the company should bear in mind that risks can occur at any given time. The exposures expected can be caused by the following factors:

Differentials in Inflation

 A country that has a lower inflation rate will have a currency that is stronger than others, at the same time, the purchasing power of the country rises. Only a few countries have not had inflation affecting their currency. However, countries that have a high rate of inflation will experience a weakening currency against the stable currencies accompanied by soaring interest rates (Henry, 2003).

Interest Rates Difference

Interest rates are the core determinants of the level of inflation and the exchange rate of a country. They are all interconnected to each other. Central banks use interest rates to influence the exchange rate as well as the level of inflation. Higher interest rates will offer investors more returns. It will attract more capital, and the exchange rate will change positively. If the inflation rate is greater than other countries, the exchange rate will depreciate.

Current Account Deficits

            It is the difference in the balance of trade between its trading partners and the country. The current accounts reflect all the transactions between two countries. If a deficit occurs, it means that the country is spending more on foreign trade than it is getting back. The country will end up borrowing more capital to close the deficit which will translate to more foreign currency into the country than it would initially get via the sale of exports (Allayannis, 2001). This excess demand for the foreign currency will cause the currency to depreciate making the goods and services in a country cheap for foreigners but expensive for domestic purposes.

Public Debt

Governments tend to borrow a lot from foreign markets to finance the public sector projects as well as funding the government thus stimulating the economy to growth. However, countries with large public debts are not attractive for investments by foreign investors. Inflation will increase due to the massive debt, the debt will, however, be finally financed with cheap dollars in the future. If the debt is too much, governments will go an extra mile to print new currencies to pay the debt (Henry, 2003). Alternatively, if it is not able to meet the debt repayments by increasing the sale of bonds locally, it can enhance the amount of securities being sold to foreign investors. However, foreign investors will not buy the securities with a weak currency because the rate of defaults is high. The high public debt will result in the low exchange rate for the country.

Terms of Trade

            It can be defined as the ratio that compares and contrasts the terms of trade between import and export prices. They are related to the current accounts and balance of payments. If the imports of a country are more than the imports, then, it shows that the price of exports had relatively increased. It also indicates that there is a greater demand for the exports. In return, the foreign exchange rate of the country become favorable to foreign investors. The request for the country’s currency increases with the increase in revenue (Henry, 2003). Moreover, if the price of the imports rises by just a small margin, the currency value of the country will decline.

EconomicPerformance and Political Stability

The performance of the country is directly related to political stability. Foreign investors prefer countries that are stable politically and have dominant economic performance. Countries with such economies are said to draw investors from other countries to invest their capital. It translates to a stronger currency which is dependable (Rodrik, 2006).

If the American Creations Investment firm is not keen on looking at the above factors, the performance of the company will be affected. Whenever they trade, they should be careful and check the performance of various currencies. Loss due to foreign exchange is disastrous because it can lead to the closure of the company. Also, the company can be liquidated to settle the investments that have been injected into the corporation. The magnitude of the risk involved will also affect the company in different ways. It is the duty of the management to ensure that the magnitude of risk is well accessed before the company settles for any deal. Otherwise, the losses will be against the company’s assets or capital

Managing the Foreign Exchange Exposure

Hedging

One way is hedging of the funds that are prone to risk. By hedging, the firm is securing its capital against any losses. Hedging prevents the share prices of a company from falling to levels that are not manageable. Also, it guards the cash flows of the company against the effect of exchange risks (Henry, 2003).

Risk Shifting

            The best way of reducing a risk is by avoiding the risk that is eminent to the company’s transactions. For instance, a firm can invoice all transactions using its home currency to avoid translation risks. It is the best way to mitigate the risks involved. The company that will be impacted by the risk is the company that changes the transactions at the lowest cost.

Risk Sharing

It is an alternative preferred if the risk is too great to bear. The two parties that are involved decide on how to share the risk. Whether the risk will be in profits or losses, the two firms will have to share it. Splitting shields the latter company from losses that are detrimental to its cash flows. Such a contract should be precisely and clearly stated on how to share the risk.

Leading and Lagging

In this preventive measure, the company plays with the flow of losses and gains by timing the foreign currency movements. When the currency of a country is appreciating, the company will lay off its liabilities and collect the gains latter (Andersen,2002). It is a way of playing around with the currency prices by delaying to collect the receivables and later collect them at a profit.

Re-invoicing Centers

These are centers that manage all corporate subsidiaries of companies to minimize the amount of exposure one subsidiary may get from another during the intracompany trade. Transactions with affiliates are carried out in the affiliate’s local currency. By doing so, the center absorbs the exposure involved in the intercompany transactions.

Final advice

The company can expand internationally and target other wealthy clients in Europe and Asia. Besides, if the company is ready to handle the risks as a result of foreign exchange, and properly mitigate them, then, there is no need for the company to pull out of the projects. However, it will depend on how sharp the management is in realizing the risk even before they happen and act on them (Henry, 2003). They should also set policies that will govern how trading shall be done to reduce the risks involved. In fact, risk trading is the most profitable way of doing business because the returns are encouraging.

Reference

Henry, P.B. and Lorentzen, P.L., 2003. Domestic capital market reform and access to global finance: Making markets work (No. w10064). National Bureau of Economic Research.

Allayannis, G., and Ofek, E., 2001. Exchange rate exposure, hedging, and the use of foreign currency derivatives. Journal of international money and finance, 20(2), pp.273-296.

Andersen, T.G., Bollerslev, T., Diebold, F.X. and Vega, C., 2002. Micro effects of macro announcements: Real-time price discovery in foreign exchange (No. w8959). National bureau of economic research.

Rodrik, D., 2006. The social cost of foreign exchange reserves. International Economic Journal, 20(3), pp.253-266.

Andersen, T.G., Bollerslev, T., Diebold, F.X. and Vega, C., 2007. Real-time price discovery in global stock, bond, and foreign exchange markets. Journal of International Economics, 73(2), pp.251-277.