Foreign Exchange Risk And International Business Finance Essay

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The first things come to the mind when we read the word foreign exchange is, it must be related to international business. And in a way it is true. When companies or individuals get themselves into such activity that involves cash flow in different currencies, the value relationship between those currencies becomes important. This relation is known as foreign exchange rate.

The rate at which currencies can be exchanged today (in real time) is known as spot rate of exchange.

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The rate on which agreed today, but exchange happens in future is referred as forward rate of exchange.

The table below goes sample spot and forward exchange rates as of November 7, 2000 4


Exchange Rates as of November 7, 2000

(Quoted as Currency per U S Dollar)





British Pound





French Franc





German Mark





Japanese Yen





Thus, a company wanting to convert 10,000,000 French francs into U.S. dollars on a spot basis

would receive,

FFI0, 000,000- 7 6225FF/$ = $1,311,905 54

Exchanging in the other direction, a company wanting to convert $5,000,000 to British pounds

on a spot basis would generate

$5,000,000 x 0 6972 £/$ = £3,486,000

(Both of these examples ignore any transactions fees or other "expenses." The use of forward

rates would be illustrated later)

Types of Exchange Rate Risks

Forex trading has attracted a lot of attention, and many people try their luck trading currencies for profit.

Exchange Rate Risk

The most widely appreciated risk associated with the foreign exchange market is the risk that an exchange rate will rise or fall unexpectedly.

Interest Rate Risk

Interest rate risk refers to the uncertainty associated with the interest rates of assets denominated in different currencies. Investors buy currencies with higher interest rates and sell currencies with lower rates, pursuing higher yields. Interest rates largely depend on the central bank’s short-term interest rates, which commercial banks use as a benchmark for setting their own rates.

Settlement Risk

Another risk in the foreign exchange market is the settlement risk–a risk that your counterparty or broker will not be able to honor his contractual commitments on agreed currency transactions.

Sovereign Risk

Sovereign risk refers to the risks associated with political, legal or other uncertainties associated with a cross-border foreign exchange transaction.

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The level of FX risk has increased significantly in last few decades. Specifically with regard to foreign exchange rates, the breakdown of the Bretton Woods Agreement s in the early 1970s led to a more volatile environment m which different currencies often fluctuate – sometimes significantly – relate to one another Combined with increased volatility m other financial variables.

Exposure to foreign exchange risk can take several different forms.

Transaction exposure arises from transactions involving future cash flows which are

denominated in a currency different felon the "home" currency This type of risk occurs

when the relevant exchange rate changes between the dates a transaction agreement ts entered

into and the date the transaction is financially consummated.

Examples of such exposures might include:

The purchase and financing of assets m another currency A classic example (mentioned m both Smithson (1998) and Campbell and Krakaw (1993)) revolves the now-defunct Laker Alrhnes In the late 1970s, the U S dollar was weak relative to the British pound, and thus there was significant demand among the British for vacations in the U S In response to this demand, Laker Airline purchased several additional planes, financing them m U S dollars When, m the next few years, the dollar strengthened relative to the pound, Laker Airline had a double problem

(1) Its revenues were in pounds and its debt largely in dollars (a mismatch which, because of the strengthened dollar, affected the company adversely), and

(2) The demand for U S vacations among the British fell (due to the no longer favorable exchange rate) The first problem resulted from a transaction exposure, the second resulted from an operating exposure Laker Airlines went bankrupt in 1982.

Translation exposure an accounting-based exposure resulting from a company has to convert asset and/or hardly ~terms from one currency to another for financial statement purposes.

This can occur, for example, when a U K parent company must restate the (foreign-denominated) assets and liabilities of a foreign subsidiary in U S dollars for the Parent’s financial statements. The degree of this risk depends upon the specific accounting rules pertaining to the exchange rate movements and the financial ~terms involved.

Operating exposure an exposure associated with the potential impact of changes in exchange rates on the future cash flows of the company. This can also be referred to as economics exposure, since the economic value of a company’s a function of the firm’s future cash flows the above-mentioned second problem experienced by Laker Airlines – the change m demand for vacations and the resulting diminished revenue stream due to the strengthened dollar’s an example of this type of exposure.

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