Currency risks normally are the result of supply and demand mechanism for different currencies. The market can be driven by trading and speculative factors. Moreover, inflation and interest rates can also play a key role in currency demand and supply dynamics.
JohnathanLevel 1
What are the currency risks and how to manage them?
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Arlie Bosco
There are three main currency risks.
Translation Risk
You own assets or owe liabilities in a currency other than your reporting currency. Changes in exchange rates will affect your balance sheet.
Example: A company in the UK put €1,000 in a German bank account. If £1= €1.17 then that amount is more valuable than if £1 = €2. But if the company is keeping the money in the German bank, or using it to pay a € liability, it doesn’t matter.
Transaction Risk
You buy or sell in a currency other than your reporting currency. So, you may be taking a risk that the exchange rate will go against you during the transaction.
A company in the UK sells goods to a German customer for €1,000 when the exchange rate is £1=€1.17. That is worth £855. By the time the company pay, the exchange rate reaches £1 = €2. In that case, the company in the UK will receive £500.
Economic Risk
You are producing in a region where the currency changes mean that your prices are not competitive against your competition.
A company in the UK produces locally and then export it to Germany. But at the same time, it competes against the US companies selling to Germany. If the US $ falls more than the £, the German customers would prefer to buy in US $.
Managing currency risks:
Forward contract
One option is to locks in the exchange rate. In that case, the company would not benefit if the rate rises, but it would not lose if it gets worse.
A Futures contract is an exchange-traded, standardised forward contract. It is conducted through a clearinghouse instead by the parties directly. In this case, the default risk is minimised.
Example: If a company in the UK has sold goods to the value of €1,000, receivable in 90 days’ time. It enters a forward contract to sell €1,000 to a bank in 90 days’ time and meets that contract with the money it receives from the customer.
Currency option
It gives the right, but not the obligation, to exercise the option when it falls due. So if rates go in the company favour, the company would benefit, but if the rate goes against the company, the company would be protected.