BRYAN B.

VILORIA

Foreign Exchange Risk

In the present era of increasing globalization and heightened currency volatility, changes in exchange
rates have a substantial influence on companies’ operations and profitability. Exchange rate volatility
affects not just multinationals and large corporations, but it also affects small and medium-sized
enterprises, including those who only operate in their home country. While understanding and managing
exchange rate risk is a subject of obvious importance to business owners, investors should also be familiar
with it because of the huge impact it can have on their holdings.
Foreign exchange risk refers to the losses that an international financial transaction may incur due to
currency fluctuations. Also known as currency risk, FX risk and exchange-rate risk, it describes the
possibility that an investment’s value may decrease due to changes in the relative value of the involved
currencies.
Foreign exchange risk arises when a company engages in financial transactions denominated in a
currency other than the currency where that company is based. Any appreciation/depreciation of the base
currency or the depreciation/appreciation of the denominated currency will affect the cash flows
emanating from that transaction. Foreign exchange risk can also affect investors, who trade in
international markets, and businesses engaged in the import/export of products or services to multiple
countries.
The proceeds of a closed trade, whether it is a profit or loss, will be denominated in the foreign currency
and will need to be converted back to the investor's base currency. Fluctuations in the exchange rate could
adversely affect this conversion resulting in a lower than expected amount.
An import/export business exposes itself to foreign exchange risk by having account payables and
receivables affected by currency exchange rates. This risk originates when a contract between two parties
specifies exact prices for goods or services, as well as delivery dates. If a currency’s value fluctuates
between when the contract is signed and the delivery date, it could cause a loss for one of the parties.
There are three types of foreign exchange risk:
1. Transaction risk (Transaction exposure): This is the risk that a company faces when it is
buying a product from a company located in another country. The price of the product will be
denominated in the selling company's currency. If the selling company's currency were to
appreciate versus the buying company's currency then the company doing the buying will have to
make a larger payment in its base currency to meet the contracted price.
Example: Company A, based in Canada, recently entered into an agreement to purchase 10
advanced pieces of machinery from Company B, which is based in Europe. The price per
machinery is €10,000, and the exchange rate between the euro (€) and the Canadian dollar ($) is
1:1. A week later, when Company A commits to purchasing the 10 pieces of machinery, the
exchange rate between the euro and Canadian dollar changes to 1:1.2
2. Translation risk (Translation exposure): A parent company owning a subsidiary in another
country could face losses when the subsidiary's financial statements, which will be denominated
in that country's currency, have to be translated back to the parent company's currency.
Example: Company A, based in Canada, reports its financial statements in Canadian dollars but
conducts business in U.S. dollars. In other words, the company makes financial transactions in
 United States dollars but reports in Canadian dollars. The exchange rate between the Canadian
dollar and the US dollar was 1:1 when the company reported its Q1 financial results. However, it
is now 1:1.2 when the company reported its Q2 financial results.
3. Economic risk: Also called forecast risk, refers to when a company’s market value is
continuously impacted by an unavoidable exposure to currency fluctuations.
Currency Risk Mitigation Strategies
Whenever corporates are trading in multiple currencies, there will inevitably be an acute risk their
profitability and performance will shift wildly as a direct result of unstable exchange rates. These so-
called ‘flash crashes’ are happening more frequently, and they’ve added a fresh injection of volatility into
foreign exchange that nobody wants to see. Overnight exchange fluctuations have the power to drastically
increase a company’s cost of capital expenditure and decrease its market value, which is why forex
hedging is absolutely vital to the success of all corporates trading in multiple currencies or working with
complex supply chains that transcend borders.
Hedging is a process by which corporates buy or sell financial products in order to protect their positions
from adverse movements in one or more currency pairs. This typically means utilizing multiple tools to
offset or balance a current trading position with a view to lower a company’s overall risk of exposure. Yet
it is worth pointing out there are quite a few different hedging strategies treasury professionals can deploy
to protect their respective organizations from big currency shifts – and each strategy comes hand-in-hand
with its own set of pros and cons.
Companies that are subject to FX risk can implement hedging strategies to mitigate that risk. This usually
involves forward contracts, options, and other exotic financial products and, if done properly, can protect
the company from unwanted foreign exchange moves.
Hedging Tools and Techniques
1. Forward Contracts. Forward contracts involve an agreement between two parties to buy/sell a
specific quantity of an underlying asset at a fixed price on a specified date in the future. In other
words, Forward contracts are those where counterparty agrees to exchange a specified quantity of
an asset at a future date for a price agreed today. These are the most commonly used foreign
exchange risk management tools. The corporations can enter into forward contracts for the
foreign currencies which it need for payment or which it will receive in future. Since the rate of
exchange is already fixed for the future transaction, there will be no variability in the cash flows.
Hence, changes that take place between the contract date and the actual transaction date does not
make any impact. This will eliminate the foreign exchange exposure. The future settlement date
can be an exact date or any time between two agreed dates. Because future contracts are private
agreements, there is a high counterparty risk. This means there may be a chance that one party
will default.

2. Currency Futures. Currency futures contract involves a standardized contract between two parties
to buy/sell an amount of currency at a fixed price on a specified date in the future and are traded
on organized exchanges. Futures contracts are more liquid than forward contracts as they are
traded in an organized exchange. A depreciation of currency can be hedged by selling futures and
currency appreciations can be hedged by buying futures. Thus, inflow and outflow of different
currencies with respect to each other can be fixed by selling and buying currency futures,
eliminating the Foreign Exchange Exposure.
 3. Currency Options. Currency options are contracts which provides the holder the right to buy or
sell a specified amount of currency for a specified price over a given time period. Currency
options give the owner of the agreement the right to buy or sell but not an obligation. The owner
of the agreement has a choice whether to use or not to use the option based on the exchange rates.
He/she can choose to sell or buy the currency or let the option lapse. The writer of the option gets
a price for granting this option. The price payable is known as premium. The fixed price at which
the owner can sell or buy the currency is called as strike price or the exercise price. Options
giving the holder a right to buy are called call options and Options giving the holder a right to sell
is called put options. It is possible to take advantage of the potential gains through currency
options. For example, if a Philippine business firm has to purchase capital goods from the USA in
US$ after three months, the company should buy a currency call option. There are two
possibilities. First, if the dollar depreciates, then the exchange rates will be favorable as spot rate
will be less than the strike price and the company can buy the US$ at the prevailing spot rate, as it
will cost less. Second, if the dollar appreciates, then the exchange rates will be unfavorable as
spot rate will be more than the strike price and the company can opt to use its right and buy the
US$ at the strike price. Hence, in both the cases the company will be paying the less to buy the
dollar to pay for the goods.

4. Currency Swaps. A currency swap involves an agreement between two parties to exchange a
series of cash flows in one currency for a series of cash flows in another currency, at agreed
intervals over an agreed period. This is done to convert a liability in one currency to some other
currency. Its purpose is to raise funds denominated in other currency. One party holding one
currency swaps it for another currency held by other party. Each party would pay the interest for
the exchanged currency at regular interval of time during the term of the loan. At maturity or at
the termination of the loan period each party would reexchange the principal amount in two
currencies.

5. Foreign Debt. Foreign debts are an effective way to hedge the foreign exchange exposure. This is
supported by the International Fischer Effect relationship. For example, a company is expected to
receive a fixed amount of Euros at a future date. There is a possibility that the company can
experience loss if the domestic currency appreciates against the Euros. To hedge this, company
can take a loan in Euros for the same time period and convert the foreign currency into domestic
currency at the spot exchange rate. And when the company receives Euros, it can pay off its loan
in Euros. Hence the company can completely eliminate its foreign exchange exposure.

6. Cross Hedging. Cross Hedging means taking opposing position in two positively correlated
currencies. It can be used when hedging of a particular foreign currency is not possible. Even
though hedging is done in a different currency, the effects would remain the same and hence
cross hedging is an important technique that can be used by companies.

7. Currency Diversification. Currency Diversification means investing in securities denominated in

different currencies. Diversification reduces the risk even if currencies are non-correlated. It will
give the company global exposure, minimize foreign exchange exposure and capitalize on
exchange rate disparities.

Internal Techniques
 1. Netting. Netting implies offsetting exposures in one currency with exposure in the same or
another currency, where exchange rates are expected to move high in such a way that losses or
gains on the first exposed position should be offset by gains or losses on the second currency
exposure. It is of two types of bilateral netting & multilateral netting. In bilateral netting, each
pair of subsidiaries nets out their own positions with each other. Flows are reduced by the lower
of each company’s purchases from or sales to its netting partner.

2. Matching. Matching refers to the process in which a company matches its currency inflows with
its currency outflows with respect to amount and timing. When a company has receipts and
payments in same foreign currency due at same time, it can simply match them against each
other. Hedging is required for unmatched portion of foreign currency cash flows. This kind of
operation is referred to as natural matching. Parallel matching is another possibility. When gains
in one foreign currency are expected to be offset by losses in another, if the movements in two
currencies are parallel is called parallel matching.

3. Leading and Lagging. These involve adjusting the timing of the payment or receivables. Leading
is accelerating payment of strengthening currencies and speeding up the receipt of weakening
currencies. Lagging is delaying payment of weakening currencies and postponing receipt of
strengthening currencies. In these the payable or receivable of the foreign currency is postponed
in order to benefit from the movements in exchange rates.

4. Pricing Policy. There can be two types of pricing tactics: price variation and currency of
invoicing policy. Price variation can be done as increasing selling prices to offset the adverse
effects of exchange rate fluctuations. However, it may affect the sales volume. So proper analysis
should be done regarding customer loyalty, market position, competitive position before
increasing price. Secondly, foreign customers can be insisted to pay in home currency and paying
all imports in home currency.
Governing authorities and regulations
RA 8799 or the Securities Regulation Code is the law that governs the use of financial securities in the
Philippines. Under the code, the Securities and Exchange Commission (SEC) is the body that will enforce
the law and shall have the powers and functions provided by it. The powers of the SEC are as follows: to
formulate policies and recommendations on issues concerning the securities market, advice Congress and
other government agencies on the securities market, and propose legislation; prepare, approve, amend or
repeal rules, regulations and orders, and issue opinions and provide guidance and supervision on the
compliance of such rules, regulations and orders; and impose sanctions for the violation of the same.
The Implementing Rules and Regulations of the Securities Regulation Code make specific mention of
derivatives with regard to the registration of securities for public offerings and for brokers engaging in
derivatives trading. However, the Philippines currently has no trading platform for derivatives and most
derivative transactions involve OTC derivatives offered by banks and embedded derivatives. Since banks
are most often the counterparties of derivatives, regulation has mostly been done by the Bangko Sentral
ng Pilipinas (BSP).
The BSP regulates the financial derivatives activities of banks operating in the Philippines. It has posted
several guidelines for banks and other market participants to participate in the financial derivatives
market. BSP Circular 594 states which derivatives activities banks can engage in. The circular makes a
distinction between an end-user, a broker and a dealer, the roles that a market participant can take in a
derivatives transaction. According to Circular 594, universal and commercial banks can act as a dealer for
the following instruments without the need of BSP approval: (i) foreign exchange (FX) forwards, FX
swaps, currency swaps and similar financial futures with tenors up to 3 years and (ii) interest
rate swaps, forward rate agreements and similar financial futures with tenors up to 10 years. Both
universal and commercial banks are also allowed to offer other more complex derivatives or hedging
instruments provided that they have licenses to do so.

References:
https://www.investopedia.com/ask/answers/06/forwardsandfutures.asp
http://www.raijmr.com/ijrhs/wp-content/uploads/2017/11/IJRHS_2016_vol04_issue_05_09.pdf
https://www.investopedia.com/articles/forex/021114/exchange-rate-risk-economic-exposure.asp
https://corporatefinanceinstitute.com/resources/knowledge/finance/foreign-exchange-risk/
https://www.investopedia.com/terms/f/foreignexchangerisk.asp