Exchange rate risks

There are 3 main types of exchange rate risk.

1 Transaction risks
e.g. companies which import and export goods may have losses due to changes
in the exchange rate. this risk can be reduced by using forward exchange rates.

2 Translation risk
Converting the accounts of a subsidiary of a multi national company into the currency
of the parent company.
Due to changes in the exchange rate, the value of assets may decrease in US dollars
for example.

3 Economic risk
a company in Sri Lanka makes and sells furniture in the Sri Lanka
its not importing or exporting
its not a subsidiary of a multi national company

e.g.
The company produces and sells a book rack using Sri Lakan wood for Rs 20,000
A competitor imports a book rack from Malaysia priced at 6000 ringit. (the exchange rate
 is 1 ringit = 5 rupees.
So when the book rack arrives in Sri Lanka the cost is 6000x5 = Rs 30,000.

one year later the exchange rate changes to

1 ringit = 3 rupees.
Now the price of the imported book rack is 6000x3 = Rs 18,000.

This is cheaper than the book rack made in Sri Lanka and
consumers will by the cheap imported one
instead of the Sri Lankan one.
The Sri Lankan company will lose sales and will make a loss.

Methods of internally managing foreign exchange risk ( Internal Hedging Methods)  

1 An exporting company can charge its customers in its local currency.

E.g. a UK exporter charges its US customer in USD dollars

A UK company exports to the US. Its invoice value is 10,000 pounds

The exchange rate is 1UK pound = USD 1.5
Therefore the price in USD is 10000x1.5 = USD 15000.
The UK company normally states its price in USD.
 The exchange rate changes to 1UK pound = USD 1.6
The exporter receives USD 15000.
When this is converted to UK pounds = 15000/1.6 =

To avoid the loss the UK company can state its price in Pounds.
That is 10,000 pounds.
The customer has to covert the 10,000 pounds into dollars.
ex rate is 1UK pound= USD 1.6 10000 pounds

2 Netting
this means cancelling out the receipts and payments in a foreign currency.
Completely or partially.

e.g. A UK exporter sends goods to US priced at USD 15000.

(the US customer is company A)
the present exchange rate is 1pound = USD 1.5

The exchange rate changes to 1 pound = USD 1.6.

However the UK company imports raw materials from the US and has to pay
its supplier Company X USD 15000.

The UK company asks company A to pay the 15000 to Company X instead of

 sending the payment to the UK. Therefore the UK company does not have a loss.

3 Matching
This method can be used to reduce translation risk.

e.g. a US multinational company has a subsidiary in Sri Lanka

The Sri Lankan subsidiary has a land worth 100 mn rupees.
The exchange rate is USD1 = Rs 200.
When the accounts of the Sri Lankan company is converted to USD and
added to the accounts of the
parent company, the land value is USD 500,000.
100,000,000
500,000.00
One year later the exchange rate changes to USD1 = Rs 300
now the land value in USD
333,333.33
Therefore there is a loss in assets of 500,000-333,333 = 166,666

In order to reduce this loss of USD 166,666

the US company takes a loan from Sri Lanka for Rs 70mn
The exchange rate is USD 1 = Rs 200
Now the value of the loan in USD
70,000,000
 350,000.00 USD

When the exchange rate changes to USD1 = Rs 300,

The value of the loan becomes
233,333.33 USD

Political risk
Means the risk arising from changes in government policies

This is less in countries such as the UK or Australia

but very high in countries such as Sri Lanka.

In order to reduce policital risk, a company has to:

1. Assess the macro risk of the country

It is the overall risk affecting the entire country
e.g. terrorist attacks.

2. Assess the micro risks

e.g. A company in Sri Lanka imports and sells chemical fertilizer.
the government bans the import of chemical fertizer.
The company has to close down.
Following this risk assessment, the company can take steps to reduce
the risk (risk respones).

Interest rate risk

In Sri Lanka we
A company may take a floating interest rate loan. rate
e.g. A loan of 1M Rs loans
The country interest rate is 10%
The interest payable per month is '1,000,000x 10%/12

The interest rates in the increase to 17%.

The interest payable per month is '1,000,000x 17%/12

Therefore the interest rate risk mainly arises from floating

interest rate loans taken by a company.

This risk needs to be analysed by the company before it can take steps to reduce it.

Factors which will affect the interest rate risk

1. The volatility of interest rates in the country (by how much it can
change under normal circumstances).
2. The sensitivity of cashlows to the interest rate
 how much of floating interest rate loans does the company have ?
3. The future financial plans of the company.
e.g. does the company want to expand ? Issue more shares ? Or take more loans ?

Ways of reducing the interest rate risk

1 Basis risk - if the company has a floating interest rate loan (liability), it can create
an asset with a floating interest rate.
The company can give a loan to an individual or another company with a floating
interest rate.

2 Reduce the amount of loans.

e.g. the company can issue more shares and use these funds to pay off its loans.

3 Smoothing
this means having a proper balance between fixed interest loans and floating
interest loans. in simple terms this means taking more fixed interest rate loans.

4 Transfer the risk to a third party such as a bank (mitigating the risk)
e.g. the company can use forward interest rates.
e.g. use interest rate futures
(These are called derivative instruments).
5 The company can employ specialist staff in its treasury division to manage the
interest rate risk.