How to hedge foreign currency risk
Businesses involved in international trade often execute a sale or purchase at one point in time but the transfer of funds takes place at a different point in time. This results in an uncertainty about the about the amount of revenue or expenditure involved in the transaction in the business' home currency.
For example, suppose an American company sells electrical equipment to a buyer in France for one million euros. The equipment is to be delivered 90 days before the payment is made. At the time the sale agreement was made the exchange rate was $1.25 euros per dollar. This meant that the company was counting on receiving something in the neighborhood of $1.25 million in the transaction. Suppose the American company's cost for producing and delivering the equipment was $1.15 million and it was counting on making a $100,000 profit on the transaction. However if the value of the euro fell to $1.10 by the time the American company received payment then it would find that it had a $50,000 loss instead of a $100,000 profit.
Suppose the American company required the French company to make the payment in dollars instead of euros. Then the French company would be bearing the risk. If the exchange rate fell from $1.25 per euro to $1.10 then what it had been expecting to pay one million euros for would cost it about 1.136 million euros.
Foreign currency or transactions risk is the risk that is the consequence of fluctuations of exchange rates. It can strongly affect businesses in a variety of ways. Even if a company does not engage in foreign sales or purchases it can still be subject to a risk because of exchange rate fluctuations. This is because the price of its foreign competition's products may be affected by a change in the exchange rate.
The Source of the Risk
Exchange rates fluctuate due to a great many factors. Some may be strictly financial but political events can also affect the exchange rates. If there is the threat of military conflict in some part of the world those holding funds there may want to transfer their holdings to the U.S. They consequently exchange their currency for dollars thus driving up the value of the dollar.
When Japan was hit by a major earthquake at Kobe, Japanese businesses began transferring funds back into Japanese yen for the rebuilding process. This had the effect of increasing the value of the yen with respect to other currencies.
In the early 1980's the tight monetary policy of the Fed resulted in high real interest rates in the U.S. compared to other countries. This in turn resulted in a high value of the dollar compared to other currencies.
Strategies for Dealing with
the Foreign Currency Transaction Risk
There exist organized markets for foreign currencies. The trading in foreign currencies now is called the spot market. There are also forward and future markets for currency transfers which will occur sometime in the future. This means that a company can enter into a contract with another party to transfer its right to receive foreign currency payments a specified time in the future. The contract may involve payment now or payment of a definite amount in the future when the foreign funds become available.
A company can also engage in speculation in an organized futures market for the foreign currency. In this strategy the company mades up in profit on its futures market transaction whatever loss it might have on it foreign trade transaction risk.
Some companies decide that they have no expertise in the foreign currencies markets and immediate sell on the forward market any foreign currency funds they are to receive. They then know exactly what profit they are making on a foreign trade transaction. Other companies decided to try their hand at foreign currency speculation. Some found that they made a profit on such speculation. Sometimes the profit on currency speculation offset losses on these companies' main operations. This resulted in those companies seriously committing themselves to such currency speculation. They set up separate division to handle their currency market operations. When these divisions had losses instead of profits the companies' financial stabilities were put at risk.
The Empirical Evidence of How Companies Handle
Their Foreign Currency Transaction Risk
Gregory Millman, the author of The Floating Battlefield. interviewed the executives in a number of companies and put the information together with information from published studies to give those of us interested in finance and economics an inside look at risk strategies and some empirical facts to compare with theory. Mr. Millman does not want the details of his studies displayed on the internet.Sources:
- Gregory J. Millman, The Floating Battlefield: Corporate Strategies in the Currency Wars (New York, AMACOM, 1990).
- Gregory J. Millman, The Vandals' Crown: How Rebel Currency Traders Overthrew the World's Central Banks (New York, The Free Press, 1995).
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