Economic Exposure Risk-Types of Foreign Exchange Risk

Economic Exposure Risk

Economic Exposure risk affects all the organizations regardless of involvement in foreign trade or investment.

Increase in foreign exchange rate will make imported goods more costly in home currency terms. Organizations using imported raw material as an input to the goods or services provided by the organization is exposed to economic risk.

Increase in the cost of raw materials to the organization will lead to increase in the cost of goods produced or services provided by the organization. Organization may have to raise selling price or reduce profit margin to remain competitive in the market against suppliers of imported goods from other foreign countries.

Economic risk is beyond the control of the organization. Organization has to accept that risk. Government can control economic risk in the long term. However, in short term, it is uncontrollable even by government. Organization can use its economic power to influence the actions of government.

Translation Risk-Types of Foreign Exchange Risk

Translation Risk

Translation risk does not involve cash flows.

Investment (land and building) in foreign currency will result in lower amount in balance sheet prepared in home currency due to depreciation of foreign currency.

Liability (Bank loans) in foreign currency will result in higher amount in balance sheet prepared in home currency due to appreciation of foreign currency.

Transaction risk is long-term risk because it is subject to long-term investments & liabilities.

Translation risk can affect key ratios such as profitability, gearing and investor ratios.

Translation risk can result in violation of loan covenants about maximum gearing level, which should not be exceeded. Reduction in assets leads to reduction in equity resulting in higher gearing ratio.

Moreover, organization may find difficulty raising finance as lenders evaluate credit risk by calculating gearing ratios.

Similarly, transaction risk can result in reduction in share price and market capitalization of the organization due to reduction in equity.

ROCE will also increase without any improve in performance of the organization. Managers will be wrongly rewarded, if ROCE is used for calculating profit related pay (PRP).

Translation risk can be controlled by organization through careful planning and using matching principle.

Transaction Risk–Types of Foreign Exchange Risk

Transaction Risk

Transaction risk is short-term risk rises due to particular transaction.

It is the risk that foreign exchange rate will adversely affect organizational profitability.

It arises due to following conditions being met, if any these conditions do not exist, then there will no transaction risk:

• Receipt and payment in foreign currency rather than home currency.
• Payment and receipt (settlement) date against purchase and sale is different from agreement date of goods or services.

Increase in foreign exchange rate makes foreign purchases more costly. Movement in foreign exchange rates makes cost of purchases higher and lower. Cost of purchase for goods cannot be exactly known in home currency until settlement is made. It is due to timing difference between agreement date and settlement date. However, purchased goods are already being sold into market between those dates. If exchange rate moves adversely, then organization can do nothing to cover increased cost of purchase.

Similarly, increase in foreign exchange rate makes foreign sales less profitable. Period between which goods are sold and receipt is expected, foreign exchange movement can decrease the amount of money received in home currency.

Significant foreign exchange losses can create liquidity problem and in extreme cases end up in liquidation.

Fortunately, transaction risk can be controlled using appropriate Hedging techniques.

Foreign Exchange Rates-Direct vs Indirect Quotes Currency

Direct Vs Indirect Quote

Foreign exchange rates are quoted in pairs

Example:

Dollar to Pound, Franks to Yen, Rupees to Dinar etc.

 

Direct Quote

A foreign exchange rate quoted as the home currency per unit of the foreign currency.

In other words, one unit of foreign currency is measured in home currency.

In Direct quote, exchange rate is represented by home currency symbol.

In Direct quote, home currency is written prior to foreign currency and home currency symbol is written just before exchange rate.

In Direct Quote, exchange rate is multiplied by the foreign currency to convert foreign currency into home currency.

Direct quote is used when foreign currency is stronger than home currency. It ease calculating foreign exchange rate by avoiding decimal places. It is used mostly used in developing countries such as Pakistan and India.

 

Indirect Quote

A foreign exchange rate quoted as the foreign currency per unit of the home currency.

In other words, one unit of home currency is measured in foreign currency.

In Indirect quote, exchange rate is represented by opposite currency symbol.

In Indirect quote, foreign currency is written prior to home currency and foreign currency symbol is written just before exchange rate.

In Indirect quote, exchange rate is divided by the foreign currency to convert foreign currency into home currency.

 

Buying & Selling Rate

Buying and selling rates are two different rates. Difference between buying and selling rate is known as spread.

 

Spread

Spread represents the profit to the foreign exchange dealer (broker).

Foreign exchange dealers sell at profit and buy to cause you loss.

 

Direct Quote

In direct quote, buying rate is higher rate and selling rate is lower rate.

 

Indirect Quote

In indirect quote, buying rate is lower rate and selling rate is higher rate.

Remember whichever quote you use, you should select an exchange rate for buying and selling which is loss making to you and profitable to foreign exchange dealer. Because, foreign exchange dealer is trading for profit and if they are making profit, then you should definitely be losing money.

Lower rate is written before the higher rate regardless of the type of quote in use.

Example:

Dollar to Pound Sterling rate is $1.554 – $1.557