Our Free Sample Essay On Currency Risk


Managing exchange rate risk is very essential in minimizing a firm’s susceptibilities from main exchange rate movement that can critically impact the firm’s profit margins as well as the value of the assets with regards to world markets globalization due to the increased exposure to risk by firms involved in international trade. Essentially, the foreign risk is basically associated with unexpected fluctuations in exchange rates as well as exchange exposure to an extent whereby the unanticipated changes within the exchange rates negatively impact the firm’s asset values or liabilities (Ito, Koibuchi, Sato, & Shimizu, 2016). Firms that are involved in international business are vulnerable to foreign exchange risk on the payables and receipts in foreign currencies (Ito et al., 2016). Therefore, foreign exchange risk management is important to firms especially those engaged in international business by mitigating exchange rate risk and saving the firm’s economic value. This paper discusses and analyzes the importance of managing Foreign Exchange risks to firms, hedging strategies that minimize the exchange rate risk and also determines whether financial hedging and long-term operational are substitutes or compliments,

Importance of managing Foreign Exchange risks to firms

Foreign exchange risk management helps firms to mitigate and also avoid experiencing negative economic impacts due to their exposure to foreign exchange risk especially when the firm relies on the future exchange rates as well as if also the exchange rate alteration cannot be entirely anticipated (Ito et al., 2016). Moreover, foreign exchange risk management helps in eradicating the disparity existing between the assets of a firm retained by the bank and also the loans funding the firm’s balance sheet which is caused by the Foreign Exchange. Management of these Foreign Exchange risks helps in balancing the firm’s balance sheet thus making it make economic gains.
Foreign Exchange risk management also helps in projecting possibilities of fluctuations in foreign exchange rates which enables firms to plan their operations and come up with effective marketing and sales strategies that are compatible with the changes in foreign exchange rates. Having a Foreign Exchange risk management helps the firm to avoid experiencing unexpected depreciation of the firm’s local currency against the United States Dollar which can result in an intense increased cost of servicing debt relative to revenues (Ito et al., 2016). Unexpected depreciation in currency exchange also negatively impacts the credit score of a bank which in turn affects the capacity of the banks to raise funds to lend to firms and consequentially, leads to the generation of a negative net income accompanied by critical long term consequences on financial stability. However, managing Foreign Exchange risks helps to avoid such problems.

Essentially, firms are exposed to 3 forms of foreign exchange risks which include; Economic, Transaction and Translation Exposure. These risks are a result of currency volatility. Transactional exposure emerges from the impact caused by the fluctuation rates on a firm’s responsibilities to make or receive payments in form of foreign currency (Ahmed & Manab, 2016). This sort of exposure is a short-term and also medium-term risk. Translation exposure emerges from the impact of currency changes on a firm’s consolidated financial statements, specifically when in possession of foreign subsidiaries. Literally, this kind of exposure tends to be medium-term to long-term risk in nature. Economic exposure is unpopular as compared to the other risks but it is a critical risk too. Economic exposure arises due to the impact of unexpected currency changes on a firm’s future cash flows and also market value (Ahmed & Manab, 2016). This risk is long-term. The effect of this risk can be significant, since the unanticipated exchange rate fluctuations can substantially impact a firm’s competitive position, regardless of whether it operates locally or internationally.

Hedging strategies that minimize the exchange rate risk
Forwarding Contracts

A forward contract typically is an agreement for the purchase or sale of a certain quantity of foreign currency at a particular price settled at a future date determined earlier before then. Foreign exchange forwards assists investors in managing risks pertaining to currency markets through the predetermination of rates and dates whereby they would sell or buy a specific foreign exchange amount (Krause & Tse, 2016). Essentially, corporate risk hedging utilizing forward contracts alleviates the value through the reduction of incentives for investments. When it matures, the firm having a long position then pays the forward price to the firm with a short position, who in return conveys the asset primarily attributed underpinned to the forward contract (Krause & Tse, 2016). The forward cover may be settled by extension or early delivery, and cancellation of the delivery. This contract assists in protecting a portfolio against probable negative currency changes and extra cost complications that are not there in the execution of a spot trade. The main advantage of this strategy is that it may be geared towards a particular firm’s need and a proper hedge can be gained.

Cross-Currency Swaps

A swap basically refers to a contract where the seller and the buyer exchange equal first principal amounts of two differing currencies. It is an exchange of liabilities drawing to two differing currencies. A swap entails exchanging currency rates between fixed rates and floating interest rates. Literally, the two parties contribute periodic payments periodically based on the predetermined regulation to replicate changes in interest rates existing between the currencies engaged (Krause & Tse, 2016). Cross-currency swap is basically exploited at the initiation of a loan period. It enables two counter-parties to make exchanges of a specified amount belonging to two different currencies and make partial repayments with time. According to currency swap, exchange of interest payments pertaining to two different currencies are made over the contract’s life as well as the principal amounts are paid back at maturity or based on the predetermined remuneration schedule (Krause & Tse, 2016). A currency swap is currently among the largest financial derivative markets worldwide.

Currency Option

A currency option is basically a contract offering the right and actually not the responsibility for buying or selling a precise quantity of a certain foreign currency to be exchanged with another currency at a fixed price. The currency option is an exceptional financial tool which deliberates on the owner and the buyer though lacking responsibility for buying or selling a basic asset (Rupeika-Apoga & Nedovis Uraev, 2015). Essentially, options are specifically suitable as a hedging tool for conditional cash flows like the way the case is in the bidding processes. An option at a sports currency provides a choice that the buyer has the right for purchasing or selling the mentioned currency against other different currencies, whereas an option on a currency future agreement provides the choice buyer with the obligation to create longer or shorter positions in the appropriate currency future contract. In essence, alternatives pertaining to spot currencies are normally present within the bank markets, whereas options based on features are exchanged.

Leading and Lagging

Firms can also use leading and lagging foreign currency payments and recipients to minimize transaction exposure. Leading basically infers to disbursing payments early, while lag infers to disbursing payments late. Firms would prefer leading soft currency obtainable and as well lag difficult currency obtainable so as to gain from the gratitude of hard currency (Kim, Tesar, & Zhang, 2015). Similarly, firms can result in i hard currency payables as well as lag soft currency payables. A lead strategy entails trying to gather foreign currency obtainable just whenever foreign currencies are anticipated to denigrate as well as pay foreign currency receivables afore they are overdue when the currency is anticipated to reduce. Alternatively, a lag strategy entails a delay in collecting currency receivables suppose that currency is anticipated as well as the delaying payable suppose the currency is anticipated to decrease.


Netting is reducing the number of transactions which a firm requires to make so as to cover or address an exposure. It needs the firm to possess centralized cash management. Actually, centralization refers to the collection of foreign currency cash flows by firms between subsidiaries and collectively groups them as inflows as well as outflows within similar currencies (Coes, 2017). The aim of netting is to save the transaction costs through netting off intercompany balancing before organizing for payment. At this point is whereby multinational groups are engaging in intergroup trading for instance associated companies situated in different countries trading with each other. The advantages include reduced cost of purchase of foreign exchange, reduced commission, lower buying and selling rates, as well as minimal loss in interest from transiting money. Loss because of netting positions through swap dealers may be as low as ten per cent for agricultural goods and a bit higher for energy and also metals.

Price Adjustments

It entails altering prices in different ways. In an instance whereby the subsidiary’s local currency tends to be losing value, the subsidiary may increase the price in order to cancel the impact of devaluation. This approach is specifically utilized in countries with a high level of devaluating and also with efficient derivative markets (Coes, 2017). Nonetheless, one disadvantage of this approach is that prices cannot be raised lacking any consideration regarding competitors since suppose prices upsurge too much, clients would definitely opt for an equal cheaper product or service acquired from a competitor (Coes, 2017). Moreover, flexibility can be shown as the capability of going through changes in the input prices or in the overall prices by regular price alterations.

Financial hedging and long-term operations are substitutes or compliments

Financial hedging together with long-term operations is simply complemented. Many researchers have implied that operational hedges are utilized in protecting against long term risks. According to a research by Petersen and Thiagarajan (2000), it implies that financial as well as operational hedges are substituting each other by suggesting that a significant motive Homestake opted to fail to utilize financial results in its capacity for adjusting operational costs responding to movement within prices (Treanor, Carter, Rogers, & Simkins, n.d.). Nonetheless, American Barrick lacked such luxury. To implicitly test the query of vs complements vs substitutes, Allayannis, Ihrig, and Weston (2001) carried out a study by hypothesizing that suppose operational as well as financial hedges are regarded to be substitutes then the probability of the usage of financial derivatives by a firm decreases with its geographical dispersal index since the more dispersed the firms of an international firm, the better the operational hedge for that firm (Treanor et al., n.d.). It is therefore evident after finding positive and substantial relations existing between the probability derivatives used by a firm as well as its geographical dispersal index, suggests that financial as well as operational hedges are definitely complemented.


To sum up, the foreign risk is basically associated with unexpected fluctuations in exchange rates as well as exchange exposure to an extent whereby the unanticipated changes within the exchange rates negatively impact the firm’s asset values or liabilities. It is therefore important to mitigate these impacts by managing foreign exchange risks for firms.