Measuring Currency Exchange Rate Risk
Minneapolis, MN | April 25, 2023 | By: John Trefethen, Director & Co-Founder
What is Currency Exchange Risk?
Before explaining how to measure currency exchange rate risk, it is important to have a basic understanding of currency exchange risk. The values of the various currencies in the world are always changing. The value of currency in one country is indicative of the economic health in that country. Depending on the country, fluctuations in value can be small or large. Companies doing business internationally need to not only monitor the risk associated with the companies they work with, but also need to be concerned about the currency exchange rate risk for the country in which the company operates.
Example of Currency Exchange Risk
Currency exchange risk is the possible loss in value of cash or assets due to changes in currency values. Often, this risk of devaluation occurs between two entities to a transaction that reside in different countries. This is also commonly referred to as currency transaction risk. Here is a simple example: A US manufacturing company wants to buy a piece of equipment from a European company. The US company signs a purchase agreement to pay 400,000 euros for the equipment. Payment is not due until the equipment is delivered. Every US dollar equals 1.10 euros. For the 400,000 euro equipment, the company expects to pay 364,000 dollars when the equipment is delivered.
In between signing the purchase agreement and taking delivery of the equipment, the EUR/USD exchange rate changes to be 0.90 euro for every dollar. Now the company will pay 444,000 dollars – 80,000 dollars more than expected. This is an increase of 22%. This is a hit on the US company’s margin and profitability.
Currency risk is not always related to transactions. It is also relevant to multi-national companies whose foreign subsidiaries use a local currency for accounting and financial reporting purposes (also known as a “functional currency”) that differs from the functional currency of the parent company. This is also commonly referred to as currency translation risk. Here is a simple example: A Canadian company, whose functional currency is Canadian dollars (“CAD”) has foreign operations based in Mexico (“MXN Subsidiary”). The MXN Subsidiary has Mexican Peso (“peso”) as its functional currency. On a quarterly basis, the Canadian company translates the financial results of the MXN Subsidiary from Peso to CAD for the Parent’s consolidated financial statements before publishing to US stakeholders and regulatory authorities. The value of the Parent’s equity in the MXN Subsidiary can change dramatically from period-to-period by virtue of the Peso-CAD exchange rate alone.
How is Currency Exchange Risk Measured
A common way to measure currency exchange risk is through a value-at-risk calculation (VaR). This calculation relies on three parameters:
The functional currency being used
The length of time the position is held
The confidence in the estimation or risk
To calculate VaR, you can use one of three models for the estimation or risk:
Historical – The historical model uses data from the past to arrive at an estimation of risk.
Variance-covariance – The variance-covariance model applies an equation that comes up with a linear distribution for the estimation or risk.
Monte Carlo – The Monte Carlo model is like the variance-covariance model, but it relies on repeated random sampling to quantify risk.
VaR can be complex to calculate and produce results that are difficult to understand. However, when the profitability of the company is at stake, it’s critical to understand the nature and extent of the risk. Consider using a currency advisor that can help with this process.
Hedging Against Currency Exchange Risk
With an understanding of currency exchange risk, you will need tools to effectively manage the risk. A few common and effective ways that companies hedge this risk include:
Forward Contracts – A contract where two parties agree to buy one currency and sell another currency, and vice-versa, at a specific exchange rate and time.
Options – A contract that provides, for an upfront fee, the option to buy one currency and sell another currency, and vice-versa, at a specific price and time.
Currency Swaps – In its most basic form, a currency swap is an agreement that consists of two streams of fixed or floating interest payments denominated in two different currencies. The two payments streams can both be fixed currency rates, floating currency rates, or some combination thereof.
Fluctuating currency exchange rates is a meaningful risk to companies that conduct international business. Being on the wrong side of a currency exchange move can be the difference between profitability and unprofitability.
To learn more on how to manage your company’s currency exchange rate risk, contact HedgeStar using the contact information below.
Author: John Trefethen, Director and Co-Founder
HedgeStar Media Contact:
Megan Roth, Marketing Manager