Foreign Exchange Currency Risk

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International Financial Management

Foreign Exchange Risk Analysis

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A currency exposure is any business operation whose profitability can be impacted by a currency exchange rate fluctuation.

Currency exposures assume many forms: they can be assets or liabilities; current or committed; contracted or merely forecast; they can be for trade, investment or balance sheet purposes. Cases of currency exposure can emerge at any point along the value chain, with various repercussions. Each requires a transfer of funds, and for each the rate of exchange is uncertain. Examples of different types of currency exposures are presented below.

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When an input (machinery, components, capital, labor, etc.) is denominated in a foreign currency, the risk exists that an unfavorable exchange rate movement will increase the cost of doing business. When the products are priced and sold in a foreign currency, an adverse exchange rate movement will make the product appear more expensive to consumers, decreasing demand or forcing the company to reduce its own profit margin to maintain lower price levels. For companies with integrated international business systems, an exchange rate shock can literally force them out of business, with their operations experiencing pressures from both cost and profit centers.

The following example illustrate this situation.

• Company A, based in the United Kingdom, has purchased equipment from a supplier in Germany. Company A has entered a contract to pay its supplier in annual installments of 100,000 DM. The first year, with an exchange rate of 1.50 £/DM, Company A must pay £66,667. The next year the exchange rate has depreciated to 1.40 £/DM. Thus Company A must now exchange £71,429 in order to have the DM 100,000 necessary to repay its debt, a 7.14 percent increase from the previous year. As the exchange rate continues to depreciate, it becomes increasingly expensive for the British company to repay its debt.

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