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Currency risk has steadily risen up the corporate agenda over the past year. Geopolitical shocks, shifting trade policies and persistent macroeconomic uncertainty (subscription required) have made foreign exchange (FX) exposure harder to ignore. Recent tensions in the Middle East offer a reminder of how quickly global events can ripple through currency markets. Periods of political instability are often accompanied by sudden shifts in exchange rates as investors reassess risk and capital flows adjust……Continue reading….
By Eric Huttman
Source: Forbes
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Critics:
A firm has economic risk (also known as forecast risk) to the degree that its market value is influenced by unexpected exchange-rate fluctuations, which can severely affect the firm’s market share with regard to its competitors, the firm’s future cash flows, and ultimately the firm’s value. Economic risk can affect the present value of future cash flows. An example of an economic risk would be a shift in exchange rates that influences the demand for a good sold in a foreign country.
Another example of an economic risk is the possibility that macroeconomic conditions will influence an investment in a foreign country.[8] Macroeconomic conditions include exchange rates, government regulations, and political stability. When financing an investment or a project, a company’s operating costs, debt obligations, and the ability to predict economically unsustainable circumstances should be thoroughly calculated in order to produce adequate revenues in covering those economic risks.
For instance, when an American company invests money in a manufacturing plant in Spain, the Spanish government might institute changes that negatively impact the American company’s ability to operate the plant, such as changing laws or even seizing the plant, or to otherwise make it difficult for the American company to move its profits out of Spain. As a result, all possible risks that outweigh an investment’s profits and outcomes need to be closely scrutinized and strategically planned before initiating the investment.
Other examples of potential economic risk are steep market downturns, unexpected cost overruns, and low demand for goods. International investments are associated with significantly higher economic risk levels as compared to domestic investments. In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with the sale and purchase of foreign government bonds.
However, economic risk can also create opportunities and profits for investors globally. When investing in foreign bonds, investors can profit from the fluctuation of the foreign-exchange markets and interest rates in different countries. Investors should always be aware of possible changes by the foreign regulatory authorities. Changing laws and regulations regarding sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect investments in foreign countries.
For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted. As a result, economic risk can be reduced by utilizing various analytical and predictive tools that consider the diversification of time, exchange rates, and economic development in multiple countries, which offer different currencies, instruments, and industries.
When making a comprehensive economic forecast, several risk factors should be noted. One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment. In a macroeconomic model, major risks include changes in GDP, exchange-rate fluctuations, and commodity-price and stock-market fluctuations. It is equally critical to identify the stability of the economic system.
Before initiating an investment, a firm should consider the stability of the investing sector that influences the exchange-rate changes. For instance, a service sector is less likely to have inventory swings and exchange-rate changes as compared to a large consumer sector. A firm has contingent risk when bidding for foreign projects, negotiating other contracts, or handling direct foreign investments.
Such a risk arises from the potential of a firm to suddenly face a transnational or economic foreign-exchange risk contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that, if accepted, would result in an immediate receivable. While waiting, the firm faces a contingent risk from the uncertainty as to whether or not that receivable will accrue.
Companies will often participate in a transaction involving more than one currency. In order to meet the legal and accounting standards of processing these transactions, companies have to translate foreign currencies involved into their domestic currency. A firm has transaction risk whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency.
To realize the domestic value of its foreign-denominated cash flows, the firm must exchange, or translate, the foreign currency for domestic. When firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market, with rates constantly fluctuating between initiating a transaction and its settlement, or payment, those firms face the risk of significant loss. Businesses have the goal of making all monetary transactions profitable ones, and the currency markets must thus be carefully observed.
Applying public accounting rules causes firms with transnational risks to be impacted by a process known as “re-measurement”. The current value of contractual cash flows are remeasured on each balance sheet. A firm’s translation risk is the extent to which its financial reporting is affected by exchange-rate movements.
As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities, or the financial statements of foreign subsidiaries, from foreign to domestic currency. While translation risk may not affect a firm’s cash flows, it could have a significant impact on a firm’s reported earnings and therefore its stock price.
Translation risk deals with the risk to a company’s equities, assets, liabilities, or income, any of which can change in value due to fluctuating foreign exchange rates when a portion is denominated in a foreign currency. A company doing business in a foreign country will eventually have to exchange its host country’s currency back into their domestic currency. When exchange rates appreciate or depreciate, significant, difficult-to-predict changes in the value of the foreign currency can occur.
For example, U.S. companies must translate Euro, Pound, Yen, etc., statements into U.S. dollars. A foreign subsidiary’s income statement and balance sheet are the two financial statements that must be translated. A subsidiary doing business in the host country usually follows that country’s prescribed translation method, which may vary, depending on the subsidiary’s business operations.
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