How to Limit Exposure to Foreign Exchange Risk?

Exposure to foreign exchange risk can arise when the domestic currency values of assets, liabilities and cash flows denominated in a foreign currency are subject to change due to exchange rate changes (FMA). If, based on ideal business framework all exchange rates were permanently fixed in relation to one another, the foreign exchange risk would not be a problem. However, in real life, it might be a challenging task for the company to manage effectively its foreign exchange exposure. There are several approaches to diminish potential risks from unexpected changes in the exchange rates, such as the spot exchange rates, forward exchange rates, and currency swaps. We will review these methods in more details.

Spot Exchange Rate

Spot Exchange rates (sometimes referred as cash prices, cash rates, today's rates, benchmark rates, straightforward rates, or outright rates) represent the rates of a foreign-exchange contracts for immediate delivery, where the exact timing of the transaction is critical. Spot rates represent the price that a buyer expects to pay for a foreign currency in another currency at the particular date. As it should be settled immediately, the globally accepted settlement cycle for foreign-exchange contracts is two banking days, though settlement can take place even quicker than that. Therefore, in most cases, the foreign-exchange contracts are settled on the second day after the day the deal is made (Investopedia, 2008).

Forward Exchange Rate

Forward transactions involve a delivery date not fixed to the next day as in case of the spot exchange, but further into the future, into any specific date possibly in 30-day, 90-day, 180-day, or as far as a year or more ahead. By using this type of transaction, the value of anticipated flows of foreign currency, in terms of its domestic currency, can be largely secured from exchange rate volatility. Certainly, with longer waiting period, there is a higher probability of the unexpected exchange rates fluctuations, which might be as positive, as negative to the product seller. Thus, buyer and seller tend to shift the risk of fluctuating exchange rates on to the bankers. The forward exchange will be coated at a premium or at a discount depending on the currency conditions in the country and the rates of interest at home and abroad. If the banks anticipate the depreciation in the value of the foreign currency of a particular country, forward rates will be quoted at a premium. If the rates of interest in the foreign country are higher than at home, and the bank can make profit by transferring the funds, the forward rate will be quoted at a discount (Polito, 2000).

Due to the high degree of unpredictability of the financial markets moves, forward exchange rates cannot be used to predict future exchange rates at the certain date (Antweiler, 2006).

There is just a limited amount of the worldwide currencies being able to participate in the Forward Exchange market, including national currencies of Britain, Canada, France, Germany, Japan, Switzerland, and the United States (Daniels, Radebaugh, & Sullivan, 2001).

Currency Swaps

Currency swap is defined as a swap that involves exchange of principal and interest in one currency for the same equivalent in another currency, and, after a specified predetermined period of time, exchange back of the original amounts swapped. Often, one party will pay a fixed interest rate, while another will pay a floating exchange rate (though there may also be fixed-fixed and floating-floating arrangements as well), and at the maturity of the swap, the principal amounts are exchanged back (Wikipedia, 2008).

While the spot and forward exchanges could be used between all interested entities, the currency swap usually involves the intercompany (InterCo) transactions that are performed between different departments and subsidiaries within the same company. As a general rule, companies are using currency swaps when they believe it would be financially justifiable to move out of one currency into another for a certain period of time without potential losses related to the foreign exchange rates deviations (Daniels, Radebaugh, & Sullivan, 2001). One of the ultimate advantages is that this kind of money exchange is considered to be a rule that the foreign exchange transaction are not required by law to be shown on the balance sheet, and originally currency swaps were invented to get around exchange control audits (Investopedia, 2008). 

References

Antweiler, W. (2006). About forward rates. Retrieved September 3, 2008, from http://ping.fm/cev9Y

Daniels, J.D., Radebaugh, L.H., & Sullivan, D.P. (2001). Globalization and Business. New York: Prentice Hall. Ch. 10, pp. 236-239.

Financial Management Association (n.d.). Foreign Exchange Exposure of "Domestic" Corporations. Retrieved September 2, 2008, from http://ping.fm/900M2

Investopedia (2008). Currency swap. Retrieved September 3, 2008, from http://ping.fm/g7EGW

Investopedia (2008). Spot Exchange Rate. Retrieved September 2, 2008, from http://ping.fm/nX1OL

Polito, E. (2000). Is the Forward Exchange Rate a useful indicator of the Future Exchange Rate? Retrieved September 2, 2008, from http://ping.fm/ngrWN

Wikipedia (2008). Currency swap. Retrieved September 3, 2008, from http://ping.fm/asJac