Foreign Currency Risk

By , and February 24, 2021Other
Foreign currency risk involves many important considerations for companies.

In this era of globalization and increasing international trade, almost every business is or will be exposed to foreign currency risk (also referred to as foreign exchange risk, FX risk, or exchange rate risk). Foreign currency risk is the financial exposure that companies face when they are not protected from the potential changes in foreign exchange rates. This exposure is a significant risk because it could lead to decreased profitability, missed targets, or significant losses. Increasing globalization has caused businesses of every shape and size to be pulled into global markets by both opportunity and necessity. Because of its ubiquitous influence, foreign currency risk is an important consideration for every successful business—domestic or international. In order to mitigate foreign currency risks, businesses need to know how they are exposed and what tools they have available to manage these risks.

Types of Currency Exposure

The first step in guarding against FX risk is to understand the various ways in which a company might be exposed. Each form of exchange rate risk is significant and can have a profound impact on a company’s bottom line. By learning to understand each type of risk, companies will be better able to see the ways in which they need to change their operations to lower their foreign currency risk.

Balance Sheet Exposure or Remeasurement Risk

Balance sheet risk is perhaps the most prominent type of exchange rate risk exposure. Balance sheet exposure, also referred to as remeasurement risk, refers to the possibility that foreign exchange rates could change between the formation and settlement of a contract. Companies experience balance sheet exposure when they accept receivables or payables that are denominated in a foreign currency. As the exchange rate changes, the value of the receivable or payable changes, which may result in a gain or loss when the transaction is settled. In other words, the company might not receive or pay the amount of money it initially anticipated in its own, domestic currency. Thus, the changes in exchange rates can have a direct impact on the firm’s financial statements, showing up as a gain or loss.

Example: Transaction Exposure

On 1/5/2018, the exchange rate between the Japanese Yen and the U.S. Dollar was $1 = ¥113. If T&C, a hypothetical U.S-based firm, enters into a contract with a Japanese vendor to purchase 100 phones at a total cost of ¥5,650,000, the contract price is equivalent to $50,000. On 3/23/2018 the payable is due, and T&C pays the Japanese vendor. However, between the date when the contract was agreed upon and the day that the contract was fulfilled, the exchange rate changed to $1= ¥104. Because T&C denominated their contract in Yen, the change in the exchange rate raised the payable amount to $54,327. In other words, T&C must pay $4,327 more than was initially anticipated when it agreed to the contract. This increase was caused by the fact that the contract was denominated in Yen, and the Yen got stronger relative to the U.S. dollar. Losses like this will always happen when the currencies in which your payables are denominated get relatively stronger and thus more expensive.

Contract Made 1/5/2018 for 100 phones (product) at 5,650,000 Yen (price) when the foreign currency exchange rate: $1 to 113 Yen, resulting in a total cost of $50,000. foreign currency exchange Rate Changes between contract date (1/5/2018) and payable due date (3/23/2018) when the same 100 phones (product) at 5,650,000 Yen when foreign currency exchange Rate is $1 to 104 Yen results in a total cost of $54,327.
Figure 1

The example above illustrates how changes in exchange rates can impact the size of a financial transaction. In our example, the company experienced a loss; however, the exchange rate could have moved in the other direction leading to a gain. Exchange rates move in both directions on a regular basis. The possibility that the movement could create a financial loss is what creates balance sheet risk. Balance sheet risk can become particularly significant for small companies because the potential losses could have a substantial, negative impact on the firm. In the worst-case scenario, these losses can put a company out of business. If a company survives a negative experience with exchange rates, substantial losses can still slow company growth and concede precious time to competitors. Weaker financial results due to foreign exchange risk can also cause investors to lose confidence, making it harder for startup and growth companies to get the funding they need.

Transaction Exposure or Cash Flow Risk

Another important aspect of foreign exchange exposure is the possibility that a company’s foreign denominated revenues and costs can change in value relative to a company’s forecasts. For example, in their public disclosures, public companies may forecast a certain level of sales for their international operations. However, if the exchange rate changes, the value of the actual revenues may rise or fall relative to projections. Thus, even if business activities such as sales and procurement are going well internationally, a change in the exchange rate can devalue revenues or inflate costs, leaving the company with weaker financial performance.

This type of risk is often referred to as “phantom” exchange rate risk because it doesn’t show up as a direct gain or loss on the balance sheet the same way that remeasurement risk does. Instead, this risk appears indirectly on a company’s financial statements as higher or lower top-line revenues or expenses. Because of its potentially significant impact on overall company performance, this type of risk is just as important to business owners and investors as balance sheet risk. Company leaders and external investors all rely heavily on a company’s forecasts to make decisions about company operations and investment opportunities respectively. Thus, investors pay close attention to a company’s plan to manage this risk. This puts pressure on company leaders to effectively manage their cash flow risk and communicate their plan to investors. The Ford Motor Company example included later in this article provides an example of how companies disclose and discuss this risk and their mitigation strategies in their public filings.

Economic or Operational Exposure

Economic or operational risk is determined by how a company positions its operations in the global economic environment. Companies face economic or operational risk any time they locate a portion of the company’s operations in another country or do business in another currency. In contrast to the one-time risk of any given transaction, operational risk is the long-term financial exposure due to long-term investment and operating decisions. Many companies outsource at least a portion of their operations, such as manufacturing. This may allow firms to take advantage of cheaper labor and local capital markets in other countries. However, other economies and currencies have the potential to strengthen or weaken over time. These fluctuations could increase or decrease the cost savings and revenues that a firm initially hoped to gain by relocating or building its operations elsewhere.

Example: Operational Exposure

As an example, we will consider Micro and Delio. These two companies are hypothetical, domestic manufacturers in the United States. Both Micro and Delio assemble similar portfolios of electrical products. Both companies outsource portions of their manufacturing to other countries. In 2017, both companies were using an Indonesian manufacturer as the supplier for an important electrical component that was used in several of their products. The cost of each component was set at 13,500,000 Rupiah (Rp). The average exchange rate in 2017 was $1 = Rp13,378, which means that both companies were spending an average of $1009 per component. An analysis done in 2017 showed that Delio could reduce the costs per component to $950 by manufacturing the component in house in the United States. Because of the cost savings, Delio invested in new manufacturing facilities and began manufacturing the component themselves. However, over the next three years, the exchange rate changed, and the Rupiah weakened compared to the dollar. In 2020, the average exchange rate was $1 = Rp14,591. Because it chose to make the component itself, Delio’s costs have not changed, but Micro’s cost per component have decreased to an average of $925. This means that overall, Delio’s initial cost advantage relative to Micro has become a disadvantage. Because Delio has invested a significant amount of time and resources into its manufacturing capability, the company will find it much more difficult to switch back to outsourced manufacturing.

With a 2017 foreign currency exchange rate of $1 = Rp13,378 and a 2020 foreign currency exchange rate of $1 = Rp14,591, Micro's outsourced cost of $1009 in 2017 results in a component cost of $925 in 2020, and Delio's In House cost of $950 in 2017 results in a component cost of $950 in 2020.
Figure 2

Operational exposure can become a significant problem because it has the potential to dramatically change expected cash inflows and outflows. Companies need to take this risk into account as they manage their cash flows so they can keep their business running smoothly. Some types of long run macroeconomic trends are somewhat predictable and should be considered as well. However, operational exchange rate exposure is, by definition, the unpredictable aspect of exchange rate changes that happen over time. This is why, as we will detail later, companies may need to use additional tools or strategies to mitigate operational exchange rate risk. Considering these risks in advance will allow businesses to operate smoothly through short-run economic shocks and save the company time and money in the long run.

Translation Exposure

Another important foreign exchange consideration for international firms is translation exposure. Translation exposure is the effect of translating the revenues and expenses of foreign denominated subsidiaries in consolidation. Companies that own foreign subsidiaries are required to consolidate, or “translate,” the subsidiaries’ financial statements into their domestic currency for reporting purposes. Regardless of a subsidiary’s performance in its own market, changes in foreign currency rates could cause the consolidated financials of the parent company to reflect performance that is better or worse than the relative performance of the subsidiary. The root cause of translation exposure is the transactional exposure faced by firms over a reporting period. Over the reporting period, a parent company’s reported revenues, expenses, assets, and liabilities will be impacted by exchange rate changes. The impact of these changes needs to be understood by company leaders and will need to be reported by public companies in their public filings. The example below from McDonald’s 2019 annual report demonstrates how companies can report and communicate the effects of exchange rate risk and specifically translation exposure.

Example: Translation Exposure for McDonald’s

McDonald’s is an international corporation that, as of 2019, operated in 119 countries. As an example of how a company might handle translation risk in their financial statements, we have included several examples from McDonald’s 2019 annual report.

In its annual report, McDonald’s explains how foreign currency rate changes would impact its earnings per share:

A significant part of the Company’s operating income is generated outside the U.S., and about 40% of its total debt is denominated in foreign currencies. Accordingly, earnings are affected by changes in foreign currency exchange rates, particularly the Euro, British Pound, Australian Dollar and Canadian Dollar. Collectively, these currencies represent approximately 80% of the Company’s operating income outside the U.S. If all four of these currencies moved by 10% in the same direction, the Company’s annual diluted earnings per share would change by about 35 cents.1

As a way of demonstrating the impact of exchange rates on their financial statements, McDonald’s includes measures that are calculated with a “constant currency” rate. The logic behind this method of reporting is explained by McDonald’s as follows:

Constant currency results exclude the effects of foreign currency translation and are calculated by translating current year results at prior year average exchange rates. Management reviews and analyzes business results excluding the effect of foreign currency translation, impairment and other strategic charges and gains, as well as income tax provision adjustments related to the Tax Cuts and Jobs Act of 2017 (“Tax Act”), and bases incentive compensation plans on these results, because the Company believes this better represents underlying business trends.2

McDonald’s explains their strategy for handling foreign exchange rate exposure. In addition, the company shows the effect of foreign currency translation along with the actual performance numbers to give an idea of how much exchange rate changes have impacted the company’s financial statements.

IMPACT OF FOREIGN CURRENCY TRANSLATION ON REPORTED RESULTS While changes in foreign currency exchange rates affect reported results, McDonald’s mitigates exposures, where practical, by purchasing goods and services in local currencies, financing in local currencies and hedging certain foreign-denominated cash flows. In 2019, results reflected the weakening of the Euro and most other major currencies. In 2018, results reflected the stronger Euro and British Pound. In 2017, results reflected the stronger Euro, offset by the weaker British Pound.3

Figure 3: Image from McDonald’s 2019 Form 10-K. Page 10.

Indirect Exposure Risks

Multinational corporations are not the only firms that experience exposure to foreign currency risk. In fact, research by Raj Aggarwal and Joel Harper suggests that “on average, domestic firm exposure to foreign exchange risk is not significantly different from the exposures faced by multinational firms.”4 This means that even small domestic firms need to consider how they are exposed to exchange rate risk. As demonstrated in the example below, domestic firms may experience increased competitive pressure due to exchange rate changes.

Example: Indirect Exposure for Boredwalk

Consider Boredwalk, a small U.S. company started by a married couple in Los Angeles in 2014. Boredwalk receives approximately 40% from T-shirt sales on Amazon. In 2016, the Chinese Yuan weakened relative to the U.S. dollar. This caused the price of Chinese goods to drop relative to those in the United States. Because consumers could now buy cheaper Chinese shirts, Boredwalk’s 2016 sales dropped considerably.

If domestic firms are not prepared for indirect exchange rate exposure, they might struggle to compete with international goods and services. Many small domestic companies may be at more of a disadvantage than larger firms because they don’t have the time or resources available to mitigate these risks. However, there are many basic principles and tools that could help all businesses decrease their exposure to changes in exchange rates.

Managing Foreign Currency Risk

Although there are many ways companies can manage their exposure to foreign currency risk, there are a few basic principles and practices that can give any company a foundation to build on. The following considerations can assist in laying the foundation companies need in order to successfully build and execute a risk mitigation strategy.

Involve All of the Relevant Stakeholders

One of the first things a company needs to do in order to create an effective risk strategy is involve all of the relevant stakeholders in the process. Often these stakeholders will include individuals from different departments and levels within the company. Starting at the top, the c-suite executives often create the high-level strategy and objectives, and ultimately need the board of directors to sign off on the plan. The company also needs to include those involved in executing the strategy. This normally includes individuals from the treasury department and operations team, among others. As the details of the strategy are being determined, the accounting and legal teams should also be involved. By including all of these stakeholders, top level managers can ensure that the goals and strategies they create are effectively executed and legally compliant.

Know Your Exposure

Another important aspect of managing foreign currency risk is for each company to understand its individual risk profile. To gain an accurate picture of its risk profile, one of the first steps a firm can take is to analyze its transactions. A transaction analysis starts by compiling information on the currencies in which the firm is transacting. In addition, a company should also analyze how it is creating its forecasts and whether or not it is accounting for the possibility of exchange rate changes in its forecasts. Management should then conduct a comprehensive analysis of the company’s revenue and cost structure across each currency to determine which areas pose the greatest financial risk. This type of analysis can help management project how currency risk may affect the company’s financial operations.

Several types of analysis can help a company see where their exposure is greatest, and how effective their risk hedging strategy is. For example, cash flow at risk (CFaR) and earnings at risk (EaR) analyses can help companies understand their exposure and how effective their hedging strategy is. Firms can also use sensitivity analysis5 to estimate how cash flow may be affected if currency rates change. Foreign exchange rate sensitivity analysis should demonstrate how changes across different exchange rates could potentially impact the company’s financial performance. An example of such an analysis, prepared by Alcoa, is shown in Figure 4.

Alcoa reported that a 0.01 change in exchange rates would result in the following shifts in its annual net income: US $ to AU $ - $11 million; Brazilian real to US $ - $3 million; US $ to UK pound - $2 million; CA $ to US $ - $ 5 million; Norwegian krone to US $ - $5 million
Figure 4: Image from “Getting a better handle on foreign currency risk” by Marc Goedhart, Tim Koller, and Werner Rehm, McKinsey and Company.

After conducting an internal analysis, firms also need to analyze their competitors to identify potential operational and positioning risks. Companies should study how their competitors are different in terms of sourcing, technology, and geographic location. If a firm’s competitors have the same cost structure, then a change in exchange rates will not cause a relative, significant structural risk. However, if most of a firm’s competitors have dramatically different operating positions, then one model may become more successful over time due to exchange rate changes and other economic factors. Many companies, such as Nike, have built successful market positions by outsourcing portions of their operations to create a better competitive position in the market.

Understand the Available Tools and Strategies

After identifying and understanding the risks they face, companies need to consider the variety of tools that are available to mitigate the various types of exposure they face. In many cases, there are things companies can do to lower their foreign currency risk in their everyday operations. There are also several financial instruments that are available and widely used by many companies to hedge against currency exposure.

One of the ways for companies to handle operational risk is to create a “natural hedge.” In other words, companies can find a way in which they can match the currency of cash inflows with cash outflows. For example, in the years leading up to 2011, BMW was experiencing significant losses because of changes in the USD-Euro exchange rate. These changes undermined BMW’s long-held strategy of manufacturing in Germany and exporting to the United States. To hedge against this exposure, BMW implemented a natural hedge strategy by expanding their manufacturing and production in the U.S.6 This strategy changed the denomination of manufacturing cash outflows to the U.S. dollar, which matched the cash inflows from U.S. sales.

Another way to hedge against currency risk is to create offsetting risks. In other words, foreign exchange rate changes will often create potential gains and losses for a company if managed correctly. For example, a strong dollar will make it more difficult for U.S companies to export their products; however, this also makes imported materials cheaper. U.S. companies can take advantage of times when the dollar is strong to import raw materials from foreign instead of local vendors. When the dollar is weaker, companies can focus on exports.

In addition to natural hedges, there are several financial instruments that companies can use to hedge against foreign currency risk as well. These financial instruments include forward contracts and options, among others. In currency risk hedges, forward contracts are the most commonly used financial instrument. Forward contracts are an agreement to trade foreign currency in the future at a predetermined rate. Although forward contracts have low initial cost and therefore low initial value, their value changes as the underlying exchange rate fluctuates. In a perfect hedge, changes to the value of the forward contract directly offset changes to the corresponding payable or receivable. When this happens, companies can secure the value of foreign-denominated payables or receivables as well as future forecasted revenues and expenses. Securing this value will mitigate the impact of exchange rate changes on cash flows and improve the reliability of internal forecasts.

Another set of financial instruments that is available, but less commonly used, is foreign currency options. Options provide companies with the right, but not the obligation, to purchase or sell foreign currency at a predetermined rate within a specified timeframe. Because options don’t create an obligation, a company is able to preserve upside potential while eliminating downside risk. However, unlike forward contracts, these tools come with an upfront cost through the premium paid to purchase the option.

Example: Ford’s Reported Use of Financial Instruments to Mitigate Fx Risk

Ford Motor Company included the following statements in their annual report for 2019. These statements detail how the company is mitigating foreign currency risk and how sensitive this strategy is to shifts in global currency markets:

Foreign Currency Risk. Foreign currency risk is the possibility that our financial results could be worse than planned because of changes in currency exchange rates. Accordingly, our practice is to use derivative instruments to hedge our economic exposure with respect to forecasted revenues and costs, assets, liabilities, and firm commitments denominated in certain foreign currencies consistent with our overall risk management strategy. In our hedging actions, we use derivative instruments commonly used by corporations to reduce foreign exchange risk (e.g., forward contracts).

The net fair value of foreign exchange forward contracts (including adjustments for credit risk) as of December 31, 2019, was a liability of $596 million, compared with an asset of $363 million as of December 31, 2018. The potential decrease in fair value from a 10% adverse change in the underlying exchange rates, in U.S. dollar terms, would have been $2.3 billion at December 31, 2019, compared with $2.5 billion at December 31, 2018. The sensitivity analysis presented is hypothetical and assumes foreign exchange rate changes are instantaneous and adverse across all currencies. In reality, some of our exposures offset and foreign exchange rates move in different magnitudes and at different times, and any changes in fair value would generally be offset by changes in the underlying exposure. See Note 21 of the Notes to the Financial Statements for more information regarding our foreign currency exchange contracts.7

Create a Risk Management Plan and Hedging Strategy

After a firm understands its risks and which tools are available and relevant for their company, the firm is ready to begin creating its hedging strategy. For companies of all types and sizes, the first portion of their strategy should delineate how the company can structure its operations to create natural hedges. In addition, firms should consider how they can structure their agreements so their contracts are in USD where possible. By creating natural hedges like these, companies can decrease foreign currency risk and avoid overspending on other financial instruments.

After finding and implementing the potential natural hedges, companies can consider how they can effectively use other tools and financial instruments that are available. For smaller companies with less available resources, there are tools and platforms available from credit institutions such as Western Union and Northern Trust. The platforms available from these companies can help the at-risk firms manage their budget and adjust for foreign exchange exposure. Other available tools on these platforms include international payment processing, forward contracts, and cash flow management tools.

While smaller companies may need to rely more on the tools provided by other institutions, larger and PE-backed firms are more likely to build and maintain their own self-directed risk management strategy. This includes leveraging the capital markets and derivatives as well as the other tools discussed earlier in the article.

Be transparent

By taking the steps to mitigate foreign currency exposure, companies are not trying to create gains; rather, they are protecting themselves against potential losses and attempting to create financial stability. In other words, executives should not use their currency risk strategy to try and raise share prices by creating short-term, temporary financial gains. Instead, company leaders should focus on building and communicating a strategy that builds investor confidence in the company’s long-term stability. Management can also appeal to investors by increasing the transparency with which it communicates the company’s sensitivity to exchange rate fluctuations. Investors are highly interested in how companies prepare for potential financial distress, and investors are more likely to trust and invest in secure companies. One way to make your exchange rate exposure clear to investors is to display the actual historical and potential future impacts of exchange rate fluctuations by currency or company segment. Successfully creating, following, and communicating a foreign exchange rate risk mitigation strategy will build investor confidence and create long-term value for the business and its investors.

Conclusion

Foreign currency risk is becoming increasingly relevant for all businesses. From the start, companies need to understand the variety of ways in which they might be exposed. Even small domestic companies would benefit from an analysis of how exchange rates might affect their future business prospects. Currency risk can take multiple forms, and management should pay attention to both short-term transactional risk and long-term operational risk. By understanding and implementing the various tools that can be used to mitigate these risks, companies can avoid unnecessary costs and potential disasters. By effectively communicating its strategies for mitigating foreign exchange risk, a firm can gain the confidence of investors and maintain its competitive position. Companies that make the necessary changes to decrease their exposure to foreign currency risk will be more likely to create and sustain a competitive advantage.



Resources Consulted


Footnotes

  1. McDonald’s 2019 Annual Report. Page 9.
  2. McDonald’s 2019 Annual Report. Page 6.
  3. McDonald’s 2019 Annual Report. Page 10.
  4. Aggarwal, Raj and Harper, Joel T., “Foreign Exchange Exposure of ‘Domestic’ Corporations.” Journal of International Money and Finance. Vol. 29, No. 8 (2010).
  5. Sensitivity analysis studies the extent to which changing the value of an input affects the output of a model.
  6. BMW’s 2010 Annual Report. Page 21
  7. Ford’s 2019 Form 10-K. Pages 78–79.
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Author John Baadsgaard

John grew up in Spanish Fork, Utah. In addition to his Strategy degree, he is also completing minors in statistics and economics. John hopes to bring a uniquely down-to-earth, data driven, as well as big-picture perspective to problem solving and analysis. In his spare time, John also loves exploring mountain peaks, cooking exotic foods, and mastering Chopin etudes. He plans to join LEK Consulting in Houston after graduation.

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