Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the reporting currency of the consolidated entity. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a international finance keith pilbeam pdf download of changes in the exchange rate between the foreign and domestic currency.
It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it. 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 at each balance sheet. Such exchange rate adjustments can severely affect the firm’s market share position with regards 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. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic risks can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic risk for a firm that sells that good.
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. Such a 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 happen. A deviation from one or more of the three international parity conditions generally needs to occur for an exposure to foreign exchange risk.
In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. A higher standard deviation would signal a greater currency risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations, be they positive or negative, and for automatically squaring deviation values. Firms with exposure to foreign exchange risk may use a number of foreign exchange hedging strategies to reduce the exchange rate risk. Firms may adopt alternative strategies to financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange risk exposure. Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards. Firms can manage translation exposure by performing a balance sheet hedge.
Since translation exposure arises from discrepancies between net assets and net liabilities on a balance sheet solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure. Bretton Woods system that firms became exposed to an increasing risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure.