Also known as FX-risk and exchange-rate risk, currency risk stems from the fluctuation of the exchange rate between two currencies. Companies engaged in cross-border operations are most exposed to currency risk. Such operations may experience unexpected profit or loss due to currency rate fluctuations – this is currency risk.
From the perspective of currency risk, stable currencies are ideal. Such currencies do not appreciate or depreciate against the operator’s own currency. Thus, they eliminate this undesired variable from the profitability equation.
It is worth noting however that perfectly stable currency pairs do not exist.
Examples of Currency Risk-induced Losses
The business world has become acutely aware of currency risk in the wake of two major recent crises. The 1994 Latin American crisis left scores of people penniless, through fast currency depreciation. The same happened in 1997, on a different scale, in Asia.
How can a business accrue losses on account of currency risk?
Consider a German investor (retail or institutional) that acquires Canadian stock. The value of the said stock appreciates by 10%, leading to 10% profits for the said investor. At the same time, the Canadian dollar depreciates by 10% against the Euro. The profits of the investor are thusly eliminated. With the costs of the trading, the investor may even have registered a loss.
In the above scenario, the appreciation of the CAD would increase the profits of the investor. In other cases, appreciation may lead to losses instead.
Let us consider a US company which has moved its production overseas. Thus, a foreign country hosts its production facilities and provides its workforce. If the currency of this country appreciates against the USD, the USD production costs of the company increase. Its profits therefore suffer.
In another example, a US company buys a product from France. The agreed cost of the purchase is USD 5,000, at a time when the USD trades at parity (1:1) with the Euro. By the time the product is delivered however, the EUR/USD exchange rate is 1.10. The buyer thus pays USD 5,500 instead of USD 5,000.
Currency Risk Types
This makes it clear that there are at least 3 currency risk sub-types:
- Translation risk plagues companies which own subsidiaries in foreign countries. It usually “comes home to roost” when the financial statements of the subsidiary are translated into the currency of the parent company.
- Transaction risk affects purchases of goods/services from foreign countries.
- Economic risk is the result of prolonged exposure to any of the mentioned currency risk types. A company that is continuously exposed to risks posed by currency rate fluctuations, will eventually see its market value affected as well.
How to Deal with Currency Risk
For investors, it makes sense to target countries with healthy currencies and interest rates. A textbook example in this regard would be Switzerland. This also means the economic outlook of the country has to be a healthy one.
High debt is a red flag in this regard, as it usually precedes inflation.
Not all business entities can however afford to operate solely in well-vetted countries. For such operators, currency risk sharing is another option.
Through such a setup, companies agree to share the risks stemming from the currency rate fluctuation. One party effectively agrees to shoulder part of the losses the other party incurs.
Currency risk sharing agreements are subject to intricate terms and conditions. The parties involved negotiate such contracts on a case-by-case basis.
For investors, currency-hedged funds are also an option. Such funds deal with currency risk through the use of futures and options. Unfortunately, hedging also reduces potential gains and is quite expensive.