Currency risk for companies and investors

A German machine maker sells a press to a US customer for five million dollars, payable in three months. It has done everything right: good product, fair price, reliable customer. Yet by the time the dollars arrive, its profit could have shrunk or vanished, just because the euro rose.

Currency riskThe risk that a change in exchange rates changes the value of what you will receive, pay or own. is the chance that a move in exchange rates changes what you receive, pay or own. Companies and investors meet it in three different forms. The first two are the ones to keep apart.

Transaction exposure is the most concrete. The German exporter in the hook has transaction exposureExposure on a specific, known foreign-currency cash flow, such as an invoice to be paid or received. It hits cash.: it will receive a fixed number of dollars, but how many euros they buy depends on EUR/USD on the payment day. If the euro strengthens, each dollar buys fewer euros and the sale is worth less. The same works in reverse for an importer paying in a foreign currency.

Translation exposure comes from consolidation. Each subsidiary keeps its books in its functional currencyThe currency of the main economic environment in which a business operates.; the group reports in its presentation currencyThe currency in which a group publishes its accounts, also called the reporting currency.. A US group with a UK subsidiary must turn pounds into dollars every reporting date. If the pound falls, the subsidiary's net assets are worth fewer dollars on paper, even though the UK business has not changed. Under IFRS (IAS 21), these translation differences go to other comprehensive incomeOther comprehensive income: a part of the accounts where some gains and losses are recorded outside profit., not to profit, until the subsidiary is sold.

Economic exposure is the broadest and the hardest to measure: exchange rates shape who wins customers over years. It is managed through strategy (where to build plants, where to buy inputs) more than through trades.

Managing it

The standard tool for transaction exposure is the FX forward from L1.6.02: sell the foreign currency forward today and the home-currency amount is fixed. A forward cuts both ways: it removes the loss if the foreign currency weakens, but also the gain if it strengthens. Many treasurers therefore hedge only part of an exposure, choosing a hedge ratioThe share of an exposure that is hedged, from 0% (none) to 100% (all).. Options (L1.7.06) can protect against losses while keeping gains, for a premium. A natural hedgeReducing currency risk by matching revenues and costs in the same currency, without using derivatives. matches revenues and costs in the same currency, for example by paying a US plant's wages out of US sales.

Investors. An investor who buys foreign shares or bonds takes on two risks: the asset and the currency. The return at home combines both, and a currency move can wipe out a good local return. Many funds that hold foreign bonds hedge most of the currency risk, because a bond's modest return can easily be swamped by exchange-rate swings; equity investors hedge less often.

Let $A$ be a receivable in dollars, $S_T$ the EUR/USD rate on the payment day, $F$ the forward rate and $h$ the hedge ratio. The euros received are the hedged part at $F$ plus the rest at $S_T$:

We divide because the exporter holds the quote currency (USD) and wants the base (EUR), as in L1.6.01. With $h = 1$ the result no longer depends on $S_T$.

For an investor with a local return $R_L$ and a change $R_{FX}$ in the value of the foreign currency, growth factors multiply:

Leave the hedge at 0% and move the payment-day rate up to 1.15: the euro strengthens and the sale loses value. Now raise the hedge to 100% and move the rate again: the euros received stop moving. Try 50% for the middle road.

Translation. A US group owns a UK subsidiary with net assets of GBP 100,000,000. If GBP/USD falls from 1.30 to 1.20, the translated net assets fall from USD 130,000,000 to USD 120,000,000, a translation loss of USD 10,000,000. Under IAS 21 it is recorded in other comprehensive income. No cash has moved, and the UK business is unchanged.

An investor. A Tokyo pension fund owns US shares that rise 8% in dollars over a year. Meanwhile USD/JPY falls from 150 to 138, so the dollar loses 8.00% against the yen. In yen, the return is $(1 + 0.08) \times (1 -0.08) - 1 = -0.64\%$: a good year in dollars becomes a small loss at home.

Accounting rules decide where currency effects show up. IAS 21, The Effects of Changes in Foreign Exchange Rates, sets how foreign transactions and foreign operations are translated, and sends translation differences on foreign operations to other comprehensive income. IFRS 9 lets a company use hedge accounting so that a forward and the exposure it hedges hit profit at the same time. US GAAP has matching rules in ASC 830 and ASC 815.

Looking ahead: banks hold capital against their currency positions under the Basel market risk rules, and insurers under Solvency II carry a currency risk charge (L4.6).

• Transaction exposure: known foreign-currency cash flows. Real cash is at stake.
• Translation exposure: converting a foreign subsidiary's accounts. Reported numbers change, cash does not; under IAS 21 the differences go to OCI.
• Economic exposure: exchange rates change competitiveness and future cash flows, even with no foreign invoices.
• A forward fixes the home-currency amount, removing both the loss and the gain. A hedge ratio sets how much is fixed.
• An investor's home return is (1 + local return) × (1 + currency change) − 1.

Currency risk

The risk that a change in exchange rates changes the value of what you will receive, pay or own.

Transaction exposure

Exposure on a specific, known foreign-currency cash flow, such as an invoice to be paid or received. It hits cash.

Translation exposure

Exposure that arises when a group converts a foreign subsidiary's accounts into its reporting currency. It changes reported figures, not cash.

Economic exposure

The longer-term effect of exchange rates on a firm's competitiveness and future cash flows, even if it never invoices in a foreign currency.

Functional currency

The currency of the main economic environment in which a business operates.

Presentation currency

The currency in which a group publishes its accounts, also called the reporting currency.

Other comprehensive income

Other comprehensive income: a part of the accounts where some gains and losses are recorded outside profit.

Hedge ratio

The share of an exposure that is hedged, from 0% (none) to 100% (all).

Natural hedge

Reducing currency risk by matching revenues and costs in the same currency, without using derivatives.