Types of Foreign Exchange Risk
Committees, which compete in an international marketplace, are at risk to changes in foreign exchange rates. These risks are of three types: transaction risks, translation risks and economic risks.
The transaction risk is the most obvious and common. A Swiss importer needs to pay for dollar imports in six months, which are ordered today. If the Swiss franc weakens against the dollar, the imports will cost more. A Swiss exporter has sold goods to someone in the US to be paid for in US dollars. By the time the goods are shipped and paid for, say in nine months, the Swiss franc may have strengthened against the dollar, making the dollar earnings worth less money. Most corporations will decide to reduce this risk by the hedging.
The translation risk is also a factor. For example, a French firm has overseas subsidiaries reporting profits in Swiss francs. It also owns land and property in Switzerland. If the Swiss Franc weakened against the euro, the profits are worth less in euros when included in the annual report. The value of the land and property may be unchanged, but, translated in euros, the assets seem to have lost value.
Should these exposures be hedged? This is a subject of huge controversy. Not hedging may distort asset values and earnings-per-share. On the other hand, hedging means spending real money to protect the county figures. In any case, sophisticated investors will take the exposure into account. Knowing that our French firm has a heavy exposure to Switzerland, they will adjust their view of the firm’s prospects. If, however, the risk is has already been hedged away, their view will be incorrect. It may be complicated by the fact that the French firm makes extensive purchases and Swiss franc, thus giving a natural offset of risk.
Economic risk is also another factor. Suppose a Dutch firm is selling goods into the US and its main competitor is a British firm. If the sterling weakens against the dollar, the Dutch firm has lost its competitive advantage. The UK left the DRM in September 1992. The Sterling fell 15% against the deutsche mark in a matter of weeks, but the Dutch Gilder did not. Obviously this is serious with the Dutch firm, but it may not be easy to hedge such a risk. It does need to be considered as part of marketing and competitive strategy.
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