Foreign Exchange Risk | International Finance

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International Finance

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Introduction
Foreign exchange risk is a risk that arises when a financial transaction is carried on other
currencies rather than domestic currency. The exchange risk exists when there are chances of
currency appreciation or currency depreciation. There are many types of foreign exchange risks
that are an economic risk, contingent risk, transaction risk and translation risk (Chan et.al,2019).
In order to understand the concept of risk a multinational company is chosen that operates in
UAE and imports goods from France. Emirates group is one of the leading players in the aviation
industry in UAE the company operates all across the world but headquarters in UAE. This
report includes detail about products that the company imports from other countries and risks
that exist in the importing of goods and raw material from the foreign market. Further, different
ways through which the risk can mitigate is explained and one or two ways of managing risk for
Emirates are identified.
Company
Emirates has been in the aviation industry for the last thirty-five years. The company started its
operations from Dubai in 1985. Emirates leased two aircraft which were Airbus 300 B4 and
Boeing 737. Emirates showed tremendous growth in the aviation industry in terms of
competition and scale. According to Skytrax Emirates airlines is one of the largest airlines as it
covers 161 destinations across 6 continents. Emirates market performance is growing up as the
company showed a net profit of US$ 62 million from sales of US$ 13.3 billion (Emirates, 2019)
Emirates positioned itself as one of the luxury services provider company that offer unique
cabins to business class people and provide high-quality luxury services to its target market.
Further, in order to improve its services and provide high-quality experience the company import

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high-class aircraft with high technology in order to reduce its fuel cost and fleet time to satisfy
customer wants. Emirates at present ordered 50 Airbus from its French manufactures, this shows
that the company import aircraft from France, in this the company has to pay in Euro instead of
AED. Due to that Emirates might face risk related to currency fluctuation means any change in
the exchange rate that is if Euro appreciated or depreciated the company total amount varies
accordingly.
Imported Products
 Airframes And Modification
 Components
 Engines
 A350 aircrafts
 Line Maintenance
Foreign Exchange Risk
Foreign exchange risk refers to the loss that the companies face on the international financial
transaction because of currency fluctuations. Foreign exchange risks exist when companies
engage in financial transactions with other currencies transactions. This can affect the investors,
traders and businesses that are engaged in the exports and imports of services and products in
multiple countries. The foreign exchange risks that are associated with international transactions
are transaction risk, translation risk and economic risk (Fablings and Grimes,2015).

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Foreign exchange risk can be mitigated by hedging as the hedging is the technique that is used
by the companies in order to manage the risk that the company is going to face because of
currency fluctuation.
Types of exchange risk
Transaction risk: When any business transactions happen in the other currency rather than the
home currency or domestic currency of the organization. When the organization thinks that there
might be a change in the rate of the currency, when the company enters into a contract till
settling it, this leads to transaction risk.
Translation risk: Translation risk arise when the company has subsidiaries in different countries
and has different reporting currency then the parent company then translation risk arises as the
company needs to change the amount of financial statement and profits of its subsidiary as per
the currency of parent company (Chan et.al,2019).
Economic risk: It is the risk that is related to the change in the market forecast of the company’s
cash flow in the future because of changes in the current exchange rate. For instance, if the
company has a monopoly in the market and near future can face competition and suddenly if the
import rate of raw material becomes cheaper it is termed as a forecast or economic risk.

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Emirates group risk related to currency and transaction risk as to the company imports aircraft
and equipment from France. Emirates has to pay its account payable in foreign currency that is
Euro, in order to manage risk related to currency fluctuations. Emirates face risk if at the time of
the transaction the foreign currency appreciated, the amount that emirates have to pay become
larger. This leads to buying or importing at a higher price because of currency fluctuation. The
companies take various initiatives in order to manage and to reduce the loss from foreign
exchange risk. Transaction risk is termed as the risk that arises from fluctuations in prices
between contract entering and contract settlement. This risk is more if the Emirates group takes a
long period of time between settling a contract and entering into a contract (Asquith,2019).
Emirates engages in international transactions to a greater extent as it operates in different
countries due to that risk of the transaction for the company is more. Emirates import aircraft
from France, this type of transaction requires a long time as the company needs to settle a deal
earlier and deliver of the settlement of contract take year to complete. When the company
engages in long term transactions there is a time delay in agreeing on the terms of exchange
transaction and completing the deal. The more the times difference between settlement and final
deal higher the transaction risk because of more time chances of fluctuation in the currency
become more.
Emirates ordered 50 Airbus, A350 at list price $16billion the deal was negotiated by the
company. The company import aircraft from France and entered into a contract with French
manufacturer for delivery of aircraft in 2021. This is a year contract in which the transaction risk
exists and the company reduced it by hedging and lock the value through future contracts. The
transaction risk can be managed by using different techniques of hedging as the company hedge
its funds in order to reduce the risk (Asquith,2019).

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Techniques to manage risk
Money market hedge: This is a technique that is used by the companies to lock the number of
foreign currency transactions as per the domestic value of the currency (Alvarez et.al,2016). The
company that operates in the UAE wants to purchase six months from France has to pay in Euro
and not in AED. The company can use the money market hedge in order to manage transaction
risk. As the company can lock in the value of Euro relative to AED, if the domestic currency
weakens relative to Euro in six months then UAE company has an idea about the transaction cost
and the account that the company has to pay after six months and accordingly the company
makes its budget.
Euro/AED forecast
Spot rate =4.102
Future rate= 4.00 (after 1 year) (from figure 1 and figure 2)
Future and Forward market hedge
Futures contracts are one of the derivate or techniques that are used to hedge foreign exchange
risk. This is considered as the arrangement between parties who are involved in the contract that
are buyer and seller. This contract includes an arrangement to sell and buy an asset at a fixed
time in the future at a fixed price. The companies use forward contracts in order to manage risk
related to foreign exposure or risk of fluctuation in prices. A forward contract is useful for the
company as it is an agreement of a specific asset on a current price on a specific date. For
instance, the UAE based company knows that the company is going to buy an asset in the near
future, the company can opt for futures contracts to hedge (Omar et.al,2017).

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Option market hedge
The options market contract includes put option and call option, currency options are one of the
most common ways to hedge against the exchange rate risk. The option is a situation in which
“buyer has the right but not the obligation to sell or buy currency at a fixed exchange rate before
specified date”, a premium amount is paid to the seller by the buyer. The premium on the option
depends on the expiration date and strike price. Call options provide the right to the holder to buy
an asset at a specific price. The company buys calls when the company thinks that prices of the
commodity will rise in the near future and sell a call when the company thinks the asset price
fall. Put option includes the right to sell the asset at a specific price or buying an asset at the spot
price. The company buys the asset if the company thinks the asset price fall and sells when to
think the price rises, this is done in order to retain position in the market for the long run
(Kearney et.al,2019).
Recommendation
It is recommended to Emirates airlines that in order to import aircraft from France, the company
is going to face transaction risk. The transaction risk can be managed or reduced through a
money hedge technique. As the spot rate is 4.10 and after one year the exchange rate fluctuated
to 4.0 the company might face issues in the future because of high fluctuation in the exchange
rate. In order to reduce the risk money market hedge is best suitable for Emirates as in this the
company can fix the price of contract as per the spot market rate and can settle in future on a
specific date. This helps the company to manage its budget accordingly and if price rises in the
future the company has no such uncertainty and issue because of currency fluctuation or
exchange rate changes.

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Conclusion
It is concluded from the report that it is important for the companies to know the foreign
exchange risk that they can face in the near future and accordingly use techniques to reduce or
manage exchange risk. From the analysis of Emirates, it is identified that the company is facing
transaction risk while importing aircraft from France as there is fluctuation in the Euro and AED
exchange rates. The company in order to manage risks can use hedging techniques and can
manage through money hedging. Hence, it is important for companies to know and manage risk
so that they can have more profits on agreements.

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References
Álvarez-Díez, S., Alfaro-Cid, E. and Fernández-Blanco, M.O., 2016. Hedging foreign exchange
rate risk: Multi-currency diversification. European journal of management and business
economics, 25(1), pp.2-7.
Asquith, J.2019. The truth is that Emirates net canceled $20 Billion of Aircraft. Accessed From:
https://www.forbes.com/sites/jamesasquith/2019/11/22/the-truth-is-that-emirates-net-canceled-
20-billion-of-aircraft-orders-at-the-dubai-airshow-contrary-to-media-headlines/#56a2c7c3521f
Boudt, K., Neely, C.J., Sercu, P. and Wauters, M., 2019. The response of multinationals’ foreign
exchange rate exposure to macroeconomic news. Journal of International Money and
Finance, 94, pp.32-47.
Chan, R.H., Guo, Y.Z., Lee, S.T. and Li, X., 2019. Foreign Exchange Modelling. In Financial
Mathematics, Derivatives and Structured Products (pp. 223-230). Springer, Singapore.
Emirates,2019. The story of Emirates. Accessed From: https://www.emirates.com/in/english/
Fabling, R. and Grimes, A., 2015. Over the hedge: do exporters practice selective
hedging?. Journal of Futures Markets, 35(4), pp.321-338.
Kearney, F., Cummins, M., and Murphy, F., 2019. Using extracted forward rate term structure
information to forecast foreign exchange rates. Journal of Empirical Finance, 53, pp.1-14.
Omar, A.B., Mohammad, K.N.B.T., and Ahmad, N.B., 2017. Exposure to foreign exchange rate
risk: A review of empirical evidence. Journal of Insurance and Financial Management, 2(5).

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Appendix
Figure 1: Euro/AED foreign exchange forecast
Source: (Boudt et.al,2019)

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Figure 2: Trend in foreign exchnage Source: (Boudt et.al,2019)