(PDF) Foreign Exchange Risk in International Transactions

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WEEK 6 CASE STUDYExecutive SummaryThis case study analysis focuses on the past two currency crises the 1992 United Kingdom andthe 1998 Hong Kong crises. The causes and what contributes to the changes in the currencyexchange rate and the firm's exposure to the exchange rate will be reviewed. The case study willexplain the possible ways in which the two countries did to deal with their crises.1.Define Currency RiskThere is a drastic effect of foreign rates change on a firm’s profitability, cash flows and marketvalue. So, it is important to measure the foreign exchange exposure and manage it and try toreduce it to the acceptable level. Accounting exposures are described as transaction exposure andtranslation exposure, and economic exposure is described as operating exposure.Currency risk refers to the risk which arises due to fluctuation in the value of currency. It is thevariance in forecasted cash flows which occurs from unexpected exchange rate fluctuations.Since, these fluctuations result in unexpected gains or losses, it is needed to manage and reducethis risk. Investors try to reduce their currency risk by entering forward hedge, money markethedge, future derivative contracts, and options derivative contracts.Currency risk is a one form of financial risk that arises from the change in price of one currencyagainst another. Whenever the business investors or companies have an assets or businessoperations across the national boundaries or one or more countries, they face a currency risks inforeign market. For example: If the United Kingdom investor has stocks in Hong Kong, thereturn that you will realize is affected by both the changes in the price of the stocks and thechanges in the value of the Hong Kong currency against the UK currency. So, if you realize a
10% return in your Hong Kong stocks but the Hong Kong currency depreciates at 10% againstthe UK currency, this will cause no gain at all.2.Discuss factors that cause and contribute to changes in currency exchange rates and afirm’s exposure to exchange rate fluctuations.The following are the reasons that cause and contribute the changes in the currency exchangerates:While there are various economic, political, and regulatory factors that affect the changes in thecurrency exchange rate. The factors are interest rate, demand and supply, political stability,economic strength, inflation, trade balance etc. For example, when we look at demand andsupply factor, as we know the basics of it, if there is a huge demand for a particular currency, theprices of that currency, the prices of that currency will tend to rise as compared to the othercurrencies. For example, US dollar is the largest traded currency in the world. As all thecountries require USD to trade in the international markets, the demand for USD will rise if thereis limited or minimum supply of USD in the currency market. When we look at interest ratesfactor, we see that interest rates and currency rates are connected to each other in some way. Ifthe interest rates of domestic currency are high, then they will require less of foreign currencypushing the value of the foreign currency down and if the interest rates of the foreign currencyare high, the demand for the foreign currency will be higher making it expensive.Factors affecting the firm exposure to currency fluctuations are as follows:a)Transaction Risk: A firm may be affected by currency exchange rate fluctuations if thepayables and receivables are in foreign currency. A minimum upside or downside in thevalue of the currency exchange can cause the firm to a greater amount of loss or gain
because of the transactions. For example, if a company in India imports iphones from Usaat $1000 per phone with a current exchange rate of Rs. 70/dollar and if the rate increasesto Rs. 73/dollar the importer will have to shell out Rs. 73,000 i.e. Rs 3,000 extra than theprevious exchange rate.b)Translation Risk: The Value of assets and liabilities that a firm has on its books which arein foreign land also causes the amount to revalue at the current rate and absorb thedifference in the equity. For example, if the assets invested in USA are valued at $100 inthe balance sheet and if the exchange rate increase from Rs. 70/dollar to Rs. 73/dollar.The assets will be revalued at Rs. 7300 as per the current exchange rate as compared toRs. 7000 in the previous exchange rate.3.Discuss how currency rate fluctuations and currency risks apply to a firm’s:Discuss the effect on Balance SheetDiscuss the effect on Income StatementDiscuss the effect on Cash Flow StatementBalance Sheet: The gains and losses from the currency exchange affect the balance sheet onlythrough the other comprehensive income which comes in the equity section of the balance sheet.Assets revalued also affect the other comprehensive income, which adds up to equity.Income Statements: The Foreign Exchange translation Losses or Gains are recorded in the OtherComprehensive Income. This amount is later added to Equity Section of the Balance Sheet in theform of retained earnings.
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