Currency Risk: The Purpose and Risk of Money

What Is Currency Risk?

Currency risk is the risk that business operations or the value of an investment will be affected by changes in exchange rates.

As companies expand their participation in the global economy, it has become increasingly important to identify and assess the impact of currency risk. Exposure to currency risk can have adverse effects on income, cash flows or net worth. Currency risk is the exposure to fluctuations in exchange rates that may arise because of one or all of the following:

• Business activities or operations in foreign markets
• Investment in securities that are issued by overseas entities
• Investment in securities that are denominated in a foreign currency

Exposure to currency risk means that the company may experience an economic or accounting benefit if exchange rates move in a positive direction or suffer an economic or accounting loss if exchange rates move in a negative direction. Currency risk, also known as foreign currency risk or foreign exchange risk, is generally classified as economic, transaction or translation risk.

Economic Risk: Economic risk is currency exposure associated with future cash flows, including strategic or competitive risk. Strategic/competitive risk is the extent to which the firm's currency profile places it at a competitive advantage or disadvantage in the event of significant changes in exchange rates. Strategic exposures may substantially exceed known transaction volumes and may relate to currencies in which the firm has no direct cash flow exposure. To evaluate strategic risk, it is necessary to examine a broad range of competitive practices, including:

• The number of buyers and sellers in the industry
• The functional currency of industry competitors
• The sensitivity of prices to changes in input costs

Market Demand

Managing strategic risk, to a significant extent, falls upon the operating manager, who determines the currency of billing and pricing and negotiates currency-variation clauses in customer contracts.

Net Monetary Risk: Net monetary risk is exposure to exchange gains or losses on monetary assets or liabilities, which are denominated in a currency other than the functional currency of that operation (e.g., U.S. debt held by a French subsidiary). Net monetary exposures may have tax consequences in the entity's country, as well as cash flow consequences if assets or liabilities are converted into the local currency.

Transaction Risk: Transaction risk is exposure to movements in exchange rates on specific cash flows. The longer exposure is outstanding, the greater the risk of unfavorable currency movements.

Transaction risk includes:

Firm Commitments Risk (Including Declared Dividends): Firm commitments risk is exposure to a contractual commitment in a foreign currency between the current date and the date of settlement. A contractual commitment may require settlement of the transaction in a foreign currency at a specified or unspecified future date. Transaction exposures are the effects of currency movements on the company's outstanding commitments. This risk also includes anticipated cash transfers over the foreseeable future (generally within the next 12-18 months) from a subsidiary, branch or business unit operating in a foreign country, which may result in currency exposure for both the remitting entity and the parent.

Budget Risk: Budget risk is exposure to income loss because of currency rates that differ from the assumed rates included in the corporate business plan.

Cash Flow Risk: Cash flow risk is exposure to cash flow changes because of foreign taxes on income in a foreign currency, which is not reflected in earnings in the firm's home or reporting currency.

Translation Risk: Translation risk is exposure to adverse effects on the financial statements because of currency fluctuations. The conversion of translating foreign currency financial statements into the reporting currency may significantly affect net margins, net asset and liability positions, and net equity positions.

Currency risk, also known as exchange risk or foreign exchange risk, is complicated. So, what can we do about it?

First, identify the root causes of currency risk. Sourcing the root causes of currency risk requires an analysis of the key business processes that influence the velocity of the cash-to-cash cycle. The analysis of business processes can be comprehensive or selective, depending on management's view of where the risks and opportunities for improvement are.

Next, measure your company’s exposure to currency risk. A company's exposure to foreign currency risk is dependent on the nature of its exposure and the complexity of its risk management activities (i.e., the use of derivatives to hedge the exposures).

Check out Currency Risk Key Performance Indicators on KnowledgeLeader for more information on sourcing root causes of currency risk and a list of nine bullet points to consider in currency risk analysis.

Finally, evaluate management practices and performance measures that can eliminate or reduce currency risk for your company. This can be a complex and multifaceted process with many questions to consider, so it may be best to seek guidance on this topic.

KnowledgeLeader’s Currency Risk Key Performance Indicators (KPIs) benchmarking tool describes risks associated with currency; identifies their root causes; and provides risk measurement information, management practices and questions to consider.

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