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Got to be certain?

Hedging currency is still one of the most popular forms of risk management in normal trading transactions, but it's by no means the only one. Will Spinney considers the options.

 

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Got to be certain
When it comes to commercial risks arising in foreign exchange, many treasurers hedge and then make the required accounting transactions – often for economic reasons. But what are the wider concepts and issues around foreign exchange risk?

 

As an example of the sort of risks businesses face, consider the two following examples:

  1.  An exporter quotes a price in the currency of his customer, say Brazilian reals, while having costs in sterling. The quote remains valid for some time, during which time sterling climbs against the real. The customer orders the goods at the old set price that now delivers 5% less in sterling terms than when the quote was provided.
  2. A transport operator needs to buy assets, which are quoted to him in a foreign currency. The rate at which the currency is bought changes the base cost of the assets and may disadvantage the purchaser compared with another operator in the field.

We could also look at this personally. Say we are going to visit the US soon and need to buy dollars. We have a risk on the sterling costs of those dollars until we have bought them. We can choose to buy them at any time before our trip; until they are bought we don’t know exactly how much the trip will cost. In fact, we could also borrow those dollars for our trip, deferring the conversion to our home currency.

The amounts involved for a single trip would not be very significant, but suppose we want to go there year after year and rent an apartment. How far does our risk extend?

If we take the time line of a typical contract with foreign exchange rates involved, we can look at the risk as several different types.

Economic risk is the risk that we are competitive in the first place and that we can actually bid. The exchange rate may make us more expensive than a foreign competitor, for example.

This is an extract from the Finance and Management Faculty magazine issue 212 July/August 2013, p.12-14