corporate currency risks explained

8/8/2019 Corporate Currency Risks Explained

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Corporate Currency Risks Explainedby Permjit Singh

Businesses that trade internationally or domestically must deal with various risks whentrading in currencies other than their home currency.

Companies typically generate capital by borrowing debt or issuing equity, and then use thisto invest in assets and try to generate a return on the investment . The investment might bein assets overseas and financed in foreign currencies, or the company's products might besold to customers overseas who pay in their l ocal currencies.

Domestic companies that sell only to domestic customers might still face currency riskbecause the raw materials they buy are priced in a foreign currency. Companies who tradein just their home currency can still face currency risk if their competitors trade in a differenthome currency. So what are a company's various currency risks? (Baffled by exchangerates? Wonder why some currencies fluctuate while others don't? This article has theanswers: Currency Exchange: Floating Rate Vs. Fixed Rate .)

Transaction RiskTransaction risk arises whenever a company has a committed cash flow to be paid orreceived in a foreign currency. The risk often arises when a company sells its products orservices on credit and it receives paymen t after a delay, such as 90 or 120 days. It is a riskfor the company because in the period between sale and receipt of funds, the value of theforeign payment when it is exchanged for home currency terms could result in a loss for thecompany. The reduced home currency value would arise because the exchange rate hasmoved against the company during the period of credit granted. (Learn more in Protect YourForeign Investments From Currency Riskand What is a currency converter and how do Iuse one?)

The example below illustrates a transaction risk:

Spot Rate

AUDReceivedFrom Sale

USDReceivedAfterExchange

Scenario A(Now)

USD1 = AUD2.00 2 million 1 million

Scenario B(After 90 days)

USD1 = AUD2.50 2 million 800,000

For the sake of the example, let's say a company called USA Printing has a homecurrency of U.S.dollars (USD) and it sells a printing machine to an Australian customer,Koala Corp., which pays in its home currency of Australian dollars (AUD) in the amount of $2million.

In scenario A, the sales invoice is paid on delivery of the machine. USA Printing rece ives $2million Australian dollars, and converts them at the spot rate of 1:2 and so receives US$1million.


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In scenario B, the customer is allowed credit by the company, so $2 million AUD is paid after90 days. USA Printing still receives A$2 million but the spot rate quoted at that time is1:2.50, so when USA Printing converts the payment, it is worth only US$800,000, adifference of US$200,000.

If the USA Printing had intended to make a pr ofit of US$200,000 from the sale, this wouldhave been totally lost in scenario B due to the depreciation of the AUD during the 90 -dayperiod. (Companies know all about these risks, learn how they avoid them in Corporate UseOf Derivatives For Hedging.)

Translation Risk A company that has operations overseas will need to translate the foreign currency values ofeach of these assets and liabilities into its home currency. It will then have to consolidatethem with its home currency assets and liabilities before it can publish its consolidatedfinancial accounts - its balance sheet and profit and loss account. The translation processcan result in unfavorable equivalent home currency values of assets and liabilities. A simplebalance sheet example of a company whose home (and reporting) currency is in pounds ()will illustrate translation risk:

Pre-Consolidation Year 1 Year 2

1:$ExchangeRate n/a 1.50 3.00

Assets

Foreign $300 200 100

Home 100 100 100

Total n/a 300 200

Liabilities

Foreign 0 0 0

Home (debt) 200 200 200

Equity 100 100 0

Total n/a 300 200

D/E ratio n/a 2 --

In Year 1, with an exchange rate of 1:1.50, the company's foreign assets are worth 200 inhome currency terms and total assets and liabilities are each 300. The debt/equity ratio, is2:1. In Year 2, the dollar has depreciated and is now trading at the e xchange rate of

1:$3.00. When Year 2's assets and liabilities are consolidated, the foreign asset is worth100 (a 50% fall in value in terms). For the balance sheet to balance, liabilities must equalassets. The adjustment is made to the value of equit y, which must decrease by 100 soliabilities also total 200. (Learn about the components of the statement of financial positionand how they relate to each other; see Reading The Balance Sheet.)

The adverse effect of this equity adjustment is that the D/E, or gearing ratio, is nowsubstantially changed. This would be a serious problem for the company if it had given acovenant (promise) to keep this ratio below an agreed figure. The consequence for thecompany might be that the bank that provided the 200 of debt demands it back or it applies


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penal terms for a waiver of the covenant.

Another unpleasant effect caused by translation is that the value of equity is much lower -not a pleasant situation for shareholders whose investment was worth 100 last year, and

some (not seeing the balance sheet when published) might try to sell their shares. Thisselling might depress the company's market share price, or make it difficult for the companyto attract additional equity investment. (Learn how to evaluate a company based on itsfinancial statements, check out our Fundamental Analysis Tutorial.)

Some companies would argue that the value of the foreign assets has not ch anged in localcurrency terms; it is still worth $300 and its operations and profitability might also be asvaluable as they were last year. This means that there is no intrinsic deterioration in value toshareholders. All that has happened is an accounting effect of translating foreigncurrency. Some companies, therefore, take a relatively relaxed view of translation risk sincethere is no actual cash flow effect. If the company were to s ell its assets at the depreciatedexchange rate in year two, this would create a cash flow impact and the translation riskwould become transaction risk.

Economic Risk

Like transaction risk, economic risk has a cash flow effect on a company. Unlike transactionrisk, economic risk relates to uncommitted cash flows, or those from expected but not yetcommitted future product sales. These future sales, and hence future cash flows, might bereduced when they are exchanged for home currency if a foreign competitor selling to thesame customer as the company (but in the competitor's currency) sees its exchange ratemove favorably (versus that of the customer) while the company's exchange rate versus thatof the customer, moves unfavorably. Note that the customer could be in the same country asthe company (and so have the same home currency) and the company would still have anexposure to economic risk. (Investing overseas begins with a determination of the risk of thecountry's investment climate Evaluating Country Risk For Internatio nal Investing.)

The company would therefore lose value (in home currency terms) through no direct fault ofits own; its product, for example, could be just as good or better than the competitor's

product, it just now costs more to the customer in the cust omer's currency.

The Bottom LineCurrency risks can have various effects on a company, whether it trades domestically orinternationally. Transaction and economic risks affect a company's cash flows, whiletransaction risk represents future and known cas h flows. Economic risk represents future butunknown cash flows. Translation risk has no cash flow effect, although it could betransformed into transaction risk or economic risk if the company were to realize the value ofits foreign currency assets or liabilities. Risk can be tricky to understand, but by breaking itup into these categories, it is easier to see how that risk affects a company's balancesheet. (Read more in Currency Moves Highlight Equity Opportunities and What is politicalrisk and what can a multinational company do to minimize exposure? )

by Permjit Singh (Contact Author | Biography)

corporate currency risks explained

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