Foreign Exchange Rate Risk

InternationalHub

21 Dec 201703:17

Summary

TLDRThis video discusses how global companies manage foreign exchange risk when conducting international business. Firms face currency fluctuations during the time between transactions and payments, which can impact their earnings or costs. To mitigate these risks, companies use three common strategies: spot rate exchanges, hedges, and currency swaps. Spot rate exchanges eliminate the time gap, hedges allow firms to set future exchange rates, and currency swaps involve swapping currencies with another company to avoid fluctuations. These strategies help reduce or eliminate exchange rate risks in international trade.

Takeaways

🌍 International companies often deal with exchange rate risk when buying or selling goods in foreign currencies.
💱 Exchange rate fluctuations can affect the value of transactions, especially when there's a time lag between agreement and payment.
📅 A common time lag in international transactions is 30 to 90 days, during which exchange rates may change.
💸 Spot rate exchanges allow companies to buy foreign currency at the time of the transaction, reducing exchange rate risk.
🏦 Hedging strategies, like forward contracts, transfer exchange rate risk to banks by agreeing to a set rate for future payments.
📊 Option contracts let companies lock in exchange rates but allow them to use the spot rate if it is more favorable when payment is due.
🔄 Currency swaps enable two companies to exchange borrowed funds in their respective currencies, reducing exchange rate risk.
🤝 Currency swaps allow companies to repay loans in their local currency, eliminating foreign exchange risks.
💡 Each of the three strategies—spot rate exchanges, hedging, and currency swaps—helps global companies mitigate currency risk.
🛡️ These strategies are essential for companies doing international business to avoid losses from fluctuating exchange rates.

Q & A

What is exchange rate risk in international business?
-Exchange rate risk refers to the potential financial loss a company faces when the value of a foreign currency changes between the time a transaction is made and when payment is received or paid.
Why is there typically a 30 to 90-day lag in accounts payable for international transactions?
-A 30 to 90-day lag in accounts payable is common because of the time gap between agreeing on a price and the actual payment, which is often part of global business operations.
How does a spot rate exchange help mitigate exchange rate risk?
-A spot rate exchange allows a company to purchase foreign currency at the current exchange rate at the time of the transaction, thereby eliminating the risk of currency value fluctuations during the payment period.
What is an example of a company using a spot rate exchange?
-An example is Hyundai Motors agreeing to buy rubber from an Indonesian company and simultaneously purchasing Indonesian Rupiah to pay for the goods, which removes the risk of currency fluctuation before the payment is made.
What is a hedge in the context of foreign exchange risk management?
-A hedge is a strategy where a company agrees with a bank to buy a specific amount of foreign currency at a predetermined rate in the future, thereby transferring the exchange rate risk to the bank for a fee.
How does an option contract differ from a forward contract in hedging?
-While both allow a company to lock in a future exchange rate, an option contract provides flexibility by allowing the company to decide whether to purchase the currency at the agreed rate or opt for the market rate if it's more favorable.
What is the downside of using an option contract?
-The downside of using an option contract is that the company has to pay the bank for the option whether it exercises it or not, which means there is a cost involved even if the option isn't used.
How does a currency swap help companies manage exchange rate risk?
-In a currency swap, two companies from different countries borrow money in their local currencies and then swap the principal, allowing each to repay the loan in their own currency, thus eliminating exchange rate risk.
Can you provide an example of a currency swap?
-An example of a currency swap is a British company needing Brazilian real and a Brazilian company needing British pounds. Both companies borrow in their local currencies and then swap, giving each the currency they need.
What are the three common strategies global firms use to manage foreign exchange risk?
-The three common strategies are spot rate exchanges, hedging (including forward contracts and options), and currency swaps.

Outlines

00:00

🌍 Understanding Exchange Rate Risk in International Business

When a company engages in international trade, either through buying or selling goods in a different country, they must deal with foreign currencies. This creates exchange rate risk because the value of foreign currencies can fluctuate between the time of the transaction and the time payment is made or received. A delay of 30 to 90 days in settling accounts payable is common, which leaves a window of time where these fluctuations can impact the company financially. To manage this risk, global firms often adopt one of three common strategies: spot rate exchanges, hedges, or currency swaps.

💱 Spot Rate Exchange Strategy

The first strategy to manage exchange rate risk is spot rate exchanges. This allows a company to buy the necessary foreign currency at the spot rate at the time of the transaction, removing any time gap between agreeing on the price and making the payment. For example, Hyundai Motors could purchase Indonesian Rupiah at the spot rate when signing a contract with an Indonesian rubber company, thereby eliminating the risk of the currency increasing in value relative to the South Korean Won before the payment is made.

🔒 Hedging Against Exchange Rate Risk

The second strategy is hedging. This involves entering into a forward contract or buying an option with a bank to lock in a future exchange rate. This way, the company, like Hyundai, can transfer the risk of currency fluctuation to the bank. If the exchange rate becomes more favorable, Hyundai could choose to use the current spot rate instead, while still paying the bank for the option. A forward contract requires Hyundai to purchase the currency at the agreed-upon rate, while an option contract gives the company more flexibility by allowing it to decide later whether to use the contracted rate or the market rate.

🔄 Currency Swaps for Exchange Rate Protection

The third strategy involves a currency swap. In a currency swap, two companies from different countries borrow money in their local currencies and then exchange the principal amounts. For instance, a British company needing Brazilian Real could swap currencies with a Brazilian company needing British Pounds. This strategy allows each company to access the foreign currency it needs while repaying the loan in its home currency, effectively eliminating exchange rate risk.

🛡️ Mitigating International Currency Risk

These three strategies—spot rate exchanges, hedging, and currency swaps—offer global firms effective ways to reduce or eliminate the risks posed by exchange rate fluctuations. By carefully managing foreign exchange risk, companies can better navigate the complexities of international trade without the financial uncertainties caused by volatile currency markets.

Mindmap

Keywords

💡Exchange Rate Risk

Exchange rate risk refers to the potential for financial loss due to fluctuations in foreign currency exchange rates. In the context of the video, companies doing business internationally face this risk when the value of a foreign currency changes between the time of a transaction and the actual payment. The risk is illustrated by the 30 to 90 day lag in accounts payable, which may cause firms to pay more or earn less than expected due to currency value changes.

💡Spot Rate Exchange

A spot rate exchange allows a company to buy foreign currency at the current exchange rate at the time of the transaction. This strategy eliminates the time gap between agreeing on a price and making the payment, thereby reducing exchange rate risk. The video uses Hyundai Motor's purchase of Indonesian Rupiah as an example, where the company buys the currency at the spot rate to avoid future fluctuations.

💡Hedge

Hedging is a financial strategy used to protect against potential losses from currency fluctuations. In the video, Hyundai hedges by purchasing an option or a forward contract to lock in a specific exchange rate for future currency purchases, shifting the exchange rate risk to a bank. This strategy helps the company avoid losing money if the foreign currency becomes more expensive before the payment is due.

💡Forward Contract

A forward contract is a type of hedge where a company agrees to buy a set amount of foreign currency at a predetermined rate on a future date. This eliminates the uncertainty of exchange rate changes, as the company locks in the price of the foreign currency in advance. In the video, this is shown as Hyundai transferring the risk of exchange rate fluctuations to a bank through a forward contract.

💡Option Contract

An option contract gives a company the right, but not the obligation, to buy foreign currency at a predetermined rate in the future. If the agreed-upon rate is worse than the spot rate at the time of payment, the company can opt not to exercise the contract. The video illustrates this with Hyundai, which can choose not to use the option if the Rupiah becomes cheaper, saving money by using the current market rate instead.

💡Currency Swap

A currency swap is a financial arrangement where two companies exchange loan principals in different currencies. This allows each company to access the foreign currency they need while paying back the loan in their local currency, thus avoiding exchange rate risks. The video presents this strategy with a British company borrowing Brazilian Rial and a Brazilian company borrowing British Pounds, and both firms swapping the currencies they need.

💡Foreign Currency

Foreign currency refers to the money used in a country different from the company's home country. In international business transactions, companies often buy or sell goods using a foreign currency. The video highlights that managing foreign currency and its fluctuating value is a critical concern for global firms, as seen in the example of Hyundai needing Indonesian Rupiah for its transactions.

💡Accounts Payable

Accounts payable represents the money a company owes to suppliers for goods or services received but not yet paid for. In the context of the video, global companies often have a 30 to 90-day window to pay, during which fluctuations in the exchange rate can lead to paying more or less than initially expected, depending on the value of the foreign currency.

💡Global Firms

Global firms are companies that operate in multiple countries, engaging in international trade and transactions. These firms are exposed to exchange rate risks when they buy or sell goods in foreign currencies. The video uses Hyundai Motor's and other companies as examples of global firms that adopt various strategies like spot rate exchanges, hedging, and currency swaps to manage exchange rate risks.

💡Foreign Exchange Risk Mitigation

Foreign exchange risk mitigation refers to strategies companies use to protect themselves from losses due to currency value fluctuations. The video explains three common strategies—spot rate exchange, hedging, and currency swaps—that global firms use to reduce or eliminate this risk in their international transactions. Each strategy aims to stabilize the cost of foreign currency in the face of uncertain future exchange rates.

Highlights

When a company does business internationally, it deals with foreign currency, either for purchases or sales.

Exchange rate risk arises when the value of foreign currency fluctuates between the transaction and payment dates.

A common lag in accounts payable is 30 to 90 days, exposing companies to exchange rate risk during that period.

Global companies seek to reduce or eliminate exchange rate risk using strategies like spot rate exchanges, hedging, or currency swaps.

A spot rate exchange involves buying the needed foreign currency at the time of the transaction to avoid exchange rate changes.

Hedging involves securing an option with a bank to purchase foreign currency at a set price within 30, 60, or 90 days.

A forward contract transfers the exchange rate risk to the bank, as the bank agrees to buy the foreign currency at a fixed price.

An option contract allows companies to buy foreign currency at an agreed rate, but they can opt for a better open market rate if available.

The benefit of an option contract is the ability to remove downside risk, even though the company must pay for the option.

A currency swap involves two companies borrowing in their local currencies and then swapping the principal amounts.

Currency swaps help companies avoid exchange rate risks by allowing them to repay loans in their local currencies.

For example, a British company needing Brazilian real can swap pounds with a Brazilian company that needs pounds.

Currency swaps are used when two companies require foreign currencies and allow both to manage exchange rate risks effectively.

These strategies—spot rate exchanges, hedging, and currency swaps—help mitigate the financial risk of doing business internationally.

Managing foreign exchange risk is crucial for global companies to avoid financial losses due to fluctuating currency values.