Foreign Exchange Rate Risk
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
🌍 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
💡Spot Rate Exchange
💡Hedge
💡Forward Contract
💡Option Contract
💡Currency Swap
💡Foreign Currency
💡Accounts Payable
💡Global Firms
💡Foreign Exchange Risk Mitigation
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.
Transcripts
when a company does business
internationally and buys or sells goods
in a different country it will either
pay for purchases in the foreign
currency or earn income from sales in
the foreign currency
exchange rate risk becomes a factor in
these interactions because the value of
the foreign currency could change
between the time of the transaction and
the time the payment is made or received
and converted to the company's home
currency
a lag of 30 to 90 days in accounts
payable is fairly common so global
companies often have at least a 30 day
window when fluctuations in exchange
rates could result in paying or earning
more or less than they planned on global
firms seek to reduce or even eliminate
this exchange rate risk by adopting one
of three common strategies spot rate
exchanges a hedge or a currency swap
let's take a look at each one of these
strategies spot rate exchanges allow a
firm to buy the needed foreign currency
at the so called spot rate at the time
of the transaction this eliminates the
time gap between agreeing on a price and
making the payment for instance if
Hyundai Motor's of Korea were to agree
to buy rubber from Salim evamist pratima
an Indonesian rubber company Hyundai
could simultaneously sign the contract
and buy Indonesian Rupiah to pay solemn
even if the payment were not due for a
few weeks this way Hyundai would remove
the risk of the rupiah gaining value
relative to the South Korean Wan in the
intervening period
the next strategy used in managing
foreign exchange risk is a hedge Hyundai
could hedge its foreign exchange risk by
agreeing with a bank to buy an option
that would allow it to purchase a set
amount of rupiah at a set price in 30 60
or 90 days agreeing to the price for the
rupiah ahead of time allows Hyundai to
transfer any exchange risk to the bank
this type of transaction is also called
a forward contract in essence it takes
the future exchange rate and shifts the
risk to the bank for a fee another type
of hedge called an option contract lets
Hyundai purchase rupiah at an
agreed-upon rate in the future but
Hyundai is not required to buy the
foreign currency if the previous
agreed-upon rate is worse than the rate
the company can get on an open market
for instance if the rupiah becomes less
expensive in the period Hyundai can use
the current spot rate to purchase rupiah
when its payment is due and pocket the
difference
hyundai pays the bank for the option
whether it exercises it or not but
buying the option removes the company's
downside risk the third strategy global
firms use to manage foreign exchange
risk is a currency swap with a currency
swap to global firms borrow money in
their local currency and then swap the
principal with the other party for
instance if a British company needs
Brazilian rial and a Brazilian company
needs a similar amount of British pounds
the British company could borrow pounds
while the Brazilian company borrows rial
then the company's swap their currencies
giving each company the foreign currency
it needs but allowing each company to
pay back the loan in its local currency
eliminating exchange rate risk
these three strategies help mitigate the
risk of doing business internationally
with foreign currency
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