Foreign Exchange Rate Risk

Summary

This 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.