Methods of reducing foreign exchange exposures to risk

There are basically two ways in which exposure to risk may be reduced. They are:

• Pooling of risks: This method underlies insurance, in which risks which may be unacceptable to individual policy holders are aggregated or “pooled” by being taken on by the insurance company. Pooling of risk also underlies the diversification of a portfolio of investments.

• Hedging of risks: Here, different parties come to an agreement which cancels one of the parties’ risks against the others. The different parties may be subject to similar but opposite risks which they wish to hedge. Alternatively, one party may wish to hedge a risk which the other party may be a speculator.

It is not worth hedging against translation risk because if overseas assets decline in value when translated to the home currency, this should be compensated for by an eventual increase in the internal value of the assets. e.g. if differential inflation is responsible for the exchange rate movement, then the internal price level changes should be transmitted to asset values. Also, if exchange markets are efficient, foreign traders should win from exchange rate movements as often as they lose.  Similarly, long term exposures should yield no long term loses as exchange rate losses are cancelled out by increases in asset values.

Direct risk reduction methods (hedging against foreign risks)

• An exporter invoicing his foreign customer in his own domestic currency or an importer arranging with his foreign supplier to be invoiced in his own currency.

• Matching the receipt one is getting in a currency with the payments one is to make in that same currency (i.e offsetting payments against receipt in the currency) A company may have foreign currency account (domiciliary account) with its bank, and receipts of foreign currency may be credited to the account pending subsequent payments in the said foreign currency. OR a company might have bank deposit account abroad and make payments with these overseas deposits.

• Companies might try to use leads and lags:

1. Lead payments: Payment in advance or
2. Lagged payment: Delaying payments beyond their due date in order to take advantage of foreign exchange movement.

• Matching overseas subsidiary’s long term assets with long-term loans or liabilities in the same currency. e.g suppose a Nigerian company with a French subsidiary decides to purchase extra premises in France which must be paid for in euros. The company may try to finance the purchase by raising a loan in euros, which it would then repay out of the operating profits (in euros) from the use of the French premises.

• Money market hedges: This means borrowing in a foreign currency in which the income will be received later. An exporter who invoices foreign customers in foreign currency hedge against the exchange risk by:

1. Borrowing an amount in the foreign currency now;
2. Converting the foreign currency lent to it into its domestic currency at the “spot rate”
3. Repaying the loan with interest out of the eventual foreign currency receipts from debtors. e.g if an exporter knows that he will receive 70,000 euros from a German customer in one year’s time, he can cover the foreign exchange risk by borrowing 70,000 euros now for one year and repaying the loan with the eventual receipt from the German customer. The euros can be converted to pounds sterling at the spot rate, so the exchange rate risk is avoided.

• Forward exchange contracts: Forward exchange contract is a contract whereby the importer or exporter arranges for a bank (not necessarily a bank, it might be any other party with the ability to buy and sell) to sell or buy a quantity of foreign currency at a future date, at a rate of exchange that is determined when the forward contract is made. A forward contract is:

1. An immediately firm and binding contract between a bank and its customer;
2. For the purchase or sale of a specified quantity of a stated foreign currency
3. At a rate of exchange fixed at the time the contract is made
4. For performance (delivery of the currency and payment for it) at a future time which is agreed upon when making the contract. The future time will be either a specified date, or anytime agreed between the two.

Recommended Readings

Brian Coyle., Hedging Currency Exposures: Currency Risk Management (Risk Management Series)

Dan Osborne., FX Mentors Secrets to protecting and profiting from foreign currency exposure (audio)