Currency Exchange Risk

Overview

Currency Risk

Currency Risk - is a form of financial risk that occurs from the potential change in the exchange of one currency in relation to another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency.

• Exchange rate: the ratio that exchanges one currency into another

Example: exchange rate A$1.00 = US$0.80,

so 1 tonne of Australian coal @ A$160/metric

= US$128/metric

• What is exchange risk?– Exchange risk arises in an international transaction when buyer and seller use

different currencies, and time elapses between sale and payment, example -

• Australian coal sold today 10,000mt @ A$160/metric = A$1,600,000

• Exporter sells in US$, so selling price is A$1,600,000 x US$0.80 = US$1,280,000

• Payment terms are 30 days from date of shipment (FOB Newcastle)

• Exchange rate today: A$1.00 = US$0.80. In 30 days: A$1.00 = US$0.85

• Payment received in 30 days: US$1,280,000/US$0.85 = A$1,506,000

• Outcome: exporter LOSES A$1,506,000 – A$1,600,000 = -A$94,000

Exchange Rate and Exchange Risk

International Marketers Dilemma

International marketer’s dilemma: Do I sell in my own currency to avoid risk (e.g. A$), or in buyer’s currency (e.g. US$, Yen, Euro)?

– If own currency, may lose sales due to lack ofcustomer orientation, foreign country regulations, lack of convertibility etc.

– May be contrary to industry norms (some world markets are denominated in US$, e.g. oil)

– If foreign currency, may be benefits, e.g. lower interest rates in foreign country, profits from astute currency management

Sources of Risk from Exchange Rate Fluctuations

1. Transaction risk: e.g. foreign transaction sales currency depreciates � reduced return to

exporter.2. Competitive risk: exporter’s own currency is appreciating, disadvantaging exporter’s manufactures from home market, (e.g. A$ = US$0.52 in 2001 to US$0.90 in 2008 = 73% increase).3. Market portfolio risk: MNE is limited to a narrow range of markets, i.e. is not diversified, so cannot balance exchange rate via multi-country operations.

What is the Foreign Exchange Market

� The forex market is a real-time network of banks, brokers and forex dealers in many countries. It has no fixed trading floor like the LME, Baltic Exchange or Chicago Mercantile Exchange. It exists only on computer screens. US$1.9 trillion

daily turnover worldwide.

� Main forex market centres (over 50%) are London, New York & Tokyo. These overlap in time zones so market activity flows around the world 24 hours/day. Other important trading hubs are Singapore, Sydney, Frankfurt, Paris, Hong Kong &

Zurich.

� Forex market operates at retail & wholesale levels: retail includes exporters exchanging and hedging currencies for transactions,

wholesale is the inter-bank market trading (and speculating) between market participants.

� The forex market most closely approximates the conditions of a ‘perfectly efficient’ market: universal availability & transparency of

information, speed of transmission, homogeneity, no barriers to entry. � BUT: Gov’ts sometimes intervene to reduce volatility.

What Determines Exchange Rate Levels

1. Main traded currencies are ‘floating’, i.e. free from Government intervention (e.g. US$, A$ since 1983, GBP). Some others are ‘fixed’, i.e. the Gov’t decides the exchange rate.

2. Fixed currencies are subject to occasional devaluations (or, rarely, revaluations) � sudden big drop in currency value. Speculators often make a killing (e.g. George Soros in 1992, GBP1bn profit). Non-trade currencies priced on ‘cross rates’.

3. Floating currencies’ exchange rates are determined by forces of supply & demand as in ratio of exports to imports, interest rates,

inflation, Gov’t economic policy, even forex market sentiment (e.g. A$ value is seen in part as linked to commodity prices).

4. In the long term, exchange rates reflect the economic success of a country.

How do International Marketers manage exchange risk?

1. Risk shifting (short term) e.g. hedging:

• Immediate currency conversion is a ‘spot’ transaction

• Conversion in the future uses a ‘forward exchange contract’: a bank agrees to fix an exchange rate at a set date in the future (expressed as a premium or discount on the spot rate, equal to the interest rate differential between the two countries), thus giving the exporter certainty in their exchange rate.

• Generally, exporters want to sell goods, not speculate on currencies.

2. Risk modifying (long term, strategic):

• Involves marketer manipulating prices or other elements of their marketing strategy.

• Export prices may be adjusted or not depending on market conditions (‘pass-through’ vs. ‘absorption’).

Strategic Risk Modifying Behaviour by the International Marketer

Scenario:Holden is selling its new Monaro to the US (rebadged the Pontiac GTO). A$ rises

against US$ from US$0.60 to US$0.90 (= 50% increase in cost of your product to GM USA). What do you do?

1. ‘Pass-through’: you keep your price

unchanged forcing the buyer to pay

more � loss of competitiveness �

loss of market share? Depends on

buyer’s level of preference for product (demand).

2. ‘Absorption’: you reduce your export price correspondingly as the A$ appreciates � your sales revenue correspondingly reduces, even to a loss.Goal of long-term market share maintenance?

In the 1990s the US Dollar appreciated hugely making imports cheaper to US consumers. Foreign car companies found they had windfall gains. Keep gains as extra profit, or pass to consumer as cheaper prices?

Strategic marketing considerations to exchange rate movements

1. Short-term:

Pricing-to-market: varying your trading terms for each

market depending on conditions there.

– Considerations: is market price-sensitive?, local competitors’ reactions, value placed on price stability (e.g. Harley Davidson), alternatives to discounts.

2. Long-term:

– Market refocus

– Streamline operations/seek efficiencies

– Shift production e.g. offshore via FDI

You are welcome to contact Nigel Bairstow at B2B Whiteboard your source of B2B Asia / Pacific marketing advice

http://www.linkedin.com/pub/nigel-bairstow/6/41b/726

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