Introduction
Foreign exchange (FX) risk, also known as currency risk, can be defined as the losses associated with an international financial transaction due to the volatility and fluctuations of the foreign currency. Apart from that, investors may find themselves facing jurisdiction risk in the form of FX risk. Foreign exchange risk affects those who trade in international markets as well as multinational businesses that import and export products and services from and to multiple countries. This essay overviews the main reasons for and factors behind FX risk and management approaches and highlights the significance of the external auditor’s role in FX risk management.
Reasons and Factors
There are three major types of FX risks, each of which is contingent on its own set of reasons and factors. Transaction risk is the probability that when the financial transactions are made in a currency other than the base currency of the company, the currency rates might move in the adverse direction (Oxelheim, Alviniussen & Jankensgard, 2020). If it happens between the date of entering the transaction and the date of settlement, the company might experience significant money losses.
A simple example would be a European company contracting an American manufacturer to supply it with certain kinds of goods. Initially, the European company agrees to pay the US supplier in US dollars and decides that the payment is due three months. During these three months, due to unrelated political events, the rate of euro to the US dollar weakens, and the European company now has to bear higher expenses.
Translation risk is the second major type of FX risk and can occur when a company deals in foreign currencies or adds foreigns assets on their balance sheets. It often happens that a company that operates in several countries and generates revenue in foreign currencies will eventually have to convert the money back into their country of domicile’s currency (Oxelheim, Alviniussen & Jankensgard, 2020). Translation risk arises if, in the meantime, exchange rates have fluctuated significantly to hurt the value of the foreign asset. For instance, a global fast-food chain opened restaurants in Venezuela before the great inflation, and the flow of income was kept in the national currency. After the crisis, the said global fast-food chain will see its revenue practically vanishing because of the depreciation.
Lastly, economic risk is associated with external economic and political factors that are often difficult to predict, such as elections, regulations, economic sanctions, and others (Oxelheim, Alviniussen & Jankensgard, 2020). For example, an international oil and gas company is operating in the country whose politics have started to lean toward the left. At some point, the said country decides to nationalize the oil and gas sector and targets foreign-owned companies. The company in question is offered compensation, which decreases its market value.
Management Approaches
Foreign exchange risk management strategies depend on the type of risk in question. It should be noted that typically, the efficiency of the selected strategy will be contingent on the ability to forecast changes.
For instance, the potentially negative effect of transaction risk can be mitigated through existing hedging mechanisms (Oxelheim, Alviniussen & Jankensgard, 2020). Firstly, a company might want to negotiate a forward contract that renders the currency rate unchangeable for a set date in the future. Another common and cost-effective hedging method is options: by purchasing one, a company receives the right to decide on the ‘at-worst’ rate for the transaction. If the option passes the expiration date, the company can conduct the transaction in the open market at a preferable rate.
As for other types of FX risks, many companies who want to hedge net asset value translation risk often resort to foreign currency loans and derivatives. However, it should be noted that derivatives pose quite a significant disadvantage as they may cause liquidity issues due to the associated cash settlements. Another risk management strategy worth mentioning is to keep the net investment as low as the situation allows (Oxelheim, Alviniussen & Jankensgard, 2020). It makes sense to leverage subsidiaries in local external debt and transfer capital to the domicile on a regular basis. Lastly, the foreign exchange gains or losses on the borrowing can be controlled in equity to mitigate the exchange differences.
Out of all types of FX risks, the economic risk might be the least foreseeable and largely uncontrollable. There is no “one-size-fits-all” solution when it comes to handling macroeconomic factors, and the ultimate solution largely depends on the particularities of a given company. Some examples, however, can shed light on how organizations manage economic risks. For instance, IKEA survived the 2008 crisis almost unbothered by maintaining strong price leadership, and Amazon addressed the vulnerability of its foreign income sources by diversifying its portfolio.
The Role of the External Auditor
Hiring an external auditor is a legal requirement for big corporations, especially when it comes to developed countries. Independent auditors offer a “fresh pair of eyes” and may provide a perspective on some aspects of a company’s financial operations that might have previously been dismissed or ignored. External auditors act as independent voices that approve or disapprove of business practices (Hodge, 2019).
They provide qualified statements or adverse opinions if they detect a previously unknown risk or have doubts about the robustness about certain risk controls. On top of that, an independent auditor can point to faults in financial or risk reporting. However, companies might want to reconsider completely trusting external auditors with risk management. Hodge (2019) for Risk Management magazine writes that at best, external auditors will provide a disclaimer of opinion if they are unable to do their job properly, be it due to a conflict of interests or other barriers. Others, however, may continue working without bringing about any significant improvements at best and mishandling their responsibilities at worst.
Conclusion
FX risk refers to a potential situation where the value of an investment may decline because of the changes in the value of the used currencies as compared to others. The most typical situation when foreign exchange risk occurs is when a firm partakes in financial transactions that happen to be denominated in a currency that is different from the one that is commonly used by the firm. Therefore, the firm puts itself in a situation where any depreciation or appreciation of the base or denominated currencies can impact the cash flows.
FX risk management entails a variety of hedging techniques that include but are not limited to forward contracts, purchasing options, regular capital repatriation, and others. The efficiency of risk management strategies largely depends on the foreseeability of future events and the ability to take action proactively. The external audit does play an indirect role in FX management, but deterring the entirety of this task to independent auditors would not be a wise decision.
References
Hodge, N. (2019). Checks and balances: Reevaluating the role of external audit. Web.
Oxelheim, L., Alviniussen, A., & Jankensgard, H. (2020). Corporate foreign exchange risk Management. John Wiley & Sons.