Foreign exchange risk

Foreign exchange risk

Foreign exchange risk

  1. Consider a U.S. hedge fund investing in Japanese Nikkei index, expecting the index to go up as Japanese fundamentals are improving. The index goes up to 11,530 by the end of the year. The yen was at 95¥/$ at the beginning and at 80¥/$ by the end of the year. Estimate the realized yield by the U.S. hedge fund. This class is International Financial Mgmt

The source of economic risk is the change in the competitive strength of imports and exports. For example, if a company is exporting (let’s say from the UK to a eurozone country) and the euro weakens from say €/£1.1 to €/£1.3 (getting more euros per pound sterling implies that the euro is less valuable, so weaker) any exports from the UK will be more expensive when priced in euros. So goods where the UK price is £100 will cost €130 instead of €110, making those goods less competitive in the European market.

Similarly, goods imported from Europe will be cheaper in sterling than they had been, so those goods will have become more competitive in the UK market. Note that a company can, therefore, experience economic risk even if it has no overt dealings with overseas countries. If competing imports could become cheaper you are suffering risk arising from currency rate movements.

Doing something to mitigate economic risk can be difficult – especially for small companies with limited international dealings. In general, the following approaches might provide some help:

  • Try to export or import from more than one currency zone and hope that the zones don’t all move together, or if they do, at least to the same extent. For example, over the six months 14 January 2010 to 14 June 2010 the €/US$ exchange rate moved from about €/US$0.6867 to €/US$ 0.8164. This meant that the € had weakened relative to the US$ (or the US$ strengthened relative to the €) by 19%. This made it less competitive for US manufacturers to export to a eurozone country. If, in the same period, the £/US$ exchange rate moved from £/US$0.6263 to £/US$0.6783, a strengthening of the US$ relative to £ of only about 8%. Trade from the US to the UK would not have been so badly affected.
  • Make your goods in the country you sell them. Although raw materials might still be imported and affected by exchange rates, other expenses (such as wages) are in the local currency and not subject to exchange rate movements.

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