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Currency risk management is a set of strategies and procedures used to minimize exposure to losses associated with changes in exchange rates. One of the first steps is to minimize a company’s reliance on global exchange rates to maintain its solvency. Next, the company might diversify the different currencies its investments are held in as a way of buffering itself from systematic risk. Finally, a company may use derivative financial products such as currency forwards and swaps to hedge any residual unsystematic risk.
Currency risk is a market risk that directly endangers the financial well-being of international businesses. Otherwise known as foreign currency risk, losses occur when exchange rates shift and a company is forced to buy or sell currency under unfavorable conditions. One example would be if a loan is taken out in a foreign currency in order to develop a new market. If the foreign currency becomes stronger, the parent company may need to spend more local currency to pay off the debt than expected.
It is crucial in currency risk management to minimize discrepancies between asset and liability currencies. It may be tempting to seek loans in countries with low interest rates and invest in countries with high interest rates, especially if foreign exchange rates are currently favorable. Unless a company has a global presence backing up this speculation, however, it is dangerous to do so and may needlessly expose the company to interest rate risk.
Another common currency risk that needs to be managed is inflation risk. If a company holds investments in a foreign currency and is dependent on the cash flow generated by these investments, the company's financial strength would be hindered if the foreign currency suddenly was worth less. One effective way to avoid this situation is to invest in a variety of economies that have floating exchange rates, thus diversifying the risk. Another currency risk management approach would be to invest in economies with currencies pegged to the parent company’s currency. This would allow both currencies to fluctuate together.
If currency risk cannot be minimized through avoidance or diversification, there are a multitude of derivative products available for currency risk management. Both currency swaps and forwards can be used to lock in current exchange rates in order to hedge short- and long-term risk. Combined with call and put options, products can be tailored to fit any business’s foreign currency strategy. As with other derivative products, those used to minimize currency risk may be very expensive and elaborate.
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