Foreign exchange risk, which is also referred to as currency risk or exchange risk, is a risk that arises from being exposed to unanticipated fluctuations in the exchange rate of currencies of two different countries. Multinational businesses and cross-border investors are often faced with exchange risk when engaging in transactions that involve cross-currency payments at a later date. There various ways of managing exchange risk to minimize financial losses. This paper analyses the various options the business to ensure it is in the best position financially as well as reduce risk exposure.
The first option would be to wait until mid-December and then receive the payment of ¥400,000. This amount would then be converted at the spot rate as at mid-December, which is expected to be $1=¥100. In that case, in mid –December, the business would have $ 4,000. If the amount was to be received in mid-June, then the amount converted into US$ at the prevailing spot rate at mid-June of $1=¥130. The business would receive $ 2,987.30 (388,349.50/130 = 2,987.3). Therefore, business will receive a higher amount in mid-December that if it was to receive the amount today. However, this depends on whether the spot rate in mid-December will be at the expected level. This option will only be chosen by a risk-taker since it does not hedge against currency risk.
The second option is entering into a 180-day forward contract. If the 180-day forward rate as at mid-June is lower than $1=¥100, it would be better to enter into a forward contract since the business would receive an amount higher than $ 4,000 and it would reduce risk exposure. However, if the 180-day forward rate as at mid-June is higher than $1=¥100 then the forward contract will only minimize risk exposure but may result in receiving a lower amount in dollars if the spot rate in mid-December is actually $1=¥100. Therefore, only a risk averse individual would choose a forward contract if the 180-day forward rate as at mid-June is higher than $1=¥100 since the individual would have hedged against currency risk but the individual would receive a lower amount in dollars if the spot rate in mid-December is actually $1=¥100.
The third option is to borrow yens from a bank at 6 per cent per annum and then pay back with the ¥400,000 that will be received in mid-December. Discounting ¥400,000 at 6 per cent per annum means that the business will receive ¥388,349.50 (400,000/1.03 = 388,349.50). The amount will then be converted to US dollars at the prevailing spot rate at mid-June which is $1=¥130. The business would receive $ 2,987.30 (388,349.50/130 = 2,987.3). The business would receive a lower amount compared to if it waited for payment in mid-December by $ 1,012.70 (4,000 - 2,987.30 = 1,012.7). Therefore, the business could invest the amount received in dollars in an American account at an interest rate that would make up for the difference. This interest rate must be higher than 50.64 % (1,012.7/4000) * 2 = 0.5064). If the business enters into a contract that locks the interest rate, then this option would minimize any currency risk. This would depend on the prevailing interest rate, available forward rates, risk attitude and certainty of the mid-December spot rate. However, the interest rate of 50.64 % is very high. Therefore, it is highly unlikely to find a US account paying that kind of interest rate or a forward contract that can lock the interest rate at that level.
References
Bekaert, G., & Hodrick, R. J. (2011). International Financial Management (2, illustrated ed.). Upper Saddle River: Prentice Hall.
