Currency Risk: The Purpose and Risk of Money

People may say that “money is the root of all evil,” but is it? It may be best to point out that the original quote is better expressed as, “for the love of money is the root of all evil,” which more properly conveys the idea that money is just a thing and not evil itself, but greed and excessive desire for money can be judged morally.

Enough philosophy – let’s get down to brass tacks. Money is useful.

Imagine three people: one is an egg farmer, another is a shoe cobbler and the third is a wagon maker. When the farmer needs new shoes, he goes to the cobbler and offers to trade an agreed-upon number of eggs for shoes. The exchange goes smoothly, and everyone carries on with their day.

The cobbler wants more eggs a week later and goes to visit the farmer. The farmer has extra eggs, but already has shoes. He really isn’t interested in trading, so the cobbler goes away with no eggs.

That same week, the farmer needs the axle fixed on his wagon. Unfortunately, the wagon maker believes his work is worth 900 eggs and he doesn’t want that many eggs, as they would spoil before he could use them. In this example, no matter how many eggs the farmer produces, the wagon will never be able to be fixed via a trade, as the wagon maker will never want that many eggs.

Fortunately, in modern society, we have money. Money (currency) has three main purposes:

• Medium of Exchange: People accept money in trade for goods and services.
• Standard of Value: The value of a good or service can be measured with money.
• Store of Value: Money can be saved and used in the future.

In industrialized nations, currency is the portion of the national money supply that consists of bank notes, government-issued paper money and coins. This currency does not require endorsement when serving as a medium of exchange. Among less-developed societies, currency still encompasses a wide diversity of items (e.g., livestock, stone carvings, tobacco or even wagon wheels) used as exchange media, as well as signs of value or wealth. In developed nations, deposits are an important means of transaction, and currency may account for only a small portion of the total money supply.

In more recent history, most money is now stored electronically and exchanged digitally rather than physically. Today, most of the world's cash does not exist in notes and coins. Checks, debit and credit cards, and online “banks” such as PayPal enable nearly every kind of payment through a user's bank account. Money has evolved to the next stage — the creation of electronic cash as an alternative to notes and coins. This doesn’t even touch on the relatively recent introduction of cryptocurrencies like bitcoin, Ripple, Ethereum and all the others. (For some interesting insights on blockchain currencies, check out this podcast: “The Promise of Blockchain in Supply Chain Management”.)

The further currency gets from physical goods, the more flexible and fungible it becomes. Unfortunately, with increased convenience often comes increased risk.

What is Currency Risk?

Currency risk is the risk that business operations or the value of an investment will be affected by changes in exchange rates.

As companies expand their participation in the global economy, it has become increasingly important to identify and assess the impact of currency risk. Exposure to currency risk can have adverse effects on income, cash flows or net worth. Currency risk is the exposure to fluctuations in exchange rates that may arise as a result of one or all of the following:

• Business activities or operations in foreign markets.
• Investment in securities which are issued by overseas entities.
• Investment in securities which are denominated in a foreign currency.

Exposure to currency risk means that the company may experience an economic or accounting benefit if exchange rates move in a positive direction or suffer an economic or accounting loss if exchange rates move in a negative direction. Currency risk, also known as foreign currency risk or foreign exchange risk, is generally classified as economic, transaction or translation risk.

Economic Risk: Currency exposure associated with future cash flows, including:

• Strategic or Competitive Risk: The extent to which the firm's currency profile places it at a competitive advantage or disadvantage in the event of significant changes in exchange rates. Strategic exposures may substantially exceed known transaction volumes and may relate to currencies in which the firm has no direct cash flow exposure. To evaluate strategic risk, it is necessary to examine a broad range of competitive practices, including:
• The number of buyers and sellers in the industry.
• The functional currency of industry competitors.
• The sensitivity of prices to changes in input costs.
• Market demand.

Managing strategic risk, to a significant extent, falls upon the operating manager, who determines the currency of billing and pricing and negotiates currency-variation clauses in customer contracts.

• Net Monetary Risk: Exposure to exchange gains or losses on monetary assets or liabilities, which are denominated in a currency other than the functional currency of that operation (e.g., U.S. debt held by a French subsidiary). Net monetary exposures may have tax consequences in the entity's country, as well as cash flow consequences if assets or liabilities are converted into the local currency.

Transaction Risk: Exposure to movements in exchange rates on specific cash flows. The longer an exposure is outstanding, the greater the risk of unfavorable currency movements.

Transaction risk includes:

• Firm Commitments Risk (Including Declared Dividends): Exposure on a contractual commitment in a foreign currency between the current date and the date of settlement. For example, a contractual commitment may require settlement of the transaction in a foreign currency at a specified or unspecified future date. Transaction exposures are the effects of currency movements on the company's outstanding commitments. This risk also includes anticipated cash transfers over the foreseeable future (generally within the next 12-18 months) from a subsidiary, branch or business unit operating in a foreign country, which may result in currency exposure for both the remitting entity and the parent.
• Budget Risk: Exposure to income loss as a result of currency rates that differ from the assumed rates included in the corporate business plan.
• Cash Flow Risk: Exposure to cash flow changes as a result of foreign taxes on income in a foreign currency, which is not reflected in earnings in the firm's home or reporting currency.

Translation Risk: Exposure to adverse effects on the financial statements as a result of currency fluctuations. The conversion of translating foreign currency financial statements into the reporting currency may significantly affect net margins, net asset and liability positions, and net equity positions.

Currency risk, also known as exchange risk or foreign exchange risk, is complicated. So, what can we do about it?

First, identify the root causes of currency risk. Sourcing the root causes of currency risk requires an analysis of the key business processes that influence the velocity of the cash-to-cash cycle. The analysis of business processes can be comprehensive or selective, depending on management's view as to where the risks and opportunities for improvement are.

Next, measure your company’s exposure to currency risk. A company's exposure to foreign currency risk is dependent on the nature of its exposure and the complexity of its risk management activities (i.e., the use of derivatives to hedge the exposures).

Check out Currency Risk Key Performance Indicators on KnowledgeLeader for more information on sourcing root causes of currency risk and a list of nine bullet points to consider in currency risk analysis.

Finally, evaluate management practices and performance measures that can eliminate or reduce currency risk for your company. This can be a complex and multifaceted process with many questions to consider, so it may be best to seek out guidance on this topic.

This information on currency risk was taken from KnowledgeLeader’s Currency Risk Key Performance Indicators (KPIs) benchmarking tool. This tool describes risks associated to currency, identifies their root causes, and provides risk measurement information, management practices and questions to consider.

More KnowledgeLeader Related Resources:

Foreign Exchange Risk and Control Matrix (RCM)

Short-Term Investments Borrowing Risk and Control Matrix (RCM)

Manage Capital Planning - Performance Measurement Questionnaire

Working Capital Management Questionnaire