What Is Currency Risk? Definition and Explanation

History Of Currency Markets

Currency markets represent one of the oldest forms of financial transactions. Archaeologists have found coins dating back to ancient Egypt. Currency exchange and government monopolies on the issuance of money go back thousands of years.

In more recent centuries, leading countries tended to establish their currencies with the backing of precious metals such as gold or silver. A currency such as the French Franc would have a value equal to a certain quantity of grams of gold.

The gold standard started to lose its hold in the early 1900s as many European countries fell into deep debt following the First and Second World Wars. However, the United States stuck with a gold-backed currency until 1971, when President Nixon eliminated the convertibility of dollars to gold.

At that point, a completely fiat-based system emerged. The U.S. Dollar remains the world’s reserve currency, meaning that it tends to be the preferred choice for other countries when they wish to hold reserves of fiat money on their balance sheets. Other major international currencies such as the Japanese Yen(¥), Swiss Franc(Fr.), Euro currency(€), and Canadian Dollar also attract substantial interest among currency traders.

The most recent major development in currency markets came in 1999 with the introduction of the euro. The euro replaced the many currencies of various individual European Union member countries. The euro was intended to serve as a strong competitor to the dollar and create a more balanced foreign exchange market. However, various economic and geopolitical crises in Europe have somewhat weakened the appeal of holding euros. Thus, the U.S. Dollar remains the dominant currency in foreign exchange markets today and the Dollar Index is the main tool for tracking its value against other major currencies.

Note: Currency is the largest financial market in the world, dramatically outpacing stocks and credit in average daily trading volume.

How Do Currency Markets Operate?

Currency markets tend to operate 24 hours per day during the business week, though liquidity is far stronger at the same time that other financial markets such as stocks are also open. Anyone, ranging from central banks and multinational companies to international tourists and retail forex traders can buy or sell currencies at a market exchange rate between two different countries’ monies.

Nowadays, currencies tend to have free-floating exchange rates set by market forces, though in some cases, countries still use foreign currency pegs where the price of one currency is closely tied to another. The central bank in Hong Kong, for example, only permits its Hong Kong Dollar to trade within the narrow range of 7.75 to 7.85 versus the U.S. Dollar. For another peg example, various Caribbean countries maintain fixed exchange rates against the U.S. Dollar to help foster tourism in their local economies.

The biggest currency trading operations tend to be large investment banks. JPMorgan (JPM) often leads the league tables for the largest forex trading volume, with other big American investment banks like Goldman Sachs (GS) and Citi (C) playing a major role. Trust banks such as State Street (STT) have large operations in currency as they oversee assets in multiple geographies for their clients. Foreign investment banks such as UBS (UBS) and Deutsche Bank (DB) are also market share leaders in the global FX market.

While investment banks are the most important player in maintaining steady currency markets, there are various other players of importance. One is large multinational corporations.

Let’s use a hypothetical example. Suppose a Japanese food company needs to buy soybeans from Brazil. The South American farmer is unlikely to want yen and the Japanese firm probably won’t have Brazilian Real on hand either. Enter the currency market. The Japanese company can go to a commercial bank and deliver yen. In all likelihood, the bank would convert these to U.S. Dollars and wire them to Brazil. Then, the local farmer could convert said dollars into real and pay their expenses in domestic currency. These money flows between international companies drive a large portion of day-to-day currency trading operations.

What Does Currency Risk Mean?

Currency risk refers to the uncertainty and change in wealth (losses or profits) that can come from fluctuations in the value of various foreign currencies.

For investors, currency risk commonly arises from the ownership of foreign stocks in one’s portfolio. For example, consider an investor who holds a U.S. brokerage account that owns shares of BT Group plc in London. If the value of the British Pound declines, those shares of BT Group plc will suddenly decline in value in U.S. Dollar terms (even if the share price doesn’t budge).

As a non-investment example, consider a British retiree who is living abroad in New York and signed a lease for an apartment at $4,000 per month. Several years ago, this would have cost the worker less than 3,000 British Pounds per month. Now, however, with the depreciation of the pound sterling, the cost would be closer to 3,500 British Pounds per month.

How Does Currency Risk Affect Businesses?

Currency risk can cause problems for companies in a variety of ways. These include, but are not limited to:

• Foreign exchange losses
• Income/Liability mismatches
• Planning uncertainty
• Uncompetitive pricing

All of these add another layer of complexity that is not present when a business solely operates within its domestic market. The trade-off is generally worth it, considering that multinational companies gain tremendous benefits of scale from operating within a much larger global marketplace. However, there are unique quirks to dealing with foreign-based revenue streams that can cause certain types of problems.

Examples of Currency Risk

The most obvious sort of currency risk is from foreign exchange losses. This happens when a company sells in a foreign market and then the value of the local currency there declines, or when a company buys in a foreign market and then the value of the local currency there rises.

Take a global consumer company such as Apple (AAPL). It may decide to sell its latest phone for, say, $1,200 or 1,000 euros, which was sensible pricing when each euro was worth $1.20. Now that the Euro has fallen to $1.00 as of this writing, however, Apple would only earn $1,000 for each iPhone that it sells for 1,000 euros. That would lead to a major shortfall versus its typical $1,200 per unit sales price. Companies can address this risk by raising prices, but there may be customer pushback. There’s also lag time due to pre-orders and other methods of locking in cheaper pricing as the currency rates fluctuate.

As an example from a buyer’s perspective, consider a chain of breakfast restaurants operating in the state of Illinois. The restaurant chain purchases large amounts of Canadian Maple Syrup for its customers. If the Canadian Dollar appreciates versus the U.S. Dollar, the maple syrup becomes more expensive to import from Canada. Contrarily, if the Canadian Dollar depreciated in value, the maple syrup would be cheaper for the U.S. company to purchase.

Income versus liability mismatches often occur for multinationals who do business in one country but borrow funds somewhere else.

Consider, for example, a Brazilian steelmaking operation. It may struggle to borrow money in local currency given the historically uneven interest rates and shifting economic backdrop in Brazil. So, the steelmaker may choose to take out a loan in U.S. Dollars or another currency. However, it would still earn revenues primarily in Brazilian Real. In the event that the Brazilian Real plunged in value, the firm’s revenues would decline sharply, making it more difficult to finance its U.S. dollar-denominated debts and associated interest payments. This could cause a profit shortfall or even a plunge in the company’s credit quality depending on the magnitude of the currency fluctuation.

This sort of liability mismatching has contributed to all sorts of panics and crises in emerging markets, such as the fall of various southeast Asian economies in the late 1990s. Developed market companies sometimes get in trouble from liability mismatching as well when they elect to borrow substantial sums in euros, yen, or other such major currencies while not earning an equivalent amount of revenues in that currency.

A less obvious form of currency risk comes from uncertainty in planning. Say a U.S. engineering firm is bidding on a power plant project in India. The company has to calculate its bid with a reasonable guess as to how much it will pay for labor, raw materials, permitting costs, and other such expenses as denominated in Indian Rupee. The American firm may have to raise its bid significantly to build in a greater margin of safety in case the value of the rupee rises sharply after the contract is signed. Whereas, for a power plant project in the domestic market, the engineering firm wouldn’t have uncertainty around the true economic cost of its expenses denominated in dollars.

Finally, there’s uncompetitive pricing. This comes from when the value of a currency appreciates sharply, thus making domestic industries uncompetitive against the global marketplace. A classic example was in the 1980s when the U.S. Dollar appreciated sharply against rival currencies such as the Japanese Yen. At the time, many American automobiles, appliances, and other such manufacturing operations shut down as the highly-valued dollar made it too expensive to compete against foreign rivals with weaker currencies.

What Is Currency Hedging?

Currency hedging is when an individual or firm takes a financial position that reduces or eliminates its risk as it pertains to exchange rate fluctuations.

Note: Forex trading is often viewed as a speculative endeavor to obtain short-term profits. However, currency hedging, when done properly,…