Week 7 Foreign Exchange Risks Discussion
Write a reply of 150 words for each Discussion
Discussion1: The foreign exchange rate is commonly referred to as the value of a nation’s currency exchange to other currencies. In simple words, the currency value you get when you exchange for another currency such as 1 dollar is worth 75 rupees in India. Foreign exchange risks are the risks involved in financial transactions from one currency to another nation’s currency. There are two types of transactions involved when dealt with exchanging a nation’s currency, appreciation is the increase in value and depreciation is the decrease in the value. This exchange rate widely depends on many factors such as import/export, international trades, investors. If a U.S. firm has a subsidiary in other countries for example Belgium, there will be some foreign exchange risks that the firm will have to face such as transaction risk, translation risk, and economic risk.
Transaction Risk – This risk is when a company buys or sells a product or service to other countries which involve either denomination or appreciation of the currency value that of the nation’s currency. For example, if the U.S. firm wants to sell a product in Belgium the firm has to give more dollars as a dollar is 0.86 euro. There is will some depreciation for the U.S. firm and appreciation for the Belgium country.
Translation Risk – The risk is when the company issues quarterly or annual financial statements there will be currency conversion through which there will be either appreciation or depreciation. In this case, the U.S. firm will depreciate some money due to currency conversion from euro to dollar.
Economic Risk – This risk is due to currency fluctuations which may happen due to variations in import/export, economic disasters such as depressions, and pandemics. For example, in 1929 there was a stock market crash that affected many countries and a big loss in GDP occurred all over the world. These crashes can happen in only one country and could affect the companies as well.
Reference:
Bates, R.P.D.S.K. T. (2014). Fundamentals of Corporate Finance (3rd Edition) | Wiley Global Education US
https://online.vitalsource.com/books/9781118901656
Foreign Exchange Risk
https://www.investopedia.com/terms/f/foreignexchangerisk.asp
Great Depression History
Discussion2:Consider, for the sake of discussion, a U.S. firm that owns a subsidiary in Belgium. This firm will face a variety of challenges due to its participation in a foreign market. One issue in particular arises from currency differences. Parrino and company (2014) explain that firms in this situation “are likely to deal in two or more currencies” and this creates a need for financial managers to “know how unexpected fluctuations in currency exchange rates can affect the firm’s cash flows and, hence, the value of the firm” (p. 676). Because this need cannot always be met, it leaves the U.S. firm with a certain level of risk.
This risk, referred to as foreign exchange rate risk, is defined as “the uncertainty associated with future currency exchange rate movements” (Parrino, et al., 2014, p. 676). At the end of the day, the U.S. firm in this situation needs information that is not necessarily available; therefore, a certain degree of uncertainty is created. For example, what if the U.S. firm desires to start a capital project at its Belgium branch? Just as in any capital budgeting project, the firm will have to consider the projected future cash flows. These cash flows, however, will “most likely be in a foreign currency that must eventually be converted to the parent’s home currency” (Parrino, et al., 2014, p. 688). In other words, projecting cash flows will not be enough to evaluate the project. More than one currency means that the forecasting of currency exchange rates will also be necessary. Unfortunately, however, the money center banks and currency specialists on Wall Street can only forecast these rates for three or four years into the future (Parrino, et al., 2014). Most capital budgeting projects have lives of 20 years or more, a time frame that is exceptionally difficult to forecast exchange rates for. This situation is just one example of how a U.S. firm with a subsidiary in Belgium could encounter foreign exchange rate risk.
Parrino, R., Kidwell, D. S., & Bates, T. W. (2014). Fundamentals of Corporate Finance (3rd ed.). Hoboken, NJ: Wiley Global Education US.
