Currency risk is a two-way risk because exchange rate movements can be either favourable with a resulting gain, or adverse with a resulting loss.
A Company might take a view that currency risk is acceptable whenever it occurs, and that gains or losses on exchange rate movements should be tolerated because over the long term they should cancel each other out. This attitude to currency exposures is considered RISK NEUTRAL.
Risk Neutrality might be a suitable strategy to adopt when the potential cost or gains are small relative to the size of the company’s business and profits.
For e.g. Suppose a UK company earns annual income of about ₤ 30million and $ 9 million, and expects annual profits to be about ₤6 million. There is some currency exposure with the dollar income.
If the current exchange rate is ₤1=$ 1.5,the dollar income would yield ₤ 600,000 at the current rate, and a fall in the value of the dollar by 20% would cost the company ₤120,000 in lost annual income. In relation to total profits of ₤6 million, the currency risk might seem tolerable. But if the total profits of the company were only ₤500,000,then the currency exposures might cause greater concerns.
If the potentials losses and gains from the exchange rate movements are high in proportion to the expected trading profits, a company should be less inclined to take a risk-neutral attitude, and ought to consider ways of managing the risk.
Risk Management involves
Avoiding risk whenever possible where significant losses might occur
Controlling risk if it cannot be avoided altogether to minimize the size of potential losses
Tolerating the risk, or even adding to exposures when exchange rate movements are more likely to be favourable than adverse.
Taking measures to avoid or minimize the risk from exposures is called HEDGING.
Management of currency risk implies that the company is not risk neutral. A company is risk averse if measures are taken to minimize the exposures, and risk seeking if measures are taken to increase exposures to profit from favourable exchange rate movements.
The aim of hedging is to reduce or eliminate the risk from adverse exchange rate movements. A consequence of hedging is either
Having to incur additional expenditure to hedge the exposure, or
Forgoing the opportunity to make a profit if there is a favourable movement in exchange rates.
Hedging therefore has a cost, or a potential cost. Companies accept the costs of hedging as the price to pay for reducing the risk of losses.
A Company might take a view that currency risk is acceptable whenever it occurs, and that gains or losses on exchange rate movements should be tolerated because over the long term they should cancel each other out. This attitude to currency exposures is considered RISK NEUTRAL.
Risk Neutrality might be a suitable strategy to adopt when the potential cost or gains are small relative to the size of the company’s business and profits.
For e.g. Suppose a UK company earns annual income of about ₤ 30million and $ 9 million, and expects annual profits to be about ₤6 million. There is some currency exposure with the dollar income.
If the current exchange rate is ₤1=$ 1.5,the dollar income would yield ₤ 600,000 at the current rate, and a fall in the value of the dollar by 20% would cost the company ₤120,000 in lost annual income. In relation to total profits of ₤6 million, the currency risk might seem tolerable. But if the total profits of the company were only ₤500,000,then the currency exposures might cause greater concerns.
If the potentials losses and gains from the exchange rate movements are high in proportion to the expected trading profits, a company should be less inclined to take a risk-neutral attitude, and ought to consider ways of managing the risk.
Risk Management involves
Avoiding risk whenever possible where significant losses might occur
Controlling risk if it cannot be avoided altogether to minimize the size of potential losses
Tolerating the risk, or even adding to exposures when exchange rate movements are more likely to be favourable than adverse.
Taking measures to avoid or minimize the risk from exposures is called HEDGING.
Management of currency risk implies that the company is not risk neutral. A company is risk averse if measures are taken to minimize the exposures, and risk seeking if measures are taken to increase exposures to profit from favourable exchange rate movements.
The aim of hedging is to reduce or eliminate the risk from adverse exchange rate movements. A consequence of hedging is either
Having to incur additional expenditure to hedge the exposure, or
Forgoing the opportunity to make a profit if there is a favourable movement in exchange rates.
Hedging therefore has a cost, or a potential cost. Companies accept the costs of hedging as the price to pay for reducing the risk of losses.