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Introduction
Exchange risk can occur when a company owns a firm or manages a branch in a foreign country, but the asset’s valuation is in the foreign country’s denomination. Individuals exposed to such exchange risk include companies which own foreign assets, companies which have branches in foreign countries, importers and exporters (Yildirim, 2012). Areas that are vulnerable to exchange risk include ownership of foreign businesses, overseas supplier’s payment, pension funds and international trade.
Exchange risk can affect a company in both positive and negative ways with the results reflecting on the company’s current market value or a stock exchange rate, which is why it is imperative to invest in a well-researched exchange risk management plan before engaging in any investment or acquisition. This research paper seeks how a company can manage an exchange using the five-step process, which is risk identification, risk assessment, risk control, risk auditing and risk review (Yildirim, 2012).
Risks Identification
This is where the risks are identified. Risks can be identified in regards to which areas in a company they influence. Below are several risks which can positively affect exchange risk.
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Contract Risk – This is a risk affecting the business during the transaction period.
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Economic Risk – It is a risk that can affect a company in the public eye.
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Conversion Risk – It is a risk that can affect the company from the accounting level.
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Subject Risk – It is a risk that can affect a company’s asset acquisition.
Risks Assessment
In this section, the risks are assessed. The assessment is done to show what kind of effect the risk may have on the company if it should engage in deals concerning exchange risk
Contract Risk – A company has contract risk if one of its foreign assets has value in the form of the foreign country’s denomination, thus subjected to the foreign exchange rate changes. A company has to convert the foreign currency to its base company currency to produce a correct financial report (Allayannis & Weston, 2001).
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Economic Risk – Company market values fluctuate due to various reasons. A company has an economic risk if its market is influenced by unpredictable exchange rates. This kind of risk can go as far as affecting the value of future profit margins.
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Conversion Risk – A company has conversion risk due to its financial reporting being at the mercy of exchange rates. This risk can occur when a foreign firm’s liabilities and assets are converted to the base company currency for financial reporting. Accounting errors can cause a significant impact on a company’s stock prices (Allayannis & Weston, 2001).
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Subject risk – This risk can occur if the company has just made a bid in regards to foreign direct investment. As the company awaits the transaction to be completed and the remittance to be made, the exchange rate can change and expose the company to either contract risks or doubt that the business deal shall push through (Allayannis & Weston, 2001).
Risks Control
Risk controls are set up to show what necessary actions are to be taken.
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Contract Risk- A company can employ the use of derivative instruments such as future and forward contracts.
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Economic Risk – To counter the economic risk, a company can diversify to other countries and even other products. This can help to balance out the losses should the exchange rate take a dive. A company can also differentiate their product, so they will not depend on one product should the exchange rate change.
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Conversion Risk – A company should hire the best team or accounting firm to do their accounting, thus raising its accounting standards and preventing discrepancies on the presented financial reports.
Risks Auditing
After risks have been identified, assessed and control measures have been established and implemented, auditing teams should be assembled to audit each of the implemented measures over a time period (Yildirim, 2012). For example, the conversion risk can be audited by inspecting all the foreign business records in great detail. A team can also be set in place to audit the verified foreign transactions and compare them to all the financial records submitted for that financial period.
Material that can substantiate transactions can be gathered and used to form auditing processes which can be taught to the staff managing the foreign asset. This can help streamline the way accounting information flows between the foreign asset and the company’s accounts team who prepare the financial report (Yildirim, 2012).
Risks Review
A review team should be assembled to appraise each and every foreign asset or investment to determine which one is a liability or an asset. After the analysis, the review team can also offer recommendations to reduce the involved risks. The review team will then produce a report and present it to the board for further assessment and scrutiny. The board would then decide on the proper way to move forward regarding the assets. (Yildirim, 2012)
References
Allayannis, G., & Weston, J. (2001). The Use of Foreign Currency Derivatives and Firm Market Value. Review of Financial Studies, 14, 243-276.
Yildirim, I. (2012). Stress Testing in Risk Management: An Application in the Turkish Banking Sector. International Journal of Trade, Economics and Finance, 3, 441-444.
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