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Introduction and objectives

Financial risks are risks that may cause direct or indirect losses stemming from uncertain future events that may have an impact on interest rates, exchange rates, and price or availability of raw materials. In this unit, we will analyze the functions of the treasury as regards managing and minimizing each of these risks, by using a number of instruments called hedging instruments.

The learning objectives in this unit are:

• Identifying the risks associated to a foreign exchange transaction and determining hedging needs.
• Using the right hedging instrument for foreign exchange transactions.
• Managing interest rate risk and using the proper hedging instruments to that end.     

Foreign exchange risk

Companies that conduct foreign exchange operations are exposed to three kinds of risk: economic risk, transaction risk and translation risk. Let us see each of them in detail:

Economic risk: It is related to long-term effects regarding fluctuations in interest rates in the current values of future cash flows. This tends to happen when a company operates in various countries of different currencies.

Transaction risk: This happens when a company has a number of accounts payable or accounts receivable with future expiration dates, in currencies other than their functional currency (i.e.the currency used in their financial statements). In such cases,  Project Finance and Risk Managemen the amount payable or receivable may vary according to currency fluctuations. For instance, when an American company sells products to a European country payable in euros in three months. The transaction is established in dollars at the corresponding euro exchange rate, but three months down the line that rate may have changed. It is this kind of risk that companies usually try to mitigate through the use of derivatives contracts.

Translation risk: This happens when one of the company’s branches, located in another country, has a different functional currency than the one used in the head office, and its financial statement is converted into the head’s functional currency when consolidating financial statements. This risk is also known as accounting risk because the branch’s assets and liabilities may vary from one accounting period to another due to fluctuations in the exchange rate. There are no hedging instruments against this kind of risk, but companies may mitigate it by isolating a branch’s needs. For example, should the branch need financing, it should request it in that branch’s

currency.

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• Posted on : January 03rd, 2020

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