Understanding corporate finance: derivative contracts: foreign exchange risk
Managing foreign exchange risk
Imagine a UK company which does business with customers and suppliers in continental Europe. Suppose the company has bought an item of machinery from a German manufacturer for €100,000. At the date when the invoice is received, €100,000 is worth £64,500. The invoice is payable in 30 days, and is paid on time. But in the interim, sterling weakens against the euro, and at the date of payment, €100,000 is worth £64,800. The company has had to find an extra £300 to fund the purchase, solely because of currency fluctuations.
Similarly, if the company had borrowed in euros, and sterling weakened, it would have to find more - in sterling terms - to repay the borrowing.
There is, of course, likely to be an upside to the movement in exchange rates. If the company has invoiced a customer €100,000 at a time when €100,000 was worth £64,500, and received payment 30 days later when the same sum was worth £64,800, it would have made an exchange profit of £300. What is true of trade debts is also true of other assets: if the company had, for example, a euro bank deposit, it would be worth more in sterling terms.
There is more about exchange gains and losses at CFM12000 onwards.
FOREX movements are largely unpredictable. This is true of the world’s major currencies. Even with currencies which, historically, have moved in one direction for a length of time, there may be short-term reversals of the trend. So without hedging, a company’s profits could vary unpredictably from year to year just because of exchange fluctuations: it might make exchange gains, but equally it is exposed to the risk of exchange losses.
For this reason, most companies with a significant foreign currency exposure will hedge the risk - see CFM13400.