Foregin Exchange Risk

6 Pages 1537 Words

Executive Summary

Foreign exchange (FX) risk is the risk that profits will change if FX rates change. FX risks present complicated transfer pricing issues. Under today’s system of floating FX rates, currencies often move dramatically over short periods. In one two-day period in 1998 the yen/U.S. dollar exchange rate moved nearly 20 percent. Empirical studies demonstrate that FX volatility can significantly affect companies’ profits.

Multinational businesses face several types of FX risk, including financial, translational, transactional and economic FX risk. We focus here on economic risk, also known as operational or competitive FX risk. Economic risk arises, for example, when a multinational business incurs costs in one currency and generates sales in another. Profits may decrease if the cost currency appreciates against the sales currency.

Under today’s system of floating FX rates, currencies often move dramatically over short periods. In one two-day period in 1998 the yen/U.S. dollar exchange rate moved nearly 20 percent. Empirical studies demonstrate that FX volatility can significantly affect companies’ profits.

Multinational businesses face several types of FX risk, including financial, translational, transactional and economic FX risk. We focus here on economic risk, also known as operational or competitive FX risk. Economic risk arises, for example, when a multinational business incurs costs in one currency and generates sales in another. Profits may decrease if the cost currency appreciates against the sales currency.

FX risk could affect Multinational businesses competitive position in the following ways:

- Initial loss of sales as lower-priced Japanese products enter the market.
- Reduced gross margins after reducing prices to compete with the Japanese products; and
- Further loss of sales if Acme’s cost structure prevents it from matching prices for the Japanese products

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