Foreign Exchange (FX) Risk

Foreign exchange, or FX, is the conversion of one country’s currency into another. In a free economy, a country’s currency is valued according to the laws of supply and demand. In other words, a currency’s value can be pegged to another country’s currency, such as the U.S. dollar, or even to a basket of currencies. A country’s currency value may also be set by the country’s government.

However, most countries float their currencies freely against those of other countries, which keeps them in constant fluctuation.

Let us take a look at an example of FX Risk:

An oil company buys Saudi Arabian fuel and sells it to car owners in Germany. The purchase happens on February 1^st, and payment is done in US dollars. The fuel is shipped, but it takes 4 weeks to bring it to the petrol stations in Germany where it will be sold in Euros. Within these four weeks, the exchange rate between the US dollar and the Euro can swing in all directions for all kinds of reasons. Most companies decide to mitigate this risk. To do so, a company enters into a contract with another party, who agrees to pay a set rate in US dollars for the Euros that the company receives when selling the petrol. Such contracts are known as “financial instruments”. The particular financial instrument just described is known as an FX hedge. Typically, the company pays a fee to a bank, also known as a “premium”, and the bank brings together the buyers and sellers of such contracts together. In return, the company secures the US dollar value of its goods. There are many variations on such hedges, which as a whole are known as financial “derivatives”, but their complexity is beyond the scope of this article. Note: As an alternative to this FX hedge, the company could convince Saudi Arabian suppliers to accept Euros, but this is not always easy.

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