Foreign Exchange Risk in a Domestic Company–Foreign Subsidiary Setting
If a domestic firm is involved in foreign operations in any way, such as a joint venture or FDI, funds flow between the domestic and foreign firms. These funds may involve the domestic firm’s provision of money to a foreign partner or subsidiary, or the domestic firm may receive income or profits from its foreign subsidiaries.
In terms of the outgoing funds to the subsidiary, the domestic firm may have to provide these funds in foreign currency. In this case, the domestic firm faces the exchange rate risk, which lies in the appreciation of the foreign currency.
Suppose an American firm has a subsidiary in Indonesia and plans to wire Rp100,000,000 to the subsidiary for the expansion of the production facility (Rp stands for the Indonesian rupiah). If the current rupiah–dollar exchange rate is Rp9,575 and remains the same for another week until the American firm sends the money, it costs the American firm $10,444 (Rp100,000,000 / 9,575).
But if the rupiah appreciates in a week from Rp9,575 to Rp9,250 per dollar, the American firm has to pay $10,811 (Rp100,000,000 / 9,250) for the same amount of rupiah.
Now if the American firm expects some of the profits from its Indonesian operation, the exchange rate risk lies in the depreciation of the rupiah. Suppose the amount of funds coming from the subsidiary in a week is Rp150,000,000.
By using the same current exchange rate of Rp9,575, and assuming that the exchange rate doesn’t change in a week, the American firm receives $15,666 (Rp150,000,000 / 9,575). However, if the rupiah depreciates to Rp9,950, the firm receives $10,050 (Rp100,000,000 / 9,950).