Foreign Exchange Risk of an Exporting Firm - dummies

Foreign Exchange Risk of an Exporting Firm

By Ayse Evrensel

When you’re involved in foreign exchange markets in any capacity, you face foreign exchange risk. Exporting firms may have accounts receivable in foreign currency. The foreign exchange risk of these firms is the possibility of depreciation in foreign currency. In this case, when the exporting firm exchanges foreign currency for the domestic currency, it receives a smaller amount of domestic currency for the same amount of foreign currency.

Suppose you export backpacks to Germany, and your accounts receivable are denominated in euros, totaling €100,000. As an American firm, you don’t use euros in your daily operations. Therefore, as soon as you receive the euros from the German importer — say, a week from now — you plan to convert them into dollars.

Suppose that the current dollar–euro rate is $1.28, and you observe the dollar appreciating every day until it reaches an exchange rate of $1.25 a week from now, when you convert the euros to dollars.

Note that the exchange rate used here is the dollar–euro rate. A decline in this exchange rate from $1.28 to $1.25 per euro indicates an appreciation of the dollar because fewer dollars are necessary to buy one euro. If the dollar appreciates against the euro, the euro must depreciate against the dollar.

You can invert this exchange rate and easily see that the euro depreciates. The euro–dollar exchange rate increases from €0.78 (1 divided by 1.28) to €0.80 (1 divided by 1.25) per dollar. Clearly, you need more euros to buy one dollar, which means depreciation of the euro.

If the exchange rate of $1.28 had remained constant, the American firm would have received $128,000 (€100,000 x $1.28). However, because the euro depreciated (or the dollar appreciated), the American firm receives only $125,000 (€100,000 x $1.25).

You may argue that most international trade is denominated in dollars. If this case is true, then somebody else is facing foreign exchange risk — namely, the German importer. Suppose that the German importer of backpacks is supposed to pay you $128,000 for the latest shipment.

By using the same exchange rates discussed, a week earlier, the company needed €100,000 ($128,000 / 1.28). But when the euro depreciates (or the dollar appreciates) to $1.25 per euro, the company must spend €102,400 ($128,000 / 1.25) to pay for your backpacks.