Foreign Exchange Risk of an Importing Firm - dummies

Foreign Exchange Risk of an Importing Firm

By Ayse Evrensel

Importing firms may have accounts payable in foreign currency. The exchange rate risk these firms face is the risk of appreciation in foreign currency. Remember, appreciation of a foreign currency means that a dollar buys fewer units of foreign currency. In this case, the amount of a domestic firm’s payments in foreign currency gets larger.

Suppose your firm imports cheese from France, and your accounts payable are denominated in euros, totaling €100,000. Again, the current dollar–euro rate as $1.28, but suppose that each day the dollar depreciates. Assume an exchange rate of $1.31 a week from now, when you make your payment.

Note that an increase in the dollar–euro rate indicates depreciation of the dollar. When the exchange rate increases from $1.28 to $1.31 per euro, clearly you need more dollars to buy one euro. If the dollar depreciates against the euro, the euro must appreciate against the dollar.

Again, you can invert this exchange rate and easily see that the euro appreciates. The euro–dollar exchange rate decreases from €0.78 (1 / 1.28) to €0.76 (1 / 1.31) per dollar. Clearly, you need fewer euros to buy one dollar, which means an appreciation of the euro.

If the initial exchange rate had remained the same, you would have paid $128,000 (€100,000 x $1.28) for the imported French cheese. However, because the euro appreciated, now you have to pay $131,000 (€100,000 x $1.31) for your imports.

Again, if your accounts payable are denominated in dollars, then the French exporter faces the foreign exchange risk. Suppose you have to pay $128,000 to the French firm for the latest shipment of cheese. By using the same exchange rates, a week earlier, the French firm would have received €100,000 ($128,000 / 1.28) as payment. But when the dollar depreciates to $1.31, it receives €97,710 ($128,000 / 1.31).