Currency risk

Currency risk is the gain or loss that comes from a movement in exchange rates. An exchange rate is simply the price of one currency in terms of another, and like any price it moves.

The loss arises because time passes between agreeing a transaction and settling it. A Zambian importer who orders goods priced at $50,000 when the rate is ZMW16.50 has committed to ZMW825,000. If the rate is ZMW18.00 when the invoice falls due, the same $50,000 costs ZMW900,000 — ZMW75,000 worse, on a purchase where nothing about the goods changed.

Two rates are quoted for every currency pair, and the difference between them is the whole of the toolkit.

• The spot rate applies to a transaction settled immediately.
• The forward rate is agreed today for delivery and settlement on a specified future date — one month forward, three months forward, and so on.

A forward rate is how a company locks in the price of a future currency transaction and removes the uncertainty. It is not a forecast the bank is offering; it is a price it will trade at.

Several things influence where rates go: the political environment, the volatility of interest rates, the difference in inflation between the two countries, market expectations, and support for the balance of payments. Two of those — interest and inflation — can be turned into arithmetic, and they are the subject of the next two sections.

Currency risk shows up in three distinct forms. They are frequently confused, and telling them apart is worth marks in itself, because only one of them is really about cash.

Transaction risk is the one hedging instruments address, because it is a defined amount on a defined date and can therefore be covered by a contract.

Translation risk is an accounting effect. It changes the reported figures without any cash moving, which is why many companies decide not to hedge it at all — spending real money to protect a book number is hard to justify.

Economic risk is the most serious and the least hedgeable. It is not one transaction but the long-run effect of the rate on the business’s ability to compete, and no forward contract addresses it. The answers are strategic: producing in the market you sell into, diversifying where revenue comes from, changing the cost base.

Interest rate parity says the difference between two countries’ interest rates is reflected in the difference between their spot and forward exchange rates. The currency with the higher interest rate trades at a forward discount, by enough to remove any advantage from moving money to earn the higher rate.

The spot rate for the dollar against the kwacha is ZMW12.177 per $1. Interest rates are 3% a year in New York and 15% in Lusaka. The kwacha is the quoted currency, since the rate is expressed as a number of kwacha to one dollar.

The kwacha is worth less forward than spot, and it has to be. An investor could otherwise borrow dollars at 3%, convert to kwacha, earn 15%, and convert back at an unchanged rate for a risk-free 12%. The forward rate moves to exactly the point where that trade earns nothing.

Note the exponent for periods of less than a year. Six months is n = 0.5, so the annual rate is raised to the power of 0.5 rather than being divided by two. The two are close but not equal, and questions are set to catch the difference.

Purchasing power parity makes the same claim about inflation. The difference between two countries’ inflation rates is reflected in the movement of the exchange rate between them, so that a given sum buys roughly the same in either country over time.

Identical arithmetic to interest rate parity, with inflation rates substituted for interest rates. Which one a question wants is decided by which rates it gives you.

With UK inflation at 6% and US inflation at 4%, and a spot rate of $1.60 = £1, the pound is the base currency and the dollar the quoted one.

It now takes fewer dollars to buy a pound, which is the dollar strengthening — as it should, since US prices are rising more slowly than British ones.

Take a case closer to home. Zambian inflation at 15% against 4% in the US, with a spot rate of ZMW26.70 = $1, gives a six-month forward rate of 26.70 × (1.15)⁰·⁵ ÷ (1.04)⁰·⁵ = ZMW28.077. Over six months the kwacha loses about 5% of its value against the dollar, purely on the inflation differential.

Which is the check to run on any answer: the higher-inflation currency weakens. If your forecast has the kwacha strengthening against the dollar while Zambian prices rise three times as fast as American ones, the two rates have gone into the formula the wrong way round.

Three techniques reduce currency exposure using nothing but the way the company arranges its own trade. They cost nothing in fees and should be considered before any instrument is bought.

Home currency invoicing

Invoice customers in kwacha, and ask suppliers to invoice in kwacha. The exposure does not disappear — it moves to the other party, who now carries it.

Which is why it depends entirely on bargaining power. A large buyer can insist; a small Zambian exporter selling into a competitive regional market usually cannot, and pushing it will either lose the sale or be paid for in a worse price.

Matching receipts and payments

A company that both earns and spends in the same foreign currency can hold an account in it and settle one against the other, converting only the net difference. A business receiving $400,000 and paying $350,000 in the same month has a real exposure of $50,000, not $750,000.

This is the most effective of the three, and it is available to any company with two-way flows in a currency — which describes most Zambian importers who also export.

Leading and lagging

Leading means settling early, lagging means delaying, to take advantage of an expected rate movement. Expecting the kwacha to weaken, an importer would want to pay its dollar suppliers now rather than in three months.

This one is different in kind from the other two, and the difference should be stated in any answer that recommends it. Matching removes exposure. Leading and lagging keeps the exposure and takes a position on which way the rate will go — it is speculation, and it loses money exactly as often as a forecast is wrong.