Managing Foreign Exchange Risk in International Trade

Abstract

The purpose of this research is to investigate how international trade companies in the East Midlands manage foreign exchange risk.

This study utilises descriptive statistics in presenting and analysing data from the primary research.

The findings of the research indicate that a majority of the firms used broad business strategies in managing their foreign exchange risk. The main problems the firms had with managing foreign exchange risks centred on customer retention and receiving payments on time. The results also indicate that there were a few firms which took an integrated approach to mitigating foreign exchange risk.

This research is of value to firms involved in international trade and also business development agencies which seek to assist firms which are planning to enter or are already operating in foreign markets.

Introduction

International trade involves exporting and importing of goods or services across foreign borders and, as soon as a firm engages in import and/or export it is exposed to numerous risks. As a result firms operating outside their home country, have to deal with the economic conditions of the foreign country in which it wishes to operate in. One of the key issues firms involved in import and/ or export are faced with is dealing with foreign currency as this is the only means by which the exchange of goods or services is facilitated. To this end it is import to study and understand the impact which foreign currency has on international trade.

Following the demise of the Bretton Woods agreement (1971) whereby exchange rates were allowed to float freely, managing foreign exchange has become important (Heakel, 2009). Consequently the prices of currencies were determined by market forces that is, demand for and supply of money (Mastry and Salam, 2007). Due to the constant changes in demand and supply which are in turn influenced by other external factors, fluctuations arise (Czinkota et al, 2009). As a result of these fluctuations firms are exposed to foreign exchange risks also known as currency risks. Firms trading in different currencies are exposed to three types of foreign exchange risks; economic, transaction and translational risk (Czinkota et al, 2009). Firms which are involved in international trade are exposed to economic and transaction risks as they both pose potential threats to the firm’s cash flow over time (Czinkota et al, 2009). Studies have shown that foreign exchange fluctuations can affect the value of a firm’s cash flow over time (Aretz, Bartram and Dufey, 2007, Judge, 2004, Bradley and Moles 2002, Allayannis and Ofek 1998, Chowdhry, 1995, Damant, 2002 and Wong 2001). More so, domestic firms although not dealing with foreign currency are also affected by foreign exchange fluctuations as the price of the commodity they trade in are also affected (Abor, 2005).

Most of the extant literatures have focused on corporate risk management for financial firms and as such financial hedging with derivatives has been the central theme of currency risk management. On the other hand there has been evidence to show alternative methods exist for firms involved in international trade, these methods of managing foreign exchange risks involve strategic and operational risk management.

However most of these studies have been carried out in isolation; financial hedging techniques carried out in isolation of strategic and operational hedging methods and vice versa. Little has been done to provide an integrated perspective, on utilising both techniques of managing foreign exchange risks with regards to international trade firms. This is the area in which the present study intends to explore thereby contributing to the overall literature

Purpose of the Research

Due to the nature of international trade which expose the firm to foreign exchange movements, thus subjecting the firm to currency risks, the purpose of this research is to explore how international trade firms deal with foreign exchange risk. The research focuses how import and export firms in the East Midlands manage their foreign exchange risk. This study also aims to explore the problems involved in managing those risks.

Research Questions

Consequently the research hopes to answer the following questions:

Do import and export firms in the East Midlands actually manage their foreign exchange rate risks?
How import and export companies in the East Midlands manage their foreign exchange risks?
What problems they encounter with managing these risks?

Definition of Key Terms

Hedge

A hedge can be defined as “making an investment to reduce the risk of adverse price movements in an asset. Investors use this strategy when they are unsure of what the market will do” (Investopedia, 2010).

Derivatives

Derivatives are instruments whose performance is derived from an underlying asset (Arnold, 2002)

Spot Rate

The spot rate is defined as the rate of exchange quoted immediately if buying or selling currency (Watson and Head)

International Trade

This involves the flow of goods and services between nations; it involves import and/ export of goods and services (Harrison et al, 2000)

The subsequent section provides a break down of how rest of the research is set out.

Chapter 2: Literature Review; this chapter provides an overview of the research topic by mapping out the key areas; theories within the risk management and finance literature are identified, explored and analysed. The concept of risk and risk management is explored. A broad classification is made on the types of risks and this is then narrowed down to include foreign exchange risk. The chapter proceeds by exploring the concept of foreign exchange and foreign exchange risks; which include the types of foreign exchange exposures. The common techniques for managing foreign exchange risks are explored. This is followed by a review of relevant literature in the key areas of the research topic.

Chapter 3: Research Methodology; in this chapter the research design and strategy are discussed.

Chapter 4: Research Findings and Analysis; this chapter presents the findings of the research which were obtained from the questionnaire. The findings are presented using tables, graphs and charts, to enable the reader gain a clearer understanding. An analysis of the findings is carried out by cross-tabulating the responses of the respondent in order to observe for any commonalities and/or differences.

Chapter 5: Conclusion and Recommendation; this chapter concludes the research and recommendations are made.