Foreign Exchange Risk Management
When a company accepts foreign currency in payment for its goods or services, it accepts some level of foreign exchange risk, since the value of that currency in comparison to the company’s home currency may fluctuate enough between the beginning of the contract and receipt of funds to seriously erode the underlying profit on the sale. This is becoming more of an issue over time because global competition is making it more likely that a company must accept payment in a foreign currency.
When dealing in foreign currencies, a company must determine its level of exposure, create a plan for how to mitigate that risk, engage in daily activities to implement the plan, and properly account for each transaction. Each of these steps is covered in the following sections.
FOREIGN EXCHANGE QUOTE TERMINOLOGY
Before delving into foreign exchange risk, it is useful to understand the terminology used in the foreign exchange quotation process. When comparing the price of one currency to another, the base currency is the unit of currency that does not fluctuate in amount, while the quoted currency or price currency does fluctuate. The U.S. dollar is most commonly used as the base currency. For example, if the dollar is the base currency and $1 is worth 0.7194 euros, then this quote is called the indirect quote of presenting a quote for euros. However, if the euro is used as the base currency, the same quote becomes $1.39 per euro (and is calculated as 1 / 0.7194), ...