Foreign exchange is the conversion of one country's currency into another. In a free market, a currency is valued according to the laws of supply and demand. In other words, a currency's value, such as the Ethiopian Birr, can be pegged to another country's currency, such as the US Dollar, or even to a basket of currencies. The sources of foreign exchange are exports of goods and services and foreign investment. The amount of foreign investment increases the supply of foreign exchange.
The main functions of foreign exchange markets are converting the currency of one country into the currency of another and providing some insurance against foreign exchange risk. Generally, there are three main types of foreign exchange risks: transaction risk, translation risk, and economic risk. The major components of foreign exchange in social marketing include trust, commitment, rewards, costs, and interdependence. The foreign exchange market enables currency conversion for international trade settlements and investment.
Foreign exchange risk is the possibility of an enterprise losing money on global trade due to fluctuations of currency. The exchange rate risk reveals the probability that the value of investment may decline due to variations in the relative values of the currencies involved. The risk inversely affects investors and any enterprises involved in external trade.
The risk takes place if a contract between two traders defines exact prices for goods or services. It may also include delivery dates of goods and services. If the value of a currency fluctuates between the date the contract is signed and the date of delivery, a loss for one of the traders or parties could result. The parties may face various types of risks mentioned earlier. They also face a jurisdiction risk that arises when laws change unexpectedly. This risk takes place in the country where the exporter is doing business. Economists are of the opinion that this risk is less common and exists primarily in unstable countries, such as those in the Horn of Africa.
Transaction risk arises when an enterprise purchases goods and services from a seller in another country. In this transaction, the price is given in the supplier's currency. When the supplier's currency appreciates against the buyer's currency, the buyer will have to pay more in line with the contractual price. This price has legal backing that forces the buyer to respect it. However, the risk of transaction exposure may impact one side of a transaction.
An enterprise that undertakes the transaction in a foreign exchange is bound to face risk. However, economists are of the opinion that the enterprise receiving or paying a bill using its local currency, such as the Ethiopian Birr, does not face the same risk. The risk may be mitigated if experts in the financial sector make risk analyses in advance. Based on professional assessment of transaction risk, Ethiopia may be in a position to mitigate impacts of foreign exchange. The concerned national authorities, including the National Bank of Ethiopia, should be in a position to study in advance the real situation of foreign exchange risk in the country for the purpose of avoiding it.
High level of exposure to exchange rate risk may cause major losses, but knowledgeable finance professionals try to mitigate/hedge those risks. As mentioned earlier one of the risks of foreign exchange transaction is translation risk. This refers to how such exchange will impact financial reporting. The risk is that the equities, assets, liabilities or income of an enterprise will change in value as a result of exchange rate changes. This risk arises because branches of a parent enterprise in another country denominate their currency in the countries where they are operating.
The parent enterprise faces possible losses when it changes the financial statements of branch enterprises into the currency of its own country. The enterprise is also exposed to operating costs, which is known as "operating exposure." In actuality, this refers to the impact on the market value of an enterprise from exposure to unexpected fluctuations of currency. This may affect the future cash flows, foreign investment and earnings of an enterprise.
Economists point out that economic exposure may have a major impact on the market value of an enterprise. Specifically, exposure is greater for multinational enterprises that have several external branches and a large number of transactions in foreign exchange. The major contributor to increased exposure of enterprises is globalization. Its outcomes are long-lasting in nature. In this situation, economic exposure is hard to measure effectively and accurately. Consequently, hedging against economic risks may be difficult as it creates unexpected changes in foreign exchange rates experienced in developing counties such as Ethiopia. However, there are ways and means to reduce such risks.
Applying the strategy of diversifying the means of production may lead to risk-sharing. The manner in which foreign currency is exchanged may affect the global expansion of an enterprise. Also, problems related to production and delayed delivery affects the rate at which currency is exchanged.
Foreign exchange trading is another currency risk mitigation strategy. This takes place in enterprises that are trading in the "currency of different countries." This financial strategy is, known as hedging, helps to reduce exposure to foreign exchange risk and financial loss. It removes a potential loss from foreign exchange trading by taking an "opposite position" in a related currency. Foreign exchange risk is created by "fluctuations" in international currencies.
There are several causes of these fluctuations indicated here. Macroeconomic factors such as: swings or changes in exchange rates, government policies, changes in inflation, interest rates, import and export duties and taxes affect the exchange rate. Foreign exchange risk may also occur when a government is "unable to repay" its debt and defaults on its payments. This would also have a direct impact on investment rates as the effects may trigger other enterprise related problems. The foreign exchange risk includes political unrest and even a change in government policies. This may impact the exchange rate and, in turn, affect enterprise transactions.
Foreign exchange risk is linked to default in making the obligation one owes. It is out of lender's control if the borrower fails to meet the commitment to pay debts. The lender must monitor the activities of an enterprise so that transactions are closed at the right time without risk of default. In this respect, there are means to manage foreign exchange risk, including the establishing of contract with a foreign exchange provider. This is a direct and common system for managing foreign exchange risk that ensures that an exporter will receive a fixed payment even if the rate of exchange fluctuates. Thus, the Ethiopian exporter, for example, should grasp the following elements: the foreign currency amount; date the importer in other country will pay and the currency exchange. Trade agreement also involves several steps including: exporter's agreement to accept payment in a different currency; exporter contacts a bank to negotiate rate of exchange; exporter and importer finalize sales price and payment agreement with assurance from the bank.
Finally, exporter then enters into a forward contract with its bank; the importer pays the exporter on time; exporter delivers the globally accepted currency. If the exporter is uncertain when the importer will pay, an alternative is to request a forward contract with the bank or service provider. This gives the exporter a date of delivery. The exporter accepts foreign currency payment only with cash in advance. This option is ideal for small transactions as well as for new relationships with importers. This option ensures full payment, and is risk-free.
But some importers may pay if cash in advance is their least desirable method of payment. Exporters have to "match" foreign currency receipts with expenditures. In this case, the exporter sets up a foreign currency bank account to conduct transactions and eliminate currency conversion fees. This is ideal for exporters that use the same foreign currency with different trading partners. With this option, it is important to assess the cost and effort required to maintain a banking account in a foreign currency. Here, traders keep a record of gains and losses resulting from currency conversions in financial statements.
Sign up for free AllAfrica Newsletters
Get the latest in African news delivered straight to your inbox
At the end, before agreeing to an importer's foreign currency requests, the exporter will have to consult with a bank to figure out some issues. These are: the time an exporter considers selling in a foreign country; the frequency a small exporter sets prices in foreign currency is noted; the types of transactions that are most suitable for foreign exchange are considered. The fees for using a forward contract are also recorded.
The most useful indicators on converting currency in foreign trade are foreign exchange risks as a result of global trade. Economists have identified some important considerations that help in limiting the risk. These are: trading in fully convertible currencies that are common in international trade; avoiding trading in "partially" convertible currencies in which governments restrict the amount that may exit or enter the countries, including Ethiopia.
The concerned authorities in Ethiopia have to know the risks to justify the rewards of foreign exchange. Global selling enhances the competitiveness and profitability of Ethiopian enterprises. If critically implemented, it may increase their benefits. However, recent information, financial skill, knowledge of planning and implementation, and monitoring are very important. They help in the development of risk mitigation strategies that must precede any global trade efforts. If these institutional capabilities are not in place, concerned authorities would fail to realize the benefits and profits from a global business enterprise expansion.
The economy of Ethiopia being mainly dependent on agricultural production for home consumption, supply of input delivery for local industries and export of produces, it needs import of tech for raising productivity. However, this strategy is mainly based on foreign exchange earning that is free from risk, if possible. This depends on the latest skills and knowhow of financial management in every sector of the Ethiopian economy.
Editor's Note: The views entertained in this article do not necessarily reflect the stance of The Ethiopian Herald
