Foreign Exchange Markets: Is it worth the risk?

The volatility in the foreign currency market over the last 15 years has highlighted the fact that we all need to look more carefully at the associated risks when dealing with the international markets. Something that is worth £1 one day could be worth 80p the next day. Credit terms agreed in America dollars, six months later could be valued at a different price depending on the market. Overseas investment projects, which are creating investment opportunities need to be aware of currency change, as trading in the wrong currency could mean the end for your business. ‘Fluctuating exchange rates create risk, and badly managed risk can lead to loss of shareholder wealth’ (Arnold, 2008)

The foreign exchange market has grown spectacularly, figures show in 1973 the equivalent of US$10bn was traded, compared with figures in 2007 which was estimated at a massive US$3,210bn. London is one of the largest currency trading centres in the world, with a 34% share.  There is a variety of people trading they include exporters/importers, tourists, fund managers, governments and central banks. The larger players are commercial banks and speculators which include hedge funds. Banks try to speculate on future movements carrying out proprietary transactions.

The global currency exchange centres are open 24hours and the vast amount of money that is traded leaves them exposed to currency risk. There are three types of risk, transaction, translation and economic risk which operate in the international market. I am going to look at translation risk, which arises because financial data denominated in one currency are then expressed in terms of another currency. Also between two accounting dates the exchange range movement can be greatly distorted.

This was the case for GlaxoSmithKline (GSK) and how the currency rate affected the profit and loss account in 2007. As the weak dollar reduced cash sales, it overall had seen sales increase by 3% in the US market. The company that was 60% UK-based had no desire to move to the US market as their share volume increased. Even with the filing of the HPV vaccine which was associated with the cervical cancer developments and the sale of Alli, an over the counter weight loss medicine which was due to go on sale. Share prices fell in the company by 7p to £14.64 a share. This is an example of how the currency change can have an adverse effect on the group profits because of the translation of the foreign subsidiaries profits. This can still occur even when the managers are performing well and increasing profits in the currency market they operate.

Sources: (Arnold, G. 2008, Financial Times, The Guardian)