Currency Risk Sharing


DEFINITION of 'Currency Risk Sharing '

A form of hedging currency risk in which the two parties to a transaction agree to share the risk from exchange rate fluctuation. Currency risk sharing generally involves a price adjustment clause, wherein the base price of the transaction is adjusted if the exchange rate fluctuates beyond a specified neutral band or zone. Risk sharing thus occurs only if the exchange rate at the time of transaction settlement is beyond the neutral band, in which case the two parties split the profit or loss.  By fostering cooperation between the two parties, currency risk sharing eliminates the zero-sum game nature of currency fluctuations, in which one party benefits at the expense of the other.

BREAKING DOWN 'Currency Risk Sharing '

Currency risk sharing depends on the relative bargaining position of the two parties to the transaction and their willingness to enter into such a risk-sharing arrangement. If the buyer (or seller) can dictate terms and perceives there is little risk of their profit margin being affected by currency fluctuation, they may be less willing to share the risk.

For example, assume a hypothetical U.S. firm called PowerMax is importing 10 turbines from a European company EC, priced at EUR $1 million each for a total order size of EUR $10 million. Owing to their longstanding relationship, the two companies agree to a currency risk sharing agreement. Payment by PowerMax is due in three months, and the company agrees to pay EC at a spot rate in three months of EUR 1 = $1.30, which means that each turbine would cost it $1.30 million for a total payment obligation of $13 million. The currency risk sharing contract between EC and USF specifies that the price per turbine will be adjusted if the euro trades below 1.25 or above 1.35. Thus, a price band of 1.25 to 1.35 forms the neutral zone over which currency risk will not be shared.

In three months, assume the spot rate is EUR 1 = $1.38. Instead of PowerMax paying EC the equivalent of $1.38 million (or EUR 1 million) per turbine, the two companies split the difference between the base price of $1.30 million and the current price (in dollars) of $1.38 million. The adjusted price per turbine is therefore the euro equivalent of $1.34 million, which works out to EUR 971,014.50 at the current exchange rate of 1.38. Thus, PowerMax has obtained a price discount of 2.9%, which is one-half the 5.8% depreciation in the dollar versus the euro. The total price paid by PowerMax to EC is therefore EUR $9.71 million, which at the exchange rate of 1.38 works out to exactly 13.4 million.

On the other hand, if the spot rate in three months is EUR 1 = 1.22, instead of PowerMax paying EC the equivalent of $1.22 million per turbine, the two companies split the difference between the base price of $1.30 million and the current price of $1.22 million. The adjusted price per turbine is therefore the euro equivalent of $1.26 million, which works out to EUR 1,032,786.90 (at the current exchange rate of EUR 1.22). Thus, PowerMax pays an additional 3.28% per turbine, which is one-half of the 6.56% appreciation in the dollar.

  1. Currency Union

    When two or more groups (usually countries) share a common currency ...
  2. Currency Forward

    A binding contract in the foreign exchange market that locks ...
  3. Digital Gold Currency - DGC

    An electronic, private currency backed by gold bullion. Companies ...
  4. Currency Strategist

    A financial professional who evaluates economic trends and geopolitical ...
  5. Accounting Currency

    The monetary unit used when recording transactions in a company's ...
  6. Double Hedging

    Hedging a position by using futures and options, thereby doubling ...
Related Articles
  1. Mutual Funds & ETFs

    Hedging With ETFs: A Cost-Effective Alternative

    The benefits of ETFs for hedging are clear and investors of all sizes are taking notice.
  2. Options & Futures

    Hedging Basics: What Is A Hedge?

    This strategy is widely misunderstood, but it's not as complicated as you may think.
  3. Options & Futures

    Practical And Affordable Hedging Strategies

    Learn how to find and use the most cost-effective ways to transfer risk.
  4. Options & Futures

    Currency ETFs Simplify Forex Trades

    Reduce your stock portfolio's risk by trading with foreign currencies.
  5. Mutual Funds & ETFs

    The VIX: Using The "Uncertainty Index" For Profit And Hedging

    Learn the best ways to profit and hedge using the Chicago Board Options Exchange Market Volatility Index.
  6. Forex Education

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  7. Mutual Funds & ETFs

    Profit From Forex With Currency ETFs

    There's always a bull market somewhere - and now you can find it with currency ETFs.
  8. Forex Education

    Currency Carry Trades 101

    This strategy can provide returns even if the currency pair doesn't move a cent.
  9. Markets

    Hedging With Puts And Calls

    This trading strategy can reduce your risk - but only if you use it effectively.
  10. Options & Futures

    Find Profits By Hedging Iron Condors

    Hedging iron condors with put calendars can help control losses, and can even make an investor more profitable.
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Why are mutual funds subject to market risk?

    Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict ... Read Full Answer >>
  4. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  5. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  6. Who decides when to print money in India?

    The Reserve Bank of India, or RBI, manages currency in India. The bank's additional responsibilities include regulating the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center