What Is Currency Risk Sharing?
Currency risk sharing is a way of hedging currency risk in which the two parties of a deal or a trade agree to share in the risk from exchange rate fluctuations.
Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. By entering into a currency sharing agreement, two or more entities can mutually hedge against those possible losses.
- Currency risk sharing is a contractual agreement between counterparties to a trade or deal to share in any losses due to currency risk or exchange rate fluctuations.
- Currency risk sharing clauses typically involves a predetermined base exchange rate and a threshold that, if crossed, will trigger the mutual split of the loss.
- These agreements are not standardized nor commonplace, and so the presence of such an agreement and its terms will depend on the ability of one of the counterparties to bargain with the other.
Understanding Currency Risk Sharing
Currency risk sharing generally involves a legally binding 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.
Still, the degree of currency risk sharing will depend on the relative bargaining position of the two parties 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.
Example of How Currency Risk Sharing Works
For example, assume a hypothetical U.S. firm called ABC is importing 10 turbines from a European company called EC, priced at €1 million each for a total order size of €10 million. Owing to their longstanding business relationship, the two companies agree to a currency risk sharing agreement. Payment by ABC is due in three months, and the company agrees to pay EC at a spot rate in three months of €1 = $1.30, which means that each turbine would cost it $1.3 million, for a total payment obligation of $13 million. The currency risk sharing contract between EC and ABC 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 €1 = $1.38. Instead of ABC paying EC the equivalent of $1.38 million (or €1 million) per turbine, the two companies split the difference between the base price of $1.3 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 €971,014.50 at the current exchange rate of 1.38. Thus, ABC has obtained a price discount of 2.9%, which is half of the 5.8% depreciation in the dollar versus the euro. The total price paid by ABC to EC is therefore €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 €1 = $1.22, instead of ABC paying EC the equivalent of $1.22 million per turbine, the two companies split the difference between the base price of $1.3 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 €1,032,786.89 (at the current exchange rate of 1.22). In the end, ABC pays an additional 3.28% per turbine, which is one-half of the 6.56% appreciation in the dollar.