A Nigerian importer agrees to pay a US supplier $200,000 in three months. Today the dollar costs ₦1,450. In three months it may cost ₦1,500, and the importer’s bill rises by ₦10 million before it has sold a single unit. An exporter faces the mirror image. Exchange rates move, and anyone with a future payment or receipt in another currency is exposed.
This topic covers why companies need foreign exchange, spot rates, direct and indirect quotes, strong and weak currencies, bid and offer rates, the three types of currency risk (translation, economic and transaction), government exchange rate policies, and the causes of exchange rate movements. The previous topic covered corporate failure. The next covers exchange rate relationships.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on basic exchange rate quotation.
In 30 seconds
A spot rate is for immediate settlement (treated as immediate in the exam); a forward rate is fixed now for a later date. A direct quote is units of home currency per unit of foreign currency (Nigeria quotes this way: ₦/$). An indirect quote is the reverse, and it is the reciprocal. If the ₦/$ rate rises, the naira weakens.
Banks quote a bid (they buy foreign currency, the weaker rate) and an offer (they sell it, the stronger rate); the bank always uses the rate better for itself. Three risks: translation (consolidating foreign accounts, non-cash), economic (long-term loss of competitiveness) and transaction (a future receipt or payment changes in value, a cash risk). Risk runs both ways. Rates move through supply and demand, inflation (PPP) and interest rates (IRP).
Governments may float, manage the float or fix the rate.
Key terms in plain English
| Term | What it means |
|---|---|
| Spot rate | The rate for immediate exchange |
| Forward rate | A rate agreed now for exchange at a set future date |
| Direct quote | Home currency per unit of foreign currency |
| Bid / offer | The rate at which a bank buys / sells the foreign currency |
| Translation risk | Gains or losses from restating a foreign subsidiary’s accounts |
| Transaction risk | Gains or losses on a future foreign currency receipt or payment |
| Economic risk | Loss of competitiveness from long-term currency moves |
Syllabus check
This topic is in syllabus area E (treasury and advanced risk management). It covers:
- the different types of foreign exchange risk;
- spot rates and what causes them to move.
CAMA 2020 and currency exposure
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Directors should manage currency exposures prudently for the benefit of the company |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should know the company’s foreign currency exposures and the rules that govern them |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Why companies need foreign exchange
International trade and investment create the need. A company buying abroad may have to pay in the supplier’s currency; a company selling abroad may be paid in the buyer’s currency or in dollars, then sell the proceeds for naira; a company investing abroad must obtain foreign currency. Major currencies trade freely in the FX markets run by banks worldwide.
Some currencies have no liquid market and foreign firms may refuse them.
Quoting rates
An exchange rate is the price of one currency in terms of another. A direct quote gives units of the domestic currency per unit of foreign currency; Nigeria uses this (for example ₦260/£1). An indirect quote gives units of foreign currency per unit of domestic currency; it is the reciprocal (£1/260 = 0.003846 per naira).
A direct quote of one currency is the indirect quote of the other, as in the UK where £1 = ₦260 is indirect.
Strong and weak
When one currency strengthens the other weakens. If ₦/$ moves from 150 to 160, the naira weakens (it takes more naira to buy a dollar) and the dollar strengthens. If £1/$1.50 moves to £1/$1.60 (indirect), the pound strengthens, since a pound buys more dollars.
Bid and offer
Banks quote two rates. The bid is where they buy the foreign currency (the weaker rate for it) and the offer is where they sell it (the stronger rate). The bank uses the rate more favourable to itself: it sells foreign currency at the stronger rate and buys it at the weaker rate. Check by reversing the deal: the customer must lose, or you used the wrong rate.
ICAN’s example. A Nigerian company needs $10,000. The bank’s ₦/$ rates are 150 to 160. The bank sells dollars at ₦160. Cost = 10,000 × 160 = ₦1,600,000. Check: selling the dollars straight back at 150 gives ₦1,500,000, a loss of ₦100,000.
ICAN’s other examples: a UK company needs $10,000 at “1.50 – 1.60” and pays 10,000 ÷ 1.5 = £6,667 (back at 1.6 gives £6,250, a loss of £417). A French company selling Aus$7,000 at 1.5230 – 1.5240 per euro receives 7,000 ÷ 1.5240 = €4,593.18; an Australian company buying €12,000 pays 12,000 × 1.5240 = Aus$18,288.
Three types of currency risk
Rates can be very volatile (the euro has ranged between about $0.75 and $1.35 since 1999), which creates risk for anyone who trades, borrows or invests in foreign currency.
- Translation risk: arises when the statements of foreign subsidiaries, in local currency, are translated into the parent’s currency for the consolidation. Gains or losses are “paper” and do not affect cash flow.
- Economic risk: long-term movements caused by changes in a country’s competitiveness. If the home currency gains over time, home goods become dearer in world markets and the company loses competitiveness. It is a strategic risk.
- Transaction risk: a future receipt or payment in foreign currency may be worth more or less in home currency by the settlement date. It arises only when settlement is in the future and the rate moves. It does affect cash flow, and the exposure lasts from the sale on credit until the cash arrives.
ICAN’s example (transaction risk). A Nigerian company sells sugar for $100,000 at ₦150/$ (expecting ₦15m) on three months’ credit. If the rate is ₦140/$ at settlement it receives ₦14m, a loss of ₦1m. At ₦170/$ it receives ₦17m, a gain of ₦2m. With a 10% margin of ₦1.5m, the final profit is ₦0.5m in the first case and ₦3.5m in the second: the exchange difference can outweigh the trading profit.
Risk is two-way, but most hedges give up gains to avoid losses, because a trading company wants to protect its margin.
Government exchange rate policy
A government may try to stabilise its currency. Today the main tool is the interest rate: higher rates attract investment, raise demand and strengthen the currency.
Policies: free floating (no policy; the market sets the rate); managed floating (market-determined within target limits, defended by interest rates); a fixed rate against a major currency or basket (problems: the two economies must stay similar, with similar inflation, and the home economy is affected by a crisis in the other); and a currency board, where new domestic currency is backed by a hard currency in reserves (Hong Kong succeeded, Argentina did not; the risks are a money shortage and higher interest rates).
Nigeria operates a managed float. The Central Bank of Nigeria used auctions (the Dutch Auction System, then the Retail Dutch Auction System from 2013); since 2023 the official and parallel windows have been unified into a market-determined rate in the Nigerian Foreign Exchange Market, now traded on an electronic matching system.
Causes of exchange rate movements
Three explanations: supply and demand, purchasing power parity and interest rate parity. Demand for a currency comes from foreign buyers of the country’s exports, exporters converting receipts and foreign investors buying its assets. Supply comes from importers and investors who sell the currency to buy foreign currency. A large trade deficit tends to depress a currency because supply from importers exceeds demand. The next topic covers the parity theories.
The rules in more depth
Why the bank always gains on a round trip
That is how it earns the spread. If your check shows a gain, you used the wrong rates.
Why translation risk is not a cash risk
No cash changes hands; only the consolidated accounts are restated.
Why transaction risk needs a gap in time
If you settle on the same day at the same rate, there is no time for the rate to move.
Why economic risk is hard to hedge
It is long term and affects the whole business model, not a single payment.
Effect on analysis
Identify the exposure, classify the risk, state the direction of loss and then choose a hedge.
Worked examples
Example 1: bid and offer. A bank quotes ₦1,450 – ₦1,500 per dollar. A Nigerian company needs $20,000.
- The bank sells dollars at the stronger rate, ₦1,500.
- Cost = 20,000 × 1,500 = ₦30,000,000.
- Selling them straight back at 1,450 gives ₦29,000,000, a loss of ₦1,000,000.
Example 2: transaction risk for an importer. A $200,000 payment is due in three months. The rate is ₦1,450 and may become ₦1,500.
- Cost now.
200,000 × 1,450 = ₦290m. - Cost at 1,500 = ₦300m.
- The exposure is ₦10m of extra cost.
Example 3: classifying risk. A Nigerian group consolidates a Kenyan subsidiary; it also buys US inputs on credit; and a rising naira makes its exports dearer for years.
- Consolidating the subsidiary is translation risk.
- The US inputs on credit are transaction risk.
- The loss of export competitiveness is economic risk.
Example 4: reciprocal. The direct quote is ₦1,500 per dollar.
- The indirect quote is 1 ÷ 1,500.
- That is $0.000667 per naira.
- A dollar is 1,500 naira from the Nigerian viewpoint.
How to score full marks
- Identify whether the quote is direct or indirect.
- Apply the bank’s rate: sells at the stronger, buys at the weaker.
- Check by reversing the deal.
- Classify the risk and say if it is cash or non-cash.
- State who loses if the rate moves.
- Link to a suitable hedge.
Common mistakes in the exam
- Dividing when you should multiply (direct against indirect).
- Using the rate favourable to the customer.
- Saying translation risk affects cash flow.
- Confusing a weaker home currency with a stronger one.
- Forgetting that risk can produce gains.
Quick revision
- Spot now; forward later. Direct = home per foreign.
- Higher ₦/$ = weaker naira.
- Bank sells at the stronger rate, buys at the weaker.
- Translation (non-cash), economic (long-term), transaction (cash).
- Policies: float, managed float, fixed, currency board.
- Causes: supply and demand, PPP, IRP.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A direct quote gives:
- Home currency per unit of foreign currency
- Foreign per unit of home
- A forward rate
- A bid only
Show the answer
A. Nigeria uses this.
Question 2. If ₦/$ rises from 150 to 160, the naira:
- Weakens
- Strengthens
- Is unchanged
- Floats
Show the answer
A. It takes more naira per dollar.
Question 3. A bank sells foreign currency at the:
- Stronger rate
- Weaker rate
- Spot only
- Forward only
Show the answer
A. It uses the rate better for itself.
Question 4. Translation risk affects:
- Consolidated accounts without cash flow
- Cash flow
- Exports only
- Tax
Show the answer
A. It is a paper risk.
Question 5. Transaction risk exists because:
- Settlement is in the future
- Rates never move
- There is no bank
- Payment is in cash today
Show the answer
A. The rate can change before settlement.
Question 6. Economic risk is:
- Long-term loss of competitiveness
- A single payment risk
- Accounting only
- Tax risk
Show the answer
A. A strategic risk.
Question 7. A fixed exchange rate policy requires:
- Similar economic conditions in both countries
- No reserves
- Free floating
- No central bank
Show the answer
A. Especially similar inflation.
Question 8. A currency board backs new domestic currency with:
- Hard currency reserves
- Gold only
- Debt
- Nothing
Show the answer
A. As in Hong Kong.
Question 9. A large trade deficit tends to:
- Depress the currency
- Raise it
- Fix it
- Cancel it
Show the answer
A. Supply exceeds demand.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Distinguish direct and indirect quotes. (3 marks) (b) Explain bid and offer rates and the rule a bank follows. (4 marks) (c) Explain why a naira move from ₦1,450 to ₦1,500 per dollar is a weakening of the naira. (3 marks)
Question 12 (20 marks). (a) Explain translation, transaction and economic risk with an example of each. (6 marks) (b) A bank quotes ₦1,450 – ₦1,500 per dollar. A company needs $20,000 and another receives $20,000. Calculate the naira cost and the naira received. (4 marks) (c) A company expects ₦15m from a $100,000 sale at ₦150/$. Calculate the outcome at ₦140/$ and ₦170/$. (4 marks) (d) Explain four government exchange rate policies. (6 marks)
Question 13 (10 marks). (a) Why does transaction risk arise only when settlement is in the future? (3 marks) (b) State three sources of demand for a currency. (3 marks) (c) Explain why hedging usually gives up exchange gains. (4 marks)
Model answers
Show the model answer to Question 11
(a) Quotes (3 marks). A direct quote gives units of home currency per unit of foreign currency. (1.5) An indirect quote gives units of foreign currency per unit of home and is the reciprocal. (1.5)
(b) Bid and offer (4 marks). The bid is the rate at which the bank buys foreign currency, the offer the rate at which it sells. (2) The bank uses the rate more favourable to itself, so it sells at the stronger rate and buys at the weaker. (2)
(c) Weakening (3 marks). More naira are needed to buy one dollar. (1.5) So the naira buys less foreign currency and has weakened, while the dollar has strengthened. (1.5)
Show the model answer to Question 12
(a) Risks (6 marks). Translation: restating a foreign subsidiary’s accounts on consolidation, a non-cash effect. (2) Transaction: a future foreign currency receipt or payment changes in value, such as a sale on credit in dollars. (2) Economic: long-term loss of competitiveness when the home currency strengthens. (2)
(b) Calculations (4 marks).
- Company buying.
bank sells at 1,500, so cost = 20,000 × 1,500 = ₦30,000,000. (2) - Company selling.
bank buys at 1,450, so receipt = 20,000 × 1,450 = ₦29,000,000. (2)
(c) Outcomes (4 marks). Expected = ₦15m. At 140: ₦14m, a loss of ₦1m. (2) At 170: ₦17m, a gain of ₦2m. (2)
(d) Policies (6 marks). Free floating: the market sets the rate. (1.5) Managed floating: market-determined within target limits, defended by interest rates. (1.5) Fixed rate against a currency or basket: needs similar economies. (1.5) Currency board: new money backed by hard currency reserves. (1.5)
Show the model answer to Question 13
(a) Timing (3 marks). If settlement is immediate there is no time for the rate to move. (1.5) The exposure lasts from the credit sale to the cash receipt. (1.5)
(b) Demand (3 marks). Buyers of the country’s exports; exporters converting receipts; foreign investors buying its assets. (1 each)
(c) Hedging (4 marks). A hedge fixes the rate in advance. (1.5) Fixing it removes both adverse and favourable movements. (1.5) A trading company wants to protect its margin, not speculate. (1)
Pathfinder on Quotes, bid and offer rates, the three currency risks and exchange rate policy
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on basic quotation. Hedging questions, such as November 2014 question 7, use these rules; see the topic on forward contracts and money market hedges. Worked examples 1 to 4 show the calculations.
Revise first: Worked examples
Questions ask you to classify exposures. See the section on the three types of currency risk.
Revise first: Three types of currency risk
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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