Understanding Foreign Exchange Risk

Foreign exchange risk, also known as currency risk, FX risk, or exchange-rate risk, refers to potential losses incurred in international financial transactions due to currency fluctuations. This risk arises when the value of involved currencies changes, leading to a decrease in the investment’s value. Jurisdiction risk is often associated with foreign exchange risk.

Key Takeaways:

• Foreign exchange risk involves potential losses from currency fluctuations in international transactions.
• It impacts investors trading in global markets and businesses engaged in cross-border trade.
• Three types of foreign exchange risk are transaction, translation, and economic risk.

Investopedia / Julie Bang

Understanding Foreign Exchange Risk

Foreign exchange risk occurs when a company conducts financial transactions in a currency different from its base currency. Fluctuations in the base or denominated currency’s value impact cash flows from the transaction. This risk also affects investors in global markets and businesses involved in international trade.

After closing a trade, the proceeds, whether profit or loss, must be converted back to the investor’s base currency. Exchange rate fluctuations can affect this conversion, resulting in unexpected amounts.

Import/export businesses face foreign exchange risk with account payables and receivables affected by currency exchange rates. Contracts with specified prices and delivery dates can lead to losses if currency value changes between contract signing and delivery.

There are three types of foreign exchange risks:

• Transaction risk: Risk faced when buying products in a foreign currency.
• Translation risk: Losses from translating financial statements of subsidiaries to the parent company’s currency.
• Economic risk: Continuous market value impact due to unavoidable currency fluctuations.

Companies can manage FX risk through hedging strategies like forward contracts and options to protect against adverse currency movements.

Foreign Exchange Risk Example

An American liquor company buys wine from a French retailer. Due to a depreciating US Dollar, the final payment in Euros increases when converted back to US Dollars.