What is Foreign Exchange Risk?
Foreign exchange risk is the chance that a foreign financial transaction will lose money because of changes in currency.
It is also called currency risk, FX risk, and exchange rate risk. It is the risk that the value of an investment could go down if the relative value of the currencies involved changes.
Foreign exchange risk is one type of country risk that investors may face.
KEY POINTS
- Foreign exchange risk is the chance that a foreign financial transaction will lose money because of changes in currency.
- Foreign exchange risk can also affect investors who trade on foreign markets and businesses that import and export goods and services to and from more than one country.
- There are three different kinds of foreign exchange risk: transaction risk, translation risk, and economic risk.
Understanding Foreign Exchange Risk
Foreign exchange risk happens when a company does business in a currency that is different from the currency in which the company is based.
If the base currency goes up or down in value or if the denominated currency goes up or down in value, it will affect the cash flows that come from that deal.
Foreign exchange risk can also affect investors who trade on foreign markets and businesses that import and export goods and services to and from more than one country.
Whether an investor made a profit or lost money on a trade, the money from the trade will be in the foreign currency and will need to be changed back to the investor’s base currency.
Changes in the exchange rate could make this conversion go wrong and give a lower amount than planned.
A business that imports and exports puts itself at risk of foreign exchange risk when the rates of exchange affect its account payables and account receivables.
This risk starts when a contract between two parties lists exact prices and delivery times for goods or services.
If the value of a currency changes between the time the contract is signed and when it is due to be delivered, it could cost one party money.
There are three kinds of currency risk:
1. Transaction Risk: This is the risk a company takes when it buys a product from a company in another country.
The price of the goods will be set in the currency of the company selling it.
If the company that is selling has a stronger currency than the company that is buying, the company that is buying will have to pay more in its base currency to meet the deal price.
2. Translation risk: A parent company that owns a subsidiary in another country could lose money when the subsidiary’s financial records, which are written in the currency of that country, have to be converted back to the currency of the parent company.
3. Economic risk: This is also known as forecast risk, is when a company’s market value is constantly affected by unavoidable currency changes.
Companies that are vulnerable to FX risk can reduce that risk by using hedging techniques.
Usually, this is done with forward contracts, options, and other strange financial products.
If done right, this can protect the company from unwelcome changes in the foreign exchange market.
Foreign Exchange Risk Example
A French store agrees to sell 100 cases of wine to an American booze company for €50 per case, or €5,000 total. The money is due when the wine is delivered.
The American company agrees to this deal at a time when the Euro and the US Dollar are both worth $1, so €1 = $1.
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So, the American company thinks that they will have to pay the agreed-upon amount of €5,000, which was $5,000 at the time of the sale, when they accept delivery of the wine.
But it will be a few months before the wine gets there. In the meantime, because of things beyond our control, the value of the US Dollar goes down against the Euro, so that at the time of arrival, €1 is worth $1.10.
The agreed-upon price is still €5,000, but the amount that the American spirits company will have to pay is now $5,500.
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