Exchange Rate Risk

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Exchange Rate Risk?

Exchange Rate Risk is defined as the risk of loss that the company bears when the transaction is denominated in a currency other than the money in which the company operates. It is a risk that occurs due to a change in the relative values of currencies.

The risk which the company runs is that there may be an adverse currency fluctuation on the date when the transaction is completed and currencies are exchanged. Foreign exchange riskForeign Exchange RiskForeign exchange risk is an unfavourable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency), also referred to as currency risk or exchange rate risk.read more also occurs when a company has subsidiaries operating in different countries. The subsidiaries prepare their financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more in the currency, which is different from the currency in which the parent company reports its financial statements.

Import and export businesses involve a large number of foreign exchange risks as the import/ export of goods and services include transactions in different currencies and exchange of currencies at a later date and time. Exchange rate risk also affects international investors and institutions, which make overseas investments in global markets.

Key Takeaways

  • Exchange rate risk refers to the possibility of experiencing losses or gains due to fluctuations in exchange rates between currencies. These fluctuations can impact the value of investments, business revenues, and financial transactions.
  • Exchange rate risk affects a wide range of individuals and entities, including those involved in international trade, multinational corporations, investors with international holdings, and anyone engaging in cross-border transactions.
  • Various factors can contribute to exchange rate risks, such as economic indicators, differences in interest rates, political events, geopolitical tensions, market speculation, and supply and demand dynamics in the foreign exchange market.

Types of Foreign Exchange Risks

Exchange Rate Risk

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#1 – Transaction Risk

Transaction riskTransaction RiskTransaction risk is the uncertainty or loss caused to the contracting party due to a change in the foreign exchange rate or currency risk on delay in settlement of a foreign transaction.read more occurs when a company buys products or services in a different currency or has receivables in another currency than their operating currency. Since the payables or receivables are denominated in a foreign currency, the exchange rate at the initiation of a transaction and on the date of settlementDate Of SettlementThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade.read more may have changed due to the volatile nature of the forex market. This can cause a gain or loss for the company depending on the direction of the movement of exchange rates and thus poses a risk to the company.

Example of Transaction Risk

A company X operating in the United States of America, buys raw material from company Y in Germany. The operational currency for Company X and Y is USD and EUR, respectively. The company buys raw material for EUR 100 Mn and needs to pay company Y 3 months down the line. At the initiation of a transaction, suppose USD/ EUR rate is 0.80; thus, if the company X had paid for the material upfront, it would have bought EUR 100 Mn for USD/ EUR 0.80 * EUR 100 Mn = USD 80 Mn.

Now suppose, after three months, USD depreciates to USD/ EUR 0.85, then the company would have to pay USD 85 Mn to buy the EUR 100 Mn to pay the company Y in Germany. Thus, company X has to pay USD 5 Mn extra due to the volatility of the USD-EUR pair. Had the dollar appreciated against the Euro, company X would have paid less to buy the EUR 100 Mn.

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#2 – Translation Risk

Translation riskTranslation RiskTranslation risk describes how fluctuations in exchange rates can affect a company's financial position (assets, liabilities, and equity) when dealing with foreign currencies.read more occurs when a company’s financial statement reporting is affected by the exchange rate volatility. A large multinational generally has a presence in many countries, and each subsidiary reports its financial statements in the currency of the country in which they operate. The parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies.read more typically reports the consolidated financials, which involves translating foreign currencies of different subsidiaries to the domestic currency. And this can have a significant impact on the company’s balance sheet and income statement and can ultimately affect the stock price of the company.

Example of Translation Risk

Company X operating in the United States of America, has subsidiaries in India, Germany, and Japan. To report the consolidated financials, company X needs to translate INR, EUR, and YEN, respectively, into USD. So if the INR, EUR, and YEN fluctuate in the forex market relative to USD, it can impact the reported earnings and balance sheet of company X. This can ultimately affect the share price of company X.

#3 – Economic Risk

A company faces economic riskEconomic RiskEconomic Risk is the risk exposure of an investment made domestically or abroad. These risks could be macroeconomic factors like government policies or collapse of the current government and major swing in the exchange rates.read more when the volatility in the exchange rate market can cause changes in the market value of the company. It represents the effects of exchange rates movement on revenues and expenses of a company, which ultimately affects the future operating cash flowsOperating Cash FlowsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more of the company and its present value.

Example of Economic Risk

Change in the exchange rate of a pair of currencies can cause changes in the demand for a product that a company produces. Since the exchange rate movement is affecting the market and revenue of the company, it can affect its present value.

How to Manage Foreign Exchange Rate Risk?

Conclusion

To conclude, we can say that the foreign exchange rate is an essential factor for companies that transact internationally, have subsidiaries abroad, and whose market value is dependent on exchange rates and affect the profitability and market value of companies. The different types of exchange rate risks are transaction, translation, and economic risk. And these can hedge depending on the nature of the risk.

Frequently Asked Questions (FAQs)

1. How does exchange rate risk impact international trade?

Exchange rate risk can impact international trade by introducing uncertainty and volatility in the value of currencies. Moreover, fluctuations in exchange rates can affect the competitiveness of imported and exported goods, pricing strategies, profit margins, and overall market demand.

2. How can investors manage exchange rate risk in their portfolios?

Investors can manage exchange rate risk in their portfolios by hedging with derivatives (e.g., futures, options), diversifying investments across different currencies, using currency exchange-traded funds (ETFs), or employing professional currency managers.

 3. Can exchange rate risk be predicted or accurately forecasted?

Exchange rate risk is difficult to predict or accurately forecast long-term. It is influenced by multiple factors, such as economic conditions, interest rates, geopolitical events, and market sentiment, making it challenging to predict currency movements precisely.

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