Foreign Exchange Risk - The Basics

Foreign Exchange Risk: The Basics

What is it?

Foreign exchange risk – also called FX risk, currency risk, or exchange rate risk – is the financial risk of an investment’s value changing due to the changes in currency exchange rates. This also refers to the risk an investor faces when he/she needs to close out a long or short position in a foreign currency at a loss, due to an adverse movement in exchange rates.

How Does it Affect Investment?

Foreign exchange risk usually affects businesses that export and/or import their products, services, and supplies. It also affects investors making international investments.

For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment’s value to either decrease or increase when the investment is sold and converted back into the original currency.

Why Does it Matter?

A foreign-exchange risk is another aspect of risk which offshore investors must accept. As a result, open positions in non-dollar-denominated items may need to shut down. Though foreign-exchange risk addresses unwanted movements that might result in losses, it is possible to benefit from favorable fluctuations with the potential for additional value above and beyond that of a currently stable investment.

Foreign Exchange Risk - The Basics 2

Types of Foreign Exchange Risk Exposure

  • Transaction Exposure

This type of exposure arises when a company takes on transactions in a currency other than its domestic currency. A company is exposed to transaction exposure when it makes or receives payments in a foreign currency.

  • Economic Exposure

Economic exposure, also called operating exposure, refers to the firm’s present value of future operating cash flows affected by changes in exchange rates.

  • Translation Exposure

Translation or accounting exposure arises when a company has assets and liabilities denominated in a currency other than its reporting currency.

Accounting regulations may require that the foreign currency value of items such as shareholdings of subsidiaries or property holdings abroad must turn into the company’s reporting currency in the preparation of consolidated accounts.

  • Contingent Exposure

Firms who bid for foreign projects, negotiate contracts directly with foreign firms or have direct foreign investments face contingent exposure. When firms negotiate with foreign firms, currency rates will always change before, during and after negotiations occur.

See Also: Learn the Best Currency Pair to Trade

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