What is foreign Exchange Risk and its types? Explained

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Author: Sarthak Bhalerao

Table of Contents

  1. What is Foreign Exchange Risk?
  2. Understanding Foreign Exchange Risk
  3. Types of Foreign Exchange Risk
  4. Mitigating Foregin Exchange Risk

Foreign Exchange Risk?

Foreign exchange risk, also known as the exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’s financial performance or financial position will be impacted by changes in the exchange rates between currencies. Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets. There are three types of foreign exchange risk, and they include transaction risk, economic risk, and translation risk.

Understanding Foreign Exchange Risk Exposure

Risk occurs when a company engages in financial transactions or maintains financial statements in a currency order than where it was headquartered. For example, a company based in Australia that does business in Canada – i.e., receives financial transactions in Canadian dollars – reports its financial statements in Australian dollars, is exposed to foreign risk. The Canadian dollars received must be converted to Australian dollars before reporting the company’s financial statements. Changes in the exchange rate between the CAD and AUD would be the risk, hence the term foreign exchange risk.

Types of Foreign Risk

There are three types of Foreign Exchange risks. They include:

  • Transaction Risk:

Transaction risk is faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before the transaction settlement. The transaction risk can be mitigated using forward contracts and options.

  • Economic Risk:

Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.

For example, an Australian furniture company that sells locally will face economic risk from furniture importers, especially if the Australian currency unexpectedly strengthens.

  • Translation Risk:

Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.

For example, a parent company that reports in Australian dollars, but an overseas subsidiary based in Canada face translation risk, As the subsidiaries, financial performance is in Australian dollars is translated to Canadian dollars for reporting purposes.

Foreign Exchange Risk Management Techniques

Mitigation of foreign exchange risk is a key risk management objective, in the investment context. There are multiple ways of mitigating this, some of them are

  • Going Short the Currency: For example if we invest in India as a U.S investor, in a public listed company. We ofcourse want to take exposure to the upside of the company we invested in but we dont want the currency risk. So we could sell INR Equalvalent to the the amount of investment we have done in the stock
  • SWAPS: These are niche products but SWAPS in bonds of foreign countries can give us the option for cashflows in either domestic or foreign currency
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Sarthak Bhalerao

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