Foreign Exchange Risk

Exchange rates are quoted as a number of units of one currency (variable currency) in exchange for one unit of the other currency (base currency). Exchange rates are very volatile in nature. This means that exchange rates can move up or down by large amounts, within a fairly short period of time. Therefore, exchange rate fluctuations create foreign exchange risk for everyone involved in buying, selling, borrowing or investing foreign currency.

Foreign exchange risk, also known as exchange rate risk or currency risk, is the risk that can have a huge financial impact on the financial performance or financial status of a business entity due to changes in exchange rates between two currencies.

Foreign exchange risk can be caused by:

• Appreciation/depreciation of the base currency (For instance US dollars) 
• Appreciation/depreciation of the foreign currency 
• A combination of both 

We can classify foreign exchange risk into three types. These are :

1) Translation risk 

2) Economic risk 

3) Transaction risk

1) Translation risk 

Translation risk is the risk of losses (or gains) arising from the translation of the financial statements of a foreign subsidiary into the currency of the parent company for preparation of consolidated accounts. International companies with foreign subsidiaries face translation risk. 

Translation risk is usually higher when a company holds a higher portion of its assets, liabilities, and equities in a foreign currency. This type of risk is also known as accounting exposure or translation exposure.

2) Economic risk 

Economic risk refers to the long-term movement in exchange rates caused by changes in the competitiveness of a country. Macroeconomic factors such as geopolitical instability and government regulations are most probably the reasons behind such type of risk. Economics risk is also termed as forecast risk.

3) Transaction risk

Transaction risk is the foreign exchange risk that arises from transactions between two parties in which the normal transaction currency of each party is different and the transaction involves a future receipt/payment between the two parties.

This types of risk is a two-way risk, and exposure to risk can lead to either losses or gains from movements in an exchange rate.

The time lag between transaction and settlement is essentially the source of transaction risk.

Volatile exchange rates increase transaction risk. Transaction risk can disrupt international trade, and make businesses more reluctant to trade internationally.