Understanding Foreign Exchange Risk

Foreign exchange risk is the risk of losses emerging in international financial transactions due to the fluctuation of currencies. It describes the possibility that an investment's value may decrease due to changes in foreign currencies.

There are three types of foreign exchange risk; let us consider each in turn:

1.) Translation risk:

This is the risk when foreign operations / investments need to be translated back the base currency. this can be considered through MNCP's who have foreign operations must have their revenues translated back to the parent company's base currency. This can also effected investors; let us consider an example.

For example, if an investor in the UK has a lot of cash invested in different US equities and the dividends are returned in USD. It was assumed that the difference between the USD and GBP was 1:1. If the dollar appreciates against the pound that so that it is 0.9:1 the investor will experience a 10% lower return on investment due to foreign exchange differences. This assumes the return must be converted back into the investor's currency.

Investors and banks also face foreign exchange risk when they close a long/short position in a foreign currency at a loss due to an adverse movement in an exchange rate. For example, any appreciation/depreciation would have an impact on the cash flows that originate from that transaction. Typically this would result in hedge accounting to cover this base.

2.) Transaction risk: 

This is the risk that a company faces when it buys products / services from a foreign company. The price of the product will be denominated in the selling companies currency. If the payment is not done instantaneously and instead is due on delivery this time period can result in a change in exchange rates; let us consider the below example

Consider a UK firm who trades with a German firm.

• The companies operate in a B2B market and agree a trade worth €15,000 when the exchange rate was 1:1 with payment due at time of delivery.
• However, in the time taken to close the trade a major political event occurs in the UK market which triggers a depreciation of the GBP against the USD.
• Therefore the exchange rate of GBP vs EUR rises to 1 : 0.90. 
• Therefore the UK firm now still has to pay €15,000 but due to a change in the exchange rate it has to pay £16,500 as opposed to £15,000 to fulfil the €15,000 due.

 3.) Economic risk

This is also known as forecast risk which refers to the potential for unavoidable exposure to currency fluctuations which can depress a company's markets value. This is known as economic exposure, which in short, can make a firms products more or less competitive in pecuniary factors depending on the change of exchange rates. This has a strong impact on cash flows of the firm. This naturally hits MNCP's much more than a sole trader who solely operates in its home economy. 

However, like all risk this can be mitigated by taking appropriate action. Whilst economic risk is unavoidable diversification of geographical focus can help mitigate the risk of global firms. Moreover, firms that are subject to FX risk can implement hedging strategies to avert some level of risk. This typical involves the utilization of options, forwards contracts and more exotic financial products.