What Is Exchange Rate Risk?
Exchange rate risk is a financial risk that arises when an individual or corporation conducts business in different currencies. The fluctuation of currency rates in the forex market causes this risk.
The value of one currency concerning another is referred to as its exchange rate. As a result, exchange rate risk is the potential loss caused by a change in the value of a currency.
Definition 2
Exchange rate risk is the risk that changes in currency exchange rates may have an unfavorable impact on the costs or revenues of economic units.
Understanding Exchange Rate Risk
Anyone involved in international trade or investment faces exchange rate risk. For example, an importer in the United States who acquires items from a supplier in Japan must pay in Japanese yen. If the yen's value against the US dollar rises, the importer will have to pay more for the same items, resulting in a loss.
Similarly, a US corporation investing in a foreign market faces exchange rate risk. If the value of the foreign currency falls, so will the value of the company's investment. This can substantially impact a company's financial status, especially if a large amount of capital has been committed.
Types of Exchange Rate Risk with Example
Individuals and businesses may face numerous types of currency rate risks:
Transaction Risk
This form of risk arises when a corporation must pay or receive a payment in a foreign currency. It results from the currency rate uncertainty between the time the transaction is agreed upon and payment.
For example, a US corporation agrees to pay a Japanese supplier 10 million yen for goods, with payment due in 60 days. If the yen rises in value against the US dollar during that time, the US corporation will have to pay more in dollars to meet its obligations.
Translation Risk
When a corporation has to translate the financial accounts of its international companies into its home currency, this risk develops. Depending on the exchange rate at the translation time, the translation may result in a gain or loss.
For example, if a US corporation owns a subsidiary in the United Kingdom and the value of the British pound falls against the US dollar, the value of the subsidiary's assets falls when translated into US dollars.
Economic Risk
Changes in currency rates affect a company's future cash flows from its foreign activities, creating this risk. Changes in interest rates, inflation rates, and political instability in foreign nations can all contribute to it.
For example, suppose a US corporation owns a subsidiary in a country with significant inflation. In that case, the value of the subsidiary's future cash flows in US dollars will fall in real terms if the exchange rate remains constant.
In Sentences
- Anyone engaged in international trade or investment must consider exchange rate risk.
- Exchange rates refer to the value of one currency with another.