Currency risk, also known as exchange rate risk or FX risk, is the possibility that the value of an investment or financial transaction will be affected by fluctuations in exchange rates between two or more currencies.
This risk can have a significant impact on companies operating abroad, as well as on investors withinvestments in different currencies.
Examples of how foreign exchange risk can affect companies
- A Spanish company exporting products to the United States may see its revenues reduced if the euro appreciates against the dollar.
- A U.S. company with a subsidiary in Brazil may see its costs increase if the dollar depreciates against the Brazilian real.
- A multinational company with operations in several countries may see its overall profitability affected by fluctuations in exchange rates between the currencies in which it operates.
Examples of how foreign exchange risk can affect investors
- A Spanish investor holding shares in a U.S. company may see the value of his investment reduced if the euro depreciates against the dollar.
- An investor who has a mutual fund that invests in bonds of different countries may see the fund’s performance affected by fluctuations in exchange rates between the currencies in which it invests.
- An investor who has a bank account in a foreign currency may see the value of his balance reduced if the foreign currency depreciates against his local currency.
How does foreign exchange risk arise?
Foreign exchange risk arises from the dynamic nature of exchange rates. The value of one currency can increase or decrease relative to another currency at any time, due to a number of factors such as:
- Differences in monetary policies: Changes in interest rates by central banks can affect the value of currencies. For example, if the U.S. Federal Reserve raises interest rates, the U.S. dollar is likely to appreciate against other currencies.
- Economic situation: Economic growth, inflation and political stability can influence confidence in a currency and therefore its value. For example, if a country’s economy is slowing down, its currency is likely to depreciate.
- Geopolitical events: Wars, political crises or natural disasters can cause volatility in the currency markets. For example, if there is a war in a country, its currency is likely to depreciate.
- Speculation: Investors’ speculative activity can also contribute to exchange rate volatility. For example, if investors speculate that the euro is going to depreciate, they are likely to sell euros, which will cause its value to fall.
Types of foreign exchange risk
Transaction risk
Refers to the risk that the value of a financial transaction will be affected by a change in the exchange rate between the date on which the transaction is agreed and the date on which it is settled.
Example
A company signs a contract to buy a machine from a German company for 100,000 euros. The euro-dollar exchange rate on the day the contract is signed is 1 euro = 1.20 dollars.
However, when the contract is settled one month later, the exchange rate has changed to 1 euro = 1.10 dollars. This means that the Spanish company has to pay 10,000 euros more than expected due to the change in the exchange rate.
Translation risk
Refers to the risk that the value of a company’s assets and liabilities in foreign currency will be affected by a change in the exchange rate.
Example
A Spanish company has a subsidiary in Mexico. At the end of the fiscal year, the subsidiary has assets worth 100 million Mexican pesos. If the peso-euro exchange rate at the end of the fiscal year is 1 peso = 0.05 euros, the value of the subsidiary’s assets in euros will be 5 million euros.
However, if the exchange rate changes to 1 peso = 0.04 euros the following year, the value of the subsidiary’s assets in euros will be reduced to 4 million euros.
Economic risk
Refers to the risk that a company’s profitability will be affected by a change in the exchange rate.
Example
A U.S. company has a factory in China. The company sells its products worldwide in U.S. dollars. If the U.S. dollar depreciates against the Chinese yuan, the U.S. company will have to pay more yuan for its production costs in China.
This will reduce the company’s profitability.
Exposure risk
Refers to the risk that a company or an investor is not hedged against foreign exchange risk.
Example
A Spanish company exports products to the United States without hedging its currency risk. If the euro appreciates against the dollar, the Spanish company will see a reduction in its revenues in euros.
Basis risk
Refers to the risk that a hedging strategy will not be fully effective due to the difference between the spot and forward exchange rates.
Example
A Spanish company uses a forward contract to hedge the foreign exchange risk of a future transaction. However, the spot exchange rate at maturity of the forward contract is different from the forward exchange rate that was set at the time the contract was purchased.
This means that the Spanish company is not fully hedged against foreign exchange risk.
Systemic risk
Refers to the risk of a global financial crisis affecting the exchange rates of all currencies.
Example
The 2008 global financial crisis caused significant volatility in the foreign exchange markets. This affected companies and investors around the world.
Political risk
Refers to the risk that a change in a country’s government or economic policies will affect its currency.
Example
A change in a country’s government can lead to uncertainty about the country’s future economic policy. This can affect confidence in the country’s currency and cause its value to depreciate.
Liquidity risk
Refers to the risk that there is insufficient liquidity in the foreign exchange market to hedge a position in a foreign currency.
Example
A Spanish company needs to buy U.S. dollars to pay an invoice. However, there is not enough liquidity in the foreign exchange market to cover the company’s position. This may force the company to pay a higher price for the U.S. dollars.
How to manage foreign exchange risk?
Strategies to manage foreign exchange risk:
- Hedging: There are different financial instruments to hedge foreign exchange risk, such as forwards, futures, options and swaps.
- Diversification: Diversifying investments and operations in different currencies can help reduce the impact of currency risk.
- Sensitivity analysis: It is important to perform a sensitivity analysis to assess the potential impact of exchange rate fluctuations on the business or investment.
- Financial planning: It is important to have a financial plan that includes strategies to manage foreign exchange risk.
Frequently asked questions about foreign exchange risk
What is the spread in the foreign exchange market?
The spread is the difference between the buying and selling price of a currency. The spread represents the cost of the exchange transaction.
What are spot and forward exchange rates?
The spot rate is the current exchange rate at which a currency can be bought or sold. The forward exchange rate is the exchange rate at a specified future date.
What are financial derivatives?
Financial derivatives are financial instruments that are based on an underlying asset, such as a currency, stock or bond. Financial derivatives can be used to hedge currency risk.
