There are three types of exchange rate risk exposure for a Financial Planner or a Risk manager:-
is the change in accounting income and balance sheet statementscaused by changes in exchange rates. Under the rules of Financial Accounting StandardsBoard, a US company must determine a functional currency for all and each of itsoffshore subsidiaries. If such a subsidiary is a stand alone firm with vertical or horizontalintegration with the particular country, the functional currency can be the local currencyotherwise it has to the dollar.
is the gain or loss that might occur during settlement of foreignexchange transaction. Such a transaction could be the sale / purchase of product or services lending or borrowing of money or any other transaction involving mergers andacquisitions.
the most important of the three, is the change in value of a companythat accompanies an unanticipated change in the exchange rates. There is a clear distinction between the anticipated and the unanticipated change of exchange rates. Theanticipated change has already been factored into the valuation of the company by themarket forces. The unanticipated comes as an unforeseen risk.
is a form of risk that arises from the change in price of onecurrency
against another. Whenever investors or companies have assets or business operationsacross national borders, they face currency risk if their positions are nothedged.
is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts;
is an accounting risk, proportional to the amount of assets held inforeign currencies. Changes in the exchange rate over time will render a reportinaccurate, and so assets are usually balanced by borrowings in that currency.The exchange risk associated with a foreign denominated instrument is a key element inforeign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.For example if you are a U.S. investor and you have stocks in Canada, the return that youwill realize is affected by both the change in the price of the stocks and the change of theCanadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would makea small loss.