Foreign Exchange Risk

Foreign Exchange Risk refers to the risk of an unfavorable change in the settlement value
of a transaction entered in a currency other than the base currency (domestic currency).
This risk arises as a result of movement in the base currency rates or the denominated
currency rates and is also called exchange rate risk or FX risk or currency risk. Foreign
exchange risks can be classified into the following three types of risks:

Transaction Risk:

Where the business transactions are entered in a currency other than the home currency of
the organization, then there is a risk of change in the currency rates in the adverse
direction from the date of entering the transaction to the date of settlement. This type of
foreign exchange risk is known as transaction risk. This risk arises on the actual and
probable import and export transactions.

Translation Risk

Where a business organization has a foreign subsidiary whose reporting currency is other
than the reporting currency of the parent company, then for consolidation purposes, the
subsidiary balance sheet items are converted into the parent company’s reporting
currency on the basis of the prevailing accounting standards. The risk of movement in the
consolidated financial position and earnings as a result of exchange rates is termed
as Translation Risk. The results, in turn, impact the stock prices. It is also termed as
Accounting Exposure.

Economic Risk
It is the risk of change in the market forecast of the company’s business and future cash
flows as a result of a change in the exchange rates. This, in turn, impacts the market value
of the firm. For e.g. a monopoly product of the company starts facing competition when
the lower exchange rate renders the imported product cheaper. This type of foreign risk is
also termed as Forecast Exchange risk.

Economic Exposure
Economic exposure increases as foreign exchange volatility increases and decreases
as it falls. Economic exposure is obviously greater for multinational companies that have
numerous subsidiaries overseas and a huge number of transactions involving foreign
currencies. However, increasing globalization has made economic exposure a source of
greater risk for all companies and consumers. Economic exposure can arise for any
company regardless of its size and even if it only operates in domestic markets.
Example
Assume that a large U.S. company that gets about 50% of its revenue from overseas
markets has factored in a gradual decline of the U.S. dollar against major global
currencies—say 2% per annum—into its operating forecasts for the next few years. If the
dollar appreciates instead of weakening gradually in the years ahead, this would represent
economic exposure for the company. The dollar’s strength means that the 50% of
revenues and cash flows the company receives from overseas will be lower when
converted back into dollars, which will have a negative effect on its profitability and
valuation.