FOREIGN EXCHANGE RISK

1. Definition:
- Foreign exchange risk refers to the losses that an international financial transaction
may incur due to currency fluctuations.
 In other words, Foreign exchange risk is the risk that a business’ financial
performance or financial position will be affected by changes in the exchange rates
between currencies.
- Foreign exchange risk arises when a company engages in financial transactions
denominated in a currency other than the currency where that company is based.
For example, a company based in Canada that does business in China receives
financial transactions in Chinese ¥ – reports its financial statements in Canadian
dollars, is exposed to foreign exchange risk.
 Foreign exchange risk can be caused by appreciation/depreciation of the base
currency, appreciation/depreciation of the foreign currency, or a combination of the
two. It is a major risk to consider for exporters/importers and businesses that trade
in international markets.
2. Types of foreign exchange risk:
The three types of foreign exchange risk include transaction risk, economic risk, and
translation risk.

(1) Transaction risk:

 - Transaction risk is the risk a company faces when it’s buying or selling a product
from a company located in another country. If a vendor’s currency were to
appreciate1 versus the buyer’s currency, then the buyer will have to make a larger
payment in their domestic currency to meet the contracted price.
- This risk generally increases when there is a longer period of time between entering
a contract and settling it as there is more opportunity for the currencies to fluctuate.
- Mitigating transaction risk can generally be done through utilizing forward contracts2
and FX options.
- For example, a US company with operations in Germany would need to bring their
euro earnings to the US account. If the agreed rate was 1.20 USD to 1 euro, and the
US exchange rate falls to 1.00 prior to the payment settlement, the company
expecting $1,200 USD in return would instead receive $1,000 USD.

(2) Translation risk:

- Translation risk (also known as ‘translation exposure’) refers to a situation where a
parent company owns a subsidiary in another country and the subsidiary’s revenue
or profits are converted to the parent company’s currency at a lower value. As
exchange rates change constantly, there can often be variances in the reported
figures between quarterly financial statements, which can impact a company’s stock
price.
- In real terms, if a company has a greater proportion of assets, liabilities or equities
denominated in a foreign currency, and if the currency is more volatile, the
translation risk is higher.
- A real world example of translation risk being handled well is BMW Group which,
while based in Munich, has received a significant increase in sales in the Asia region -
with China as their fasted-growing market. Despite the rise in sales, the exchange
rates often eroded into their reported earnings. To mitigate this, BMW Group set up
regional treasury centers in the US, UK and Singapore, and used forward contracts to
lock in favorable rates.
1
Increase in value
2
Is an agreement to buy or sell an asset at a specific price on a specified date in the future and options.
(3) Economic risk:
- Economic risk, also known as forecast risk, is the risk that a company’s market value
is impacted by unavoidable exposure to exchange rate fluctuations.
- This risk can be created by macroeconomic conditions like exchange rates,
government regulations and geopolitical stability. It’s one of the reasons why
international investment can be riskier than domestic investment and it typically
affects the shareholders and bondholders of a company.
- An example of economic risk in 2019 is that potentially faced by Hong Kong. Protests
dominated the landscape with people taking to the streets to express their
displeasure over the proposed Extradition Bill. This would enable almost anyone
who enters Hong Kong - whether in transit, to visit or as a resident, to be extradited
to China. The fear is that Hong Kong’s standing as a safe and reliable commercial hub
will face irreparable damage in the wake of the conflict. So those with businesses
that operate in the region are faced with unprecedented uncertainty.

3. Advantages and disadvantages of Foreign Exchange Risks

3.1. Advantages
 - Foreign exchange fluctuation provides an opportunity of gaining from favorable
movement in the currency of open foreign exchange position.
- Availability of numerous new and innovative products to hedge the risk.
- Foreign exchange markets operate round the clock3 in one or the other country;
hence the hedging or speculation is possible anytime.
3.2. Disadvantages of Foreign Exchange Risks
- Hedging the risk involves an additional cost.
- It can result in huge losses even if there is a small movement in the rates where the
open position is huge.

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happening or done all day and all night