Foreign Exchange Risk

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What is 'Foreign Exchange Risk'

Foreign exchange risk - also called FX risk, currency risk, or exchange rate risk - is the financial risk of an investment's value changing due to the changes in currency exchange rates. This also refers to the risk an investor faces when he needs to close out a long or short position in a foreign currency at a loss, due to an adverse movement in exchange rates.

BREAKING DOWN 'Foreign Exchange Risk'

Foreign exchange risk typically affects businesses that export and/or import their products, services and supplies. It also affects investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency.

Transaction Exposure

A firm is exposed to foreign exchange risks if it has receivables and payables whose values are directly affected by currency exchange rates. Contracts between two different firms with different domestic currencies set contracts with specific rules. This contract provides exact prices for services and exact delivery dates. However, this contract faces the risk of exchange rates between the involved currencies changing before the services are delivered or before the transaction is settled.

Economic Exposure

A firm faces foreign exchange risks due to economic exposure - also referred to as forecast risk - if its market value is impacted by unexpected currency rate volatility. Currency rate fluctuations may affect the company's position compared to its competitors, its value and its future cash flow. These currency rate changes may also have good effects on firms. For example, a company from the United States with a milk supplier from New Zealand will be able to cut costs if the U.S. dollar strengthens against the New Zealand dollar. In this light, economic exposure may be managed strategically through arbitrage and outsourcing.

Translation Exposure

All firms generally prepare financial statements. These statements are created for reporting purposes. They are provided for multinational partners, thus the need for the translation of important figures from the domestic currency to another currency. These translations face foreign exchange risks, as there can be changes in foreign exchange rates when the translation from the domestic currency to another currency is performed. Though translation exposure may not impact a firm's cash flow, it can change the overall reported earnings of the firm, which affects its stock price.

Contingent Exposure

Firms who bid for foreign projects, negotiate contracts directly with foreign firms, or have direct foreign investments face contingent exposure. When firms negotiate with foreign firms, currency rates will continuously change before, during and after negotiations occur. For example, a firm may be waiting for a bid to be accepted by another foreign firm. As the firm waits, it faces contingent exposure, since currency rates may fluctuate and the firm will never know the status of their domestic currency in contrast with the foreign firm's currency when the bid is finally accepted.