What is Foreign Exchange Risk
Foreign exchange risk describes the risk that an investment’s value may change due to changes in the value of two different currencies. It is also known as currency risk, FX risk and exchange-rate risk.
Foreign exchange risk sometimes also refers to risk an investor faces when they need to close out a long or short position in a foreign currency and do so at a loss due to fluctuations in exchange rates.
Some types of exposure associated with foreign exchange risk include economic exposure, translation exposure and contingent exposure.
Economic exposure, or forecast risk, refers to when a company’s market value is impacted by currency volatility. Translation exposure refers to when foreign exchange rates change, affecting the figures that a multinational company reports to its shareholders. Contingent exposure refers to the risk that firms face when they bid on projects in foreign currencies.
Foreign Exchange Risk
BREAKING DOWN Foreign Exchange Risk
Foreign exchange risk most often affects businesses engaged in exporting and importing products or supplies. It also applies to businesses that offer services in multiple countries and individuals who invest internationally.
Any time an investor must convert money into another currency to make an investment, that face potential changes in the currency exchange rate between their home currency and the currency of their investment. These changes will affect the investment's value or the business’ bottom line.
A business exposes itself to foreign exchange risk by having payables and receivables affected by currency exchange rates. This risk originates when a contract between two parties specifies exact prices for goods or services, as well as delivery dates. If a currency’s value fluctuates between when the contract is signed and the delivery date, it could cause a loss for one of the parties.
How Foreign Exchange Risk Works
For example, an American liquor company signs a contract to sell a French retailer 100 cases of whiskey for a 50 euros per case, or 5,000 euros total. The American company agrees to this contract at a time when the euro and the dollar are of equal value. Thus, the American company expects that when they deliver the whiskey, the agreed upon payment of 5,000 euros will equal roughly $5,000.
However, it may take a few months for the whiskey company to deliver the goods. In the meantime, Europe undergoes an economic crisis and the value of the euro goes down sharply. By the time the whiskey is delivered, one euro is worth only $.75. Thus, though the French company still pays the agreed upon 5,000 euros, that amount is now equal to only $3,750.