Loading the player...

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.

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.

RELATED TERMS
  1. Translation Risk

    Translation risk is the exchange rate risk associated with companies ...
  2. Transaction Exposure

    Transaction exposure is the level of risk from fluctuating exchange ...
  3. Foreign Currency Effects

    Foreign currency effects are gains of losses on foreign investments ...
  4. Currency Futures

    Currency futures are a transferable contract that specifies the ...
  5. Euro ETF

    A euro ETF is an exchange-traded fund that invests in the euro, ...
  6. Currency Risk

    Currency risk is a form of risk that arises from the change in ...
Related Articles
  1. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments. Find out more about currency risk analysis in global investing.
  2. Investing

    3 Strategies to Mitigate Currency Risk (EUFX)

    Discover the often overlooked risk known as currency risk, and learn three strategies to mitigate or eliminate it in your portfolio.
  3. Investing

    The 3 biggest risks faced by international investors

    Investing internationally is a great way to diversify your portfolio, but as an investor you need to know the risks and barriers that are faced in global markets.
  4. Trading

    Corporate Currency Risks Explained

    Corporate currency risks include transaction, translation and economic risks.
  5. Trading

    Currency fluctuations: How they effect the economy

    Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. Read on for what effects these changes can have.
  6. Trading

    Hedging with currency swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it with currency swaps.
  7. Trading

    What causes a currency crisis?

    Find out what can cause a currency to collapse and what central banks can do to help in times of currency crisis.
  8. Investing

    Currency Positions You Can Take Now

    The foreign currency market is the largest financial market in the world, and investors in this market have many options.
  9. Insights

    Ever Wanted to Own International Stocks? Here's How

    Tips and strategies for users to trade in different exchanges around the world.
RELATED FAQS
  1. The risks businesses face in international finance

    When an organization engages in international financing activities, it takes on additional risk, including foreign exchange ... Read Answer >>
  2. How does the balance of payments impact currency exchange rates?

    Take a brief look at the relationship between a nation's balance of payments and the exchange rate value of its currency ... Read Answer >>
  3. How do you make money trading money?

    Trading money, particularly in the forex market, is a speculative risk, as you are betting that the value of a currency will ... Read Answer >>
  4. Financial Risk vs Business Risk

    Understand the key differences between a company's financial risk and its business risk – along with some of the factors ... Read Answer >>
  5. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
  6. How do national interest rates affect a currency's value and exchange rate?

    Generally, higher interest rates increase the value of a country's currency and lower interest rates tend to be unattractive ... Read Answer >>
Trading Center