Currency risk

Currency risk or exchange rate risk is a form of financial risk that arises from the potential change in
the exchange rate of one currency in relation to another. Investors or businesses face an exchange rate
risk when they have assets or operations across national borders or if they have loans or borrowings in a
foreign currency.
An exchange rate risk can result in an exchange gain as well as a loss. To neutralize the risk of a loss
(but at the same time forgoing any potential exchange gain), some businesses hedge all their foreign
exchange exposure or exposure beyond some predetermined comfort level, which is a way of
transferring the risk to another business prepared to carry the risk or has a reverse risk exposure.
Hedging can involve the use of a forward contract.

Types of currency risk

There are two basic types of currency risk:
• Transaction risk is the risk that an exchange rate will change unfavourably over time.
• Translation risk is an accounting concept. It is proportional to the amount of assets held in
foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and
so assets are usually balanced by borrowings in that currency.
A currency risk exists regardless of whether investors invest domestically or abroad. If they invest in
the home country, and the home currency devalues, investors have lost money. All stock market
investments are subject to a currency risk, regardless of the nationality of the investor or the investment,
and whether they are in the same or different currency. Some people argue that the only way to avoid
currency risk is to invest in commodities (such as gold) which hold value independently of the
monetary system.[citation needed]

Consequences of risk
The currency risk associated with a foreign denominated instrument is a significant consideration in
foreign investment. For example, if a U.S. investor owns stocks in Canada, the return that will be
realized is affected by both the change in the price of the stocks and the change of the Canadian dollar
against the US dollar. Suppose that the investor realized a return on the stocks of 15% but if the
Canadian dollar depreciated 15% against the US dollar, then the movement in the exchange rate would
cancel out the realized profit on sale of the stocks.
If a business buys or sells in another currency, then revenue and costs can move upwards or downwards
as exchange rates between the transaction currency changes in relation to the home currency. Similarly,
if a business borrows funds in another currency, the repayments on the debt could change in terms of
the home currency; and if the business has invested overseas, the returns on investment may alter with
exchange rate movements.
Currency risk has been shown to be particularly significant and particularly damaging for very large,
one-off investment projects, so-called megaprojects. This is because such projects are typically financed
by very large debts nominated in currencies different from the currency of the home country of the
owner of the debt. Megaprojects have been shown to be prone to end up in what has been called the
"debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen foreign currency
and interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available
to do so. Financial restructuring is typically the consequence and is common for megaprojects.[1]

What Does Foreign-Exchange Risk Mean?

1. The risk of an investment's value changing due to changes in currency exchange rates.
2. The risk that an investor will have to close out a long or short position in a foreign currency at a
loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate
risk".

Foreign-Exchange Risk
This risk usually affects businesses that export and/or import, but it can also affect 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.

Background
Businesses involved in international trade often execute a sale or purchase at one point in time but the
transfer of funds takes place at a different point in time. This results in an uncertainty about the about
the amount of revenue or expenditure involved in the transaction in the business' home currency.
For example, suppose an American company sells electrical equipment to a buyer in France for one
million euros. The equipment is to be delivered 90 days before the payment is made. At the time the
sale agreement was made the exchange rate was $1.25 euros per dollar. This meant that the company
was counting on receiving something in the neighborhood of $1.25 million in the transaction. Suppose
the American company's cost for producing and delivering the equipment was $1.15 million and it was
counting on making a $100,000 profit on the transaction. However if the value of the euro fell to $1.10
by the time the American company received payment then it would find that it had a $50,000 loss
instead of a $100,000 profit.
Suppose the American company required the French company to make the payment in dollars instead
of euros. Then the French company would be bearing the risk. If the exchange rate fell from $1.25 per
euro to $1.10 then what it had been expecting to pay one million euros for would cost it about 1.136
million euros.
Foreign currency or transactions risk is the risk that is the consequence of fluctuations of exchange
rates. It can strongly affect businesses in a variety of ways. Even if a company does not engage in
foreign sales or purchases it can still be subject to a risk because of exchange rate fluctuations. This is
because the price of its foreign competition's products may be affected by a change in the exchange
rate.

The Source of the Risk

Exchange rates fluctuate due to a great many factors. Some may be strictly financial but political events
can also affect the exchange rates. If there is the threat of military conflict in some part of the world
those holding funds there may want to transfer their holdings to the U.S. They consequently exchange
their currency for dollars thus driving up the value of the dollar.
When Japan was hit by a major earthquake at Kobe, Japanese businesses began transferring funds back
into Japanese yen for the rebuilding process. This had the effect of increasing the value of the yen with
respect to other currencies.
In the early 1980's the tight monetary policy of the Fed resulted in high real interest rates in the U.S.
compared to other countries. This in turn resulted in a high value of the dollar compared to other
currencies.
Strategies for Dealing with
the Foreign Currency Transaction Risk
There exist organized markets for foreign currencies. The trading in foreign currencies now is called the
spot market. There are also forward and future markets for currency transfers which will occur
sometime in the future. This means that a company can enter into a contract with another party to
transfer its right to receive foreign currency payments a specified time in the future. The contract may
involve payment now or payment of a definite amount in the future when the foreign funds become
available.
A company can also engage in speculation in an organized futures market for the foreign currency. In
this strategy the company mades up in profit on its futures market transaction whatever loss it might
have on it foreign trade transaction risk.
Some companies decide that they have no expertise in the foreign currencies markets and immediate
sell on the forward market any foreign currency funds they are to receive. They then know exactly what
profit they are making on a foreign trade transaction. Other companies decided to try their hand at
foreign currency speculation. Some found that they made a profit on such speculation. Sometimes the
profit on currency speculation offset losses on these companies' main operations. This resulted in those
companies seriously committing themselves to such currency speculation. They set up separate division
to handle their currency market operations. When these divisions had losses instead of profits the
companies' financial stabilities were put at risk.