Understanding Currency Risk & Its Types

Key Highlights

• Foreign exchange risk is the risk that changes in currency exchange rates will have an impact on a company's financial performance or position.
• Three categories of foreign exchange risk exist: transaction risk, economic risk, and translation risk.
• Foreign exchange risk is a big concern for exporters/importers and businesses who conduct business in international markets.

What is Currency Risk?

Currency risk, often known as exchange-rate risk, derives from changes in the price of one currency in comparison to another currency. Currency risk exposes investors and firms with assets or commercial activities across national borders to unpredictability in profits and losses.

Many institutional investors, such as hedge funds and mutual funds, as well as multinational corporations, use forex, futures, options contracts, or other derivatives to hedge risk.

Understanding Currency Risk

The danger arises when a corporation conducts financial transactions or keeps financial records in a currency different from the one in which it is headquartered..

Example of Currency Risk

Suppose, A corporation situated in Canada and a business in China—that is, receiving financial transactions in Chinese yuan and publishing its financial statements in Canadian dollars—is subject to foreign exchange risk.

To be recorded on the company's financial accounts, financial transactions received in Chinese yuan must be converted to Canadian dollars. The risk would be changes in the exchange rate between the Chinese yuan (foreign currency) and the Canadian dollar (local currency), hence the name foreign exchange risk.

Foreign exchange risk can be created by an increase or decrease in the value of the base currency, an increase or decrease in the value of the foreign currency, or a combination of the two. It is a significant risk for exporters/importers and businesses who do business in international marketplaces.

Types of Foreign Exchange Risk

Currency risk occurs when the value of one currency fluctuates, affecting transactions, investments, or assets denominated in foreign currencies. In a global market, effective management is critical for firms and investors to minimise losses, protect financial positions, and improve performance.

Foreign currency risk can be classified into three types:

Transaction Risk The risk that a corporation bears while conducting financial transactions between jurisdictions is known as transaction risk. The risk is that the exchange rate will fluctuate before the transaction is completed. The primary driver of transaction risk is the delay between the transaction and settlement. Options and forward contracts can be utilized to lower transaction risk.

Economic risk The risk that a company's market value will be damaged by inevitable exposure to exchange rate swings is known as economic risk, sometimes known as forecast risk. This type of risk is typically caused by macroeconomic variables such as geopolitical instability and/or government laws.

Translation risk Translation risk, also known as translation exposure, refers to the risk faced by a firm headquartered in the United States but conducting business in a foreign jurisdiction whose financial performance is reported in the company's home currency. When a company keeps a larger proportion of its assets, liabilities, or stocks in a foreign currency, the risk of translation grows.

Conclusion

Currency risk, also known as exchange-rate risk, is a significant concern for businesses involved in international transactions. It involves fluctuations in currency values, which can affect profits and losses. It includes transaction, economic, and translation risks, each requiring specific strategies. Transaction risk involves timing financial transactions between different currencies, while macroeconomic factors influence economic risk.

Translation risk occurs when a company reports financials in its home currency. Hedging techniques like forward contracts and options can help mitigate these risks. Proactively managing currency risk is crucial for global businesses.