What is Foreign Exchange Risk?
Another name of this kind of financial risk is “Exchange Rate Risk”. This risk relates to the loss of finances or the impact due to monetary loss caused by fluctuations in currency or exchange rates (Ganti 2020). By definition, this risk describes the probability of an investment’s worth that affects a company’s financial value changing with changes in the exchange value of different currencies in transactions.
Your firm might be exposed to this type of risk upon engaging in an exchange of currency different from the original currency of the country that the company is based in. Appreciation and depreciation of the original currency or the receiving type of currency will consequently affect the monetary gain from the transaction. Multiple parties like investors, international traders, import/ export traders face the possibility of facing this risk.
Drastic changes in exchange rates is one of the silent killers in international trading. The downside includes the gain or loss of a transaction having to be converted to the investor’s company’s national currency. (Investopedia 2021). There is guaranteed loss for at least one party due the exchange rate bringing the total to a lesser amount to the agreed upon rate.
Export/Import businesses can suffer from this type of risk by account payables and receivables being a victim of exchange fluctuations. If there is a binding agreement between the involved parties that specifies the prices plus cost of delivery, the change in currency value might cause loss for one part depending on the type of change (Investopedia 2021)
3 Types of Foreign Exchange Risk
The most basic type of risk is – Transaction Risk. It is faced by companies during a transaction involved in the purchase of a product or service across international borders. As the standard rule, the selling price will be dominated by the seller’s currency. Depending on the appreciation of the seller’s currency, the buyers will pay extra in their own currency to meet the price agreed in the contract.
This exposure arises in businesses exchanges in foreign currency. The chances of facing this risk is a difference in time between seller and buyer. The difference in time set while entitling the cash versus the physical reception of cash (if payable) as well as order of purchase and date of the settlement invoice (Ainsworth 2021).
During the ownership of a subsidiary in a foreign location by a parent company, the foreign country will dominate the currency value. In this case, the owning firm can face potential loss due to the necessary translation back to the value of the parent company currency.
The conversion of balance sheets or economic statements from a foreign contact to the reported currency of the former is what translation risk means. It is important to note that the company with the higher and greater amount of portion of its assets and investments in different currencies faces a greater risk specifically of this type. The exchange rate fluctuation affects the economic performance very differently in the original company’s currency.
These risks occur when an organization’s commercial value gets affected by exposure to always changing currency rates. This unavoidable change of the two types of currencies can change due to several factors and can have a large impact on the value of the company if left unprotected. Foreign trade carries the largest risk on ending up on one side of a large profit or the depreciation of currency and value and
How to mitigate risks?
These types of risks can be avoided by observing the ups and downs in the currency value and conversion rate during transactions and preferably maintaining in American Dollars (USD). Experts believe that the exchange currency is maintained according to this global standard. Also, the risk is on the buyer and it is safer to quote and fix prices in one universally acclaimed currency. The movement of the payment is a major part of the issue and a detailed plan of the finances will be a strong mitigation strategy.
Submitted By: Ananya Mangwani, Student Risk Committee Member
Ainsworth P, 2021, “A Guide to Managing Foreign Exchange Risk” <https://www.toptal.com/finance/interim-cfos/foreign-exchange-risk>
Investopedia 2021, <https://www.investopedia.com/terms/a/accountspayable.asp>