Foreign Exchange Risk: What It Is and Hedging Against It, With Examples

What Is Foreign Exchange Risk?

Foreign exchange risk refers to the losses that a business conducting international transactions can incur due to fluctuations in currency rates. Changes in the relative value of the currencies involved can change the real costs of goods ordered from abroad or delivered to a foreign customer, or increase the cost of a planned expansion in a foreign country. Investments in foreign companies can suffer losses due entirely to exchange rate changes.

Foreign exchange risk is also known as currency risk, FX risk, and exchange-rate risk,

Understanding Foreign Exchange Risk

Foreign exchange risk arises when a company engages in financial transactions denominated in a currency other than that of the company's home country. Any appreciation or depreciation of the base currency or the depreciation or appreciation of the denominated currency will alter the cash flows emanating from that transaction.

Foreign exchange risk can also affect investors who trade in international markets and businesses engaged in the import/export of products or services to multiple countries.

The proceeds of a closed trade, whether it is a profit or loss, are denominated in the foreign currency and will need to be converted back to the investor's base currency. Fluctuations in the exchange rate could adversely affect this conversion, resulting in a lower-than-expected amount.

An import/export business is exposed to foreign exchange risk by having account 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 the time the contract is signed and the delivery date, it will cause a loss for one of the parties.

Types of Foreign Exchange Risk

There are three types of foreign exchange risk:

1. Transaction risk: This is the risk that a company faces when it buys a product from a company located in another country. The price of the product will be denominated in the selling company's currency. If the selling company's currency appreciates versus the buying company's currency, the company doing the buying will have to make a larger payment in its base currency to meet the contracted price.
2. Translation risk: A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency.
3. Economic risk: Also called forecast risk, this occurs when a company’s market value is continuously impacted by unavoidable exposure to currency fluctuations.

Companies that are subject to FX risk can implement hedging strategies to mitigate that risk. This usually involves forward contracts, options, and other exotic financial products. If done properly, these strategies can protect the company from adverse foreign exchange moves.

Foreign Exchange Risk Example

An American liquor company signs a contract to buy 100 cases of wine from a French retailer for €50 per case, or €5,000 total, with payment due at the time of delivery.

The American company agrees to this contract at a time when the Euro and the US Dollar are of equal value, so €1 = $1. Thus, the American company expects that when they accept delivery of the wine, they will be obligated to pay the agreed-upon amount of €5,000, which at the time of the sale was $5,000.

However, it will take a few months for the wine to be delivered. In the meantime, due to unforeseen circumstances, the value of the US dollar depreciates versus the euro. By the time the wine is delivered, €1 = $1.10.

The contracted price is still €5,000 but now the US dollar amount that the American importer must pay is $5,500.

The Bottom Line

Foreign exchange risk is a fact of life for any company doing business abroad and any investor buying foreign stocks. Companies mitigate these risks using various strategies such as buying forward contracts on the forex to get a guaranteed rate at a future date. Investors can minimize the risks by investing in international ETFs that hedge against foreign exchange risk.