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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.
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]
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.