3 Types of Foreign Exchange Risk

Foreign investors and international businesses are more vulnerable to foreign exchange risk due to exchange rate volatility. The foreign exchange rates can increase or decrease depending on inflation rates, interest rates, and terms of trade.

If you’ve invested in foreign assets and make international money transfers frequently, it’s imperative to understand the various types of foreign exchange risks. Sending funds overseas exposes you to the exchange risks. Thankfully, you can minimize the impacts.

In this guide, we look into the different types of foreign exchange risks and examples of how they occur. You’ll also learn the measures to minimize the impacts of the risks.

Understanding the Basics of Foreign Exchange Risk

What is foreign exchange risk? It refers to the losses a business or an individual is likely to incur when making international money transfers due to exchange rate volatility. The investment assets’ values can fall when the value of the currencies involved change.

Any fluctuation in the exchange rate between currencies will also affect the financial performance of a business operating across borders. Unfortunately, the impact can negatively affect profitability, calling for tips on managing foreign exchange risk.

Foreign exchange risk will likely occur when companies perform financial transactions denominated in currencies different from local currencies. Any change in the value of the base currency or denominated currency will affect cash flows in the trades.

For that reason, foreign exchange risk mainly affects foreign investors trading in international markets. Businesses that import and export products or services between countries are also more vulnerable to foreign exchange risks.

When the proceeds of a closed trade are denominated in foreign currency, the investor will need to convert it to the base currency. However, fluctuations in exchange rates will influence the amount of money the investor will get, resulting in either losses or profits.

In most cases, foreign exchange risk originates when the contract between two parties trading across borders specifies fixed prices for products and the delivery dates. If the value of the currencies involved changes between the date the contract is signed and the delivery date, one of the parties may suffer losses.

Types of Foreign Exchange Risks

Now that you understand the circumstances in which foreign exchange risks can occur, let us look at the three types of foreign exchange risks.

1.    Transaction Risk

Transaction risk can occur in a company that buys or sells products from a company based in another country. The risk can originate from the adverse impact the fluctuating exchange rates can bring onto a completed transaction before settlement.

For example, if a vendor’s currency was to appreciate against the buyer’s currency, the buyer will have to pay more in domestic currency to fulfill the contracted price.

However, if the buyer’s currency appreciates against the vendor’s currency, the buyer will pay less in domestic currency to meet the contracted prices of goods.

Transaction risk can be greater when the period between the date of contract entry and settlement is longer. The chances that the foreign exchange rates will fluctuate are higher.

For example,

A Canadian company operating in the U.S. would want to bring their USD earnings to the Canadian account. If the agreed foreign exchange rate was 1.20 CAD to 1 USD, and the Canadian exchange rate falls to 1.10 before the payment settlement, the company expecting CAD 1,200 in return would instead receive CAD 1,100.

2.    Translation Risk

Also known as translation exposure, a parent company headquartered domestically, owning a subsidiary in a foreign country, can face translation risk.

If the subsidiary submits financial statements denominated in the country’s currency, the parent company will translate it back to the headquarters’ domestic currency. As a result, it could experience losses when the exchange rates are unfavourable.

Notably, the translation risk would be higher when the parent company has a greater portion of its assets or equities in the foreign country.

For instance, a parent company headquartered in Canada that reports in Canadian dollars but has a subsidiary operating in China faces translation risk. The subsidiary’s financial performance, which is denominated in Chinese Yuan, will have to be converted into Canadian dollars for accurate reporting.

3.    Economic Risk

Also known as the “forecast risk,” economic risk can occur when a company’s market value is impacted by inevitable circumstances that cause exchange rate fluctuations. Such unavoidable factors can shift a country’s economic landscape.

Economic risk can result from macroeconomic factors such as government regulations, exchange rates, and geopolitical stability. These factors are unavoidable, and that is why international investments tend to be riskier than domestic investments.

For instance, a Canadian automobile company selling vehicles will face economic risk from automobile importers if the Canadian dollar strengthens unexpectedly.

An excellent example of economic risk is that experienced in Hong Kong in 2019. Many people took to the streets to express their infuriation over the Extradition Bill proposed by the Hong Kong government.

Despite Hong Kong having a stable economy, the escalating protests affected the region’s economy. Foreign investors with businesses operating in the region experienced unprecedented uncertainty.

Managing Foreign Exchange Risk

To effectively manage foreign exchange risks, you need to understand the type of risk your business is facing: transaction, translation, or economic risk.

Here are the benefits your business can enjoy by hedging foreign exchange risk.

• Improved financial budgeting and forecasting
• Protection of cash flow and profit margins
• A better understanding of currency fluctuation impacts
• Improved borrowing capacity

In most cases, businesses that operate internationally mitigate foreign exchange risk by utilizing forward contracts. It involves locking in the current exchange rate for future use at a specific date. It eliminates the risk of negative fluctuations in the exchange rates.

Final Words

If your business is exposed to foreign exchange risk, consider hedging the exposure with KnightsbridgeFX. Whether you need to pay your international suppliers or your overseas employees, you can call us to book a transaction and lock in a favourable exchange rate. We offer consistent bank-beating rates to help you save more money.