Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business financial performance or financial position will be impacted by changes in the exchange rates between currencies.
i.e. If you purchase a product in another country and payment happens minutes later, the exchange rate probably won't change much, or at all. Most of the time, the rate fluctuation over the course of a few minutes is minimal to nothing. So, the rate you expect to pay is what you end up paying. The three types of foreign exchange risk include transaction risk, economic risk, and translation risk. Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets.
Transaction Risk-Transaction
risk is the simplest and most common foreign exchange risk. It occurs when the
actual transaction takes place. The risk comes from the possibility of the
rates changing so that the value of the currency is different than when the
transaction started.
Transaction
risk is directly related to the delay between committing to a deal and actually
making payment. The longer the time period between the agreement to make
payment and the payment actually occurring, the greater the risk of the value
of your currency going down, so that you end up paying more than what you
initially intended.
As an illustration, a Canadian business with operations in China wants to deposit CNY 600 in profit into its Canadian account. If the currency rate was 1 CAD for 6 CNY at the time of the transaction and it drops to 1 CAD for 7 CNY before settlement, the expected receipt would be
CAD100 (CNY600/6) rather than CAD86 (CNY 600/7).
Economic Risk-This
is also known as operating exposure. Economic risk is the risk of a company's
value being affected by changing currency rates and is the most complex type of
foreign exchange risk. Any organization that does business internationally will
be exposed to economic risk.
However, a company must take measures to protect itself from fluctuations, or it carries the risk of depreciating currency and value. There can be a considerable impact on a company's market value due to the possibility of volatile movement in the foreign currency market.
Translation Risk
is also known as accounting exposure and affects multinational companies that
have holdings or are operating in other countries.
Translation
risk happens due to the translation of the books into the home currency from
another currency.
Changes
in the exchange rate between the currency in which a company reports and the
currency in which it has its assets and liabilities can lead to big impacts on
the balance sheet. Translation risk occurs during financial reporting of
foreign operations that are reported in the home currency. While translation
risk can have a large negative impact on a company's financial results, balance
sheet hedging can mitigate this risk.
Examples of Foreign
Exchange Risk:
Question 1:
Recently, Company A, based in Canada, and Company B, based in Europe, entered
into a deal for Company A to buy 10 cutting-edge pieces of machinery.
The cost of each piece of equipment is €10,000, and the euro (€) and Canadian dollar (5) exchange rates are 1:1. Company A, based in Canada, recently entered into an agreement to purchase 10 advanced pieces of machinery from Company B. which is based in Europe. The price per machinery is €10,000, and the exchange rate between the euro (€) and the Canadian dollar ($) is 1:1. A week later, when Company A commits to purchasing the 10 pieces of machinery, the exchange rate between the euro and Canadian dollar changes to 1:1.2. Is it an example of transaction risk, economic risk, or translation risk?
Answer: The above is an example of transaction risk, as the time delay between transaction and settlement caused Company A to need to pay more, in Canadian dollars, for the pieces of machinery.
Question 2: Company A, based in Canada, reports its financial statements in Canadian dollars but conducts business in U.S. dollars. In other words, the company makes financial transactions in United States dollars but reports in Canadian dollars. The exchange rate between the Canadian dollar and the US dollar was 1:1 when the company reported its Q1 financial results. However, it is now 1:1.2 when the company reported its Q2 financial results. Is it an example of transaction risk, economic risk, or translation risk?
Answer:
The above is an example of translation risk. The company's financial
performance from Q1 to Q2 is negatively impacted due to the translation from
the US dollar to the Canadian dollar.