Foreign Exchange Risk
The risk that a business' financial performance or financial
position will be affected by changes in the exchange rates
between currencies
What is Foreign Exchange Risk?
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.
Summary
Foreign exchange risk refers to the risk that a business’
financial performance or financial position will be affected by
changes in the exchange rates between currencies.
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.
Understanding Foreign Exchange Risk
The risk occurs when a company engages in financial transactions or
maintains financial statements in a currency other than where it is
headquartered. For example, a company based in Canada that does
business in China – i.e., receives financial transactions in Chinese
yuan – reports its financial statements in Canadian dollars, is
exposed to foreign exchange risk.
The financial transactions, which are received in Chinese yuan, must
be converted to Canadian dollars to be reported on the company’s
financial statements. Changes in the exchange rate between the
Chinese yuan (foreign currency) and Canadian dollar (domestic
currency) would be the risk, hence the term foreign exchange risk.
Foreign exchange risk can be caused by appreciation/depreciation of
the base currency, appreciation/depreciation of the foreign
currency, or a combination of the two. It is a major risk to consider
for exporters/importers and businesses that trade in international
markets.
Types of Foreign Exchange Risk
The three types of foreign exchange risk include:
1. Transaction risk
Transaction risk is the risk faced by a company when making
financial transactions between jurisdictions. The risk is the change in
the exchange rate before transaction settlement. Essentially, the
time delay between transaction and settlement is the source of
transaction risk. Transaction risk can be mitigated using forward
contracts and options.
For example, a Canadian company with operations in China is
looking to transfer CNY600 in earnings to its Canadian account. If
the exchange rate at the time of the transaction was 1 CAD for 6
CNY, and the rate subsequently falls to 1 CAD for 7 CNY before
settlement, an expected receipt of CAD100 (CNY600/6) would
instead of CAD86 (CNY600/7).
2. Economic risk
Economic risk, also known as forecast risk, is the risk that a
company’s market value is impacted by unavoidable exposure to
exchange rate fluctuations. Such a type of risk is usually created by
macroeconomic conditions such as geopolitical instability and/or
government regulations.
For example, a Canadian furniture company that sells locally will
face economic risk from furniture importers, especially if the
Canadian currency unexpectedly strengthens.
3. Translation risk
Translation risk, also known as translation exposure, refers to the
risk faced by a company headquartered domestically but conducting
business in a foreign jurisdiction, and of which the company’s
financial performance is denoted in its domestic currency.
Translation risk is higher when a company holds a greater portion of
its assets, liabilities, or equities in a foreign currency.
For example, a parent company that reports in Canadian dollars but
oversees a subsidiary based in China faces translation risk, as the
subsidiary’s financial performance – which is in Chinese yuan – is
translated into Canadian dollar for reporting purposes.
Examples of Foreign Exchange Risk
Question 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 U.S. dollar to the Canadian
dollar.
