Foreign Exchange Risk
Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. Also known as currency risk, FX risk and exchange-rate risk, it describes the possibility that an investment’s value may decrease due to changes in the relative value of the involved currencies. Investors may experience jurisdiction risk in the form of foreign exchange risk.
Definition: Foreign exchange risk, also known as currency risk or exchange rate risk, refers to the potential loss in international financial transactions due to fluctuations in exchange rates. It describes the possibility that the value of an investment may decline due to changes in the relative value of the currencies involved. Investors may experience judicial risk in the form of foreign exchange risk.
Origin: The concept of foreign exchange risk emerged with the increase in international trade and cross-border investments. After the collapse of the Bretton Woods system, fixed exchange rates were replaced by floating exchange rates, increasing exchange rate volatility and making the management of foreign exchange risk particularly important.
Categories and Characteristics: Foreign exchange risk is mainly divided into three categories: transaction risk, translation risk, and economic risk.
- Transaction Risk: Refers to the loss due to exchange rate fluctuations during foreign exchange transactions. It typically occurs when companies engage in cross-border transactions.
- Translation Risk: Refers to the fluctuation in the value of assets and liabilities due to exchange rate changes when companies prepare financial statements.
- Economic Risk: Refers to the impact of long-term exchange rate changes on a company's future cash flows and market competitiveness.
Specific Cases:
- Case 1: A US company signs a contract with a European supplier priced in euros. After the contract is signed, the euro depreciates against the dollar, requiring the US company to pay more dollars to fulfill the contract, increasing costs.
- Case 2: A Japanese company has significant investments in the US. Due to the appreciation of the yen against the dollar, the company's profits decrease when repatriating US earnings to Japan, affecting its financial performance.
Common Questions:
- How to manage foreign exchange risk? Companies can hedge foreign exchange risk using financial instruments such as foreign exchange futures, options, and forward contracts.
- Does foreign exchange risk only affect large companies? No, foreign exchange risk also affects small and medium-sized enterprises, especially those engaged in international trade.
