Introduction

In this chapter, we will explore the various types of foreign exchange risks faced by businesses and investors engaged in international transactions. Understanding these risks is essential for managing exposures in global markets effectively. We will delve into three primary types of foreign exchange risks: transaction risk, translation risk, and economic risk. Each risk carries its distinct characteristics and implications, which we will discuss in detail. Additionally, we will explore examples of how these risks can impact businesses and practical strategies to hedge against them.

Transaction Risk

Transaction risk, also known as short-term risk or settlement risk, arises from the uncertainty of exchange rate movements between the time a transaction is initiated and the time it is settled. This risk is prevalent in cross-border trade when payments are subject to exchange rate fluctuations. Transaction risk affects the value of foreign currency-denominated receivables or payables and can lead to unexpected gains or losses for businesses.

Example: Let’s consider a US-based importer who purchased goods from a European supplier. The payment is due in three months, and the exchange rate between the US dollar (USD) and the Euro (EUR) may fluctuate during this period. If the EUR appreciates against the USD by the payment date, the importer will have to pay more in USD to settle the invoice, resulting in a transaction loss. Conversely, if the EUR depreciates, the importer may benefit from a transaction gain.

Translation Risk

Translation risk, also known as accounting risk or balance sheet risk, occurs when a company’s financial statements are translated from the functional currency (the currency of the entity’s primary operations) into another reporting currency (e.g., for consolidation purposes). Exchange rate fluctuations between the functional currency and the reporting currency can impact the financial position and performance of the company.

Example: Consider a US multinational corporation with a subsidiary in Japan. The subsidiary’s financial statements are maintained in Japanese Yen (JPY), the functional currency. At the end of the reporting period, the subsidiary’s financials need to be translated into USD, the reporting currency, for consolidation with the parent company’s financials. If the JPY depreciates against the USD, the translated financials will show lower revenues and profits in USD terms, impacting the consolidated financial statements.

Economic Risk

Economic risk, also known as long-term risk or operating risk, arises from the exposure of a company’s cash flows and profitability to changes in exchange rates. Economic risk can be caused by factors such as changes in market conditions, inflation rates, interest rates, and economic performance of different countries.

Example: Suppose a US-based company manufactures goods in the US and exports them to various countries. A significant portion of its revenues comes from sales in the Eurozone. If the Euro depreciates against the USD over time, the company’s US dollar revenues from Eurozone sales will decrease when converted, affecting its profitability. Economic risk highlights the challenges of conducting business in a global market with volatile exchange rates.