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.

Understanding Foreign Exchange Risk

Foreign exchange risk arises when a company engages in financial transactions denominated in a currency other than the currency where that company is based. Any appreciation / depreciation of the base currency or the depreciation / appreciation of the denominated currency will affect the cash flows emanating from that transaction. Foreign exchange risk can also affect investors, who trade in international markets, and businesses engaged in the import / export of products or services to multiple countries.

The proceeds of a closed trade, whether its a profit or loss, will be denominated in the foreign currency and will need to be converted back to the investor's base currency. Fluctuations in the exchange rate could adversely affect this conversion resulting in a lower than expected amount.

An import/export business exposes itself to foreign exchange risk by having account payables and receivables affected by currency exchange rates. This risk originates when a contract between two parties specifies exact prices for goods or services, as well as delivery dates. If a currency‘s value fluctuates between when the contract is signed and the delivery date, it could cause a loss for one of the parties.

Types Of Foreign Exchange Risk

There are three types of foreign exchange risk:

Transaction risk: This is the risk that a company faces when it's buying a product from a company located in another country. The price of the product will be denominated in the selling company's currency. If the selling company's currency were to appreciate versus the buying company's currency then the company doing the buying will have to make a larger payment in its base currency to meet the contracted price.

Translation risk: A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency.

Economic risk: Also called forecast risk, refers to when a company‘s market value is continuously impacted by an unavoidable exposure to currency fluctuations.

Companies that are subject to FX risk can implement hedging strategies to mitigate that risk. This usually involves forward contracts, options, and other exotic financial products and, if done properly, can protect the company from unwanted foreign exchange moves.

Capital risk management-Different types

Sometimes referred to as investment risk, capital market risk is a term that refers to one of the risks associated with investing. Capital markets such as the stock, bond, foreign currency and derivatives markets are considered risky because of the constantly changing prices of the securities that are traded. In other words, security prices are volatile. Securities prices are not influenced just by their fundamentals, but also by broader market influences such as economic news, political developments, currency movements, or even ―black-swan‖ unexpected events such as a massive earthquake, tsunami or general market panic. While debatable, some consider price volatility to be a proxy for risk. The risk of financial loss associated with either choosing to or being forced to sell a security when prices have declined is what is meant by capital market risk.

Types of Capital risk

I. Market risk

Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged against in other ways.

ii. Industry risk 

Industry Risk refers to the impact that the state's industrial policy can have on the performance of a specific industry.

iii. Regulatory Risk

Regulatory risk is the risk that a change in regulations or legislation will affect a security, company, or industry. Companies must abide by regulations set by governing bodies that oversee their industry. Therefore, any change in regulations can cause a rippling effect across an industry.

Regulations can increase costs of operations, introduce legal and administrative hurdles, and sometimes even restrict a company from doing business.

iv. Business Risk

Business risk can be defined as uncertainties or unexpected events, which are beyond control. In simple words, we can say business risk means a chance of incurring losses or less profit than expected. These factors cannot be controlled by the businessmen and these can result in a decline in profit or can also lead to a loss.

Business risk is the possibilities a company will have lower than anticipated profits or experience a loss rather than taking a profit. Business risk is influenced by numerous factors, including sales volume, per- unit price, input costs, competition, and the overall economic climate and government regulations.

v. Interest rate risk

Interest rate risk is the danger that the value of a bond or other fixed-income investment will suffer as the result of a change in interest rates. Investors can reduce interest rate risk by buying bonds that mature at different dates. They also may allay the risk by hedging fixed-income investments with interest rate swaps and other instruments.

A long-term bond generally offers a maturity risk premium in the form of a higher built-in rate of return to compensate for the added risk of interest rate changes over time.

vi. Liquidity Risk

Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process

vii. Product Risk

Product risk is the risk that you may not actually be able to deliver the product to market within the resources (time, money) that you have available to you. And if you do deliver the product, the risk is also in that the product may not work exactly as well as hoped or promised or envisioned.

Types of product market risks are:

  1. Credit/Default risk
  2. Basis risk
  3. Settlement risk
  4. Currency risk
  5. Foreign exchange risk
  6. Commodity risk

I. Credit/Default risk

A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial.

Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and credit ratings for corporate and government debt issues. Credit ratings for debt issues are provided by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's (S&P), Moody's, and Fitch Ratings.

Default risk can change as a result of broader economic changes or changes in a company's financial situation. Economic recession can impact the revenues and earnings of many companies, influencing their ability to make interest payments on debt and, ultimately, repay the debt itself. Companies may face factors such as increased competition and lower pricing power, resulting in a similar financial impact. Entities need to generate sufficient net income and cash flow to mitigate default risk.

ii. Basis risk

Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other.

iii. Settlement risk

Settlement risk-also often called delivery risk - is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. Settlement risk can also be the risk associated with default, along with any timing differences in a settlement between the two parties. Default risk can also be associated with principal risk.

iv. Currency risk

Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency depreciation will negatively affect the value of one's assets, investments, and their related interest and dividend payment streams, especially those securities denominated in foreign currency.

v. Foreign exchange risk

Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. Foreign exchange risk can also affect investors, who trade in international markets, and businesses engaged in the import / export of products or services to multiple countries. They are classified into three types:

  • Transaction risks
  • Translation risks
  • Economic risks

vi. Commodity risk

Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc.

Commodity price risk to buyers stems from unexpected increases in commodity prices, which can reduce a buyer's profit margin and make budgeting difficult. For example, automobile manufacturers face commodity price risk because they use commodities like steel and rubber to produce cars.

In the first half of 2016, steel prices jumped 36%, while natural rubber prices rebounded by 25% after declining for more than three years. This led many Wall Street financial analysts to conclude that auto manufacturers and auto parts makers could see a negative impact on their profit margins.