What is Foreign Exchange Risk?

Foreign exchange risk is the possibility that the value of a transaction or an investment will change because of variations in currency exchange rates. For example, a seller commits to be paid in 60 days in a different currency; if the value of that currency declines during the intervening time period, the seller will incur a loss when the receivable is paid.

This is a significant risk for businesses engaged in exporting or importing activities where some of their transactions are conducted in a different currency than the entity’s home currency. This risk is also a concern when investments are made in a foreign currency, since a loss may be incurred on the investment when it is eventually sold and the funds are converted back into the investor’s home currency.

Example of Foreign Exchange Risk

A manufacturer of widgets in the United States enters into an arrangement to buy 1,000 widget components from a European supplier for 10,000 Euros, with payment due on the delivery date (which will be three months in the future). At the moment, the exchange rate is $1.10 to one Euro. However, by the time the manufacturer receives the widget components, the exchange rate has worsened to $1.20 to the Euro. This means that, instead of having to pay $11,000 under the original arrangement, the company now has to pay its supplier $12,000.

Foreign Exchange Risk Mitigation Activities

Foreign exchange risk can be mitigated by entering into offsetting hedging transactions, as well as by insisting that all transactions by conducted in one’s home currency. Another option is to only buy and sell within one’s home country, though doing so can reduce access to better foreign suppliers, while also limiting one’s sales.