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Home › Resources › Foreign Exchange › Foreign Exchange

Risk

Foreign Exchange Risk


The risk that a business' financial performance or financial position
will be affected by changes in the exchange rates between currencies

Written by CFI Team

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.

Help
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.

Additional Resources

Thank you for reading CFI’s guide on Foreign Exchange Risk. To keep
learning and developing your knowledge base, please explore the
additional relevant resources below:

Devaluation

Market Risk

International Trade

Multinational Corporation (MNC)

See all foreign exchange resources

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