Foreign exchange risk

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the domestic currency of the consolidated entity.

Investors and businesses exporting or importing goods and services, or making foreign investments, have an exchange-rate risk but can take steps to manage (i.e. reduce) the risk.

Many businesses were unconcerned with, and did not manage, foreign exchange risk under the international Bretton Woods system. It was not until the switch to floating exchange rates, following the collapse of the Bretton Woods system, that firms became exposed to an increased risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure. The currency crises of the 1990s and early 2000s, such as the Mexican peso crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis, led to substantial losses from foreign exchange and led firms to pay closer attention to their foreign exchange risk.

A firm has economic risk (also known as forecast risk) to the degree that its market value is influenced by unexpected exchange-rate fluctuations, which can severely affect the firm's market share with regard to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic risk can affect the present value of future cash flows. An example of an economic risk would be a shift in exchange rates that influences the demand for a good sold in a foreign country.

Another example of an economic risk is the possibility that macroeconomic conditions will influence an investment in a foreign country. Macroeconomic conditions include exchange rates, government regulations, and political stability. When financing an investment or a project, a company's operating costs, debt obligations, and the ability to predict economically unsustainable circumstances should be thoroughly calculated in order to produce adequate revenues in covering those economic risks. For instance, when an American company invests money in a manufacturing plant in Spain, the Spanish government might institute changes that negatively impact the American company's ability to operate the plant, such as changing laws or even seizing the plant, or to otherwise make it difficult for the American company to move its profits out of Spain. As a result, all possible risks that outweigh an investment's profits and outcomes need to be closely scrutinized and strategically planned before initiating the investment. Other examples of potential economic risk are steep market downturns, unexpected cost overruns, and low demand for goods.

International investments are associated with significantly higher economic risk levels as compared to domestic investments. In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with the sale and purchase of foreign government bonds. However, economic risk can also create opportunities and profits for investors globally. When investing in foreign bonds, investors can profit from the fluctuation of the foreign-exchange markets and interest rates in different countries. Investors should always be aware of possible changes by the foreign regulatory authorities. Changing laws and regulations regarding sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect investments in foreign countries. For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted. As a result, economic risk can be reduced by utilizing various analytical and predictive tools that consider the diversification of time, exchange rates, and economic development in multiple countries, which offer different currencies, instruments, and industries.

When making a comprehensive economic forecast, several risk factors should be noted. One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment. In a macroeconomic model, major risks include changes in GDP, exchange-rate fluctuations, and commodity-price and stock-market fluctuations. It is equally critical to identify the stability of the economic system. Before initiating an investment, a firm should consider the stability of the investing sector that influences the exchange-rate changes. For instance, a service sector is less likely to have inventory swings and exchange-rate changes as compared to a large consumer sector.