Written by in Business on November 8, 2022
Foreign exchange risk – also known as currency risk, FX risk and exchange-rate risk – is something that anyone who transacts or does business in more than one currency should be aware of. Forex risk is the possibility of incurring losses, most commonly due to currency fluctuations. All multi-currency transactions are subject to the whims of flux. All appreciation and depreciation of the base currency or the denominated currency will impact the individuals or businesses on both ends of the transaction. Further, other parties such as investors, suppliers, and service providers will also carry a level of risk. The potential for loss is the amount of risk that each stakeholder is taking on.
Forex exposure refers to a company's risk when making transactions in foreign currencies. Identifying their risk exposure is important to put a calculated risk management strategy in place. There are three types of risk: Transaction risk, translation risk, and economic risk.
Transaction exposure is considered a short-run type of forex exposure. It refers to the risk involved in a transaction involving foreign currency. It can negatively impact you financially. This is the nature of transactional risk: transacting in different currencies and exposing yourself to potential loss.
As most business transactions aim to turn a profit, this type of exposure can impact your bottom line if you are dealing with large-volume transactions and particularly volatile currencies.
Translation exposure, on the other hand, comes about when translating books or records of accounts into your local currency. This type of exposure is relevant in the case that you are pulling reports or showing financial statements to governing bodies or shareholders, for example. Just as you would translate something into another language, you may need to translate your accounts or assets into your home currency for reporting or record-keeping purposes.
Suppose the foreign currency has moved in an unfavourable direction at translation time. In that case, it could impact your numbers and the opinions or contingencies associated with those you report to.
While this type of exposure isn’t necessarily risky, it’s worth being aware of as it is something that can impact your outward-facing value. Luckily, this is typically temporary as things can sway back in the other direction.
Finally, economic exposure. This exposure type is the most significant and the most impactful. It is considered a “long-run” exposure type because of its long-winded and high-level ramifications. Economic exposure is the degree to which a business's overall value is directly impacted by foreign exchange.
If your business is heavily exposed to risk in this way, unexpected currency fluctuations can affect your future cash flows, investments, earnings, and overall market value.
The other two exposure types measure your risk in specific circumstances, whereas economic exposure measures your overall risk due to foreign exchange fluctuations.
Economic exposure can be mitigated through both operational strategies and risk management strategies.
There’s a lot to learn when it comes to forex risk. At the top of the pile is how to protect yourself from loss. If you want to learn more about how to manage foreign exchange risk, click below to download our free white paper: “Your Guide to Managing Forex Risk as Your Business Grows Global.”
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