Foreign Exchange Risk Defined
A foreign currency exchange risk is the loss that can occur between international financial transactions due to currency fluctuations.
This is commonly mentioned as a fx risk, currency risk or exchange-rate risk.
Another version of this is a jurisdiction risk in the form of a foreign exchange risk.
A Jurisdiction risk is a risk that arises when someone operates in a foreign jurisdiction.
This risk can occur when you do business in another country, especially when an investor is exposed to unexpected changes in the laws of that certain country.
These are known as foreign exchange exposures.
Everything You Need to Know
When we try to understand foreign exchange risk, we are looking at a risk that occurs when a company decides to engage in a financial transaction that is conducted in a currency that is different from the currency that that company is based on.
This means that the value of the money fluctuates, and there is a risk of the value appreciating or depreciating in its base value.
This can be most commonly felt by investors who trade on international markets or businesses involved with import or export of products or services throughout more than one country at any period of time.
Types of Foreign Currency Exchange Risks
There four types of foreign exchange currency risks.
Transaction risk, translation risk, contingent risk and economic risk.
Transaction risk occurs when a company buys a product from a company that is geographically in a different location.
This means that the price has an advantage in the country which sells the product.
In other words, the company which buys the product pays more for it than the price defined in the company which sells the product.
This risk can occur when a company bids for foreign projects, negotiates other contracts, or handles direct foreign investments.
This can happen due to the potential of a firm to face a transactional or economic foreign-exchange risk contingent on the outcome of the contract.
In other terms, when a company waits for a project bid to be accepted by a foreign business, which when accepted will result in an immediate receivable, during the waiting period the company faces a contingent risk from the uncertainty of whether or not the receivable will acute.
Economic risk occurs when a company’s market value is shifted due to currency fluctuations.
This can affect the company’s market share when measured by its competitors and the firm’s future cash flow.
There is also the possibility that macroeconomic conditions will influence an investment in a foreign country, such as exchange rates, interest rates, government regulations and political stability within that specific country.
When a project is being financed, a company’s operating cost, debt obligations and the prediction of economic unsustainable circumstances can be calculated in order to produce adequate revenue that covers these risks, in other words, this is known as risk management and can lead to the calculation of profit margins.
Exchange Rate Risk Defined
The exchange rate risk is an unavoidable risk which involves foreign investment and can be mitigated through hedging methods.
Keep in mind that this risk is, as mentioned above, unavoidable, but it can be mitigated.
This risk occurs due to the fluctuation between an investor’s default country’s currency and the currency in the foreign country he is investing in.
These risks can be mitigated by using a hedged exchange-traded fund or through different investment paths such as futures or options, and there are a lot of hedging strategies investors tend to use.
How It Works
The US dollar can constantly surge, and the risk can erode returns from overseas investments.
This means that any foreign investor who makes U.S. investments can perform well because of the depreciation of the local currency against the USD, and it can lead to better returns.
When you decide to make a foreign investment, you need to leave the exchange rate risk unhedged when the local currency is depreciating against the foreign-investment currency.
You can hedge it when the local currency is appreciating against the foreign-investment currency.
Currency exchange rates are commonplace for travelers, bankers, international investors, and businesses with global trade. For people not involved in these fields, an exchange rate may seem a bit confusing. Before we look at how to read and calculate currency exchange rates, it is necessary first to define what it is.
An exchange rate is the amount of one currency you need to buy another currency. For example, if you have 100 US dollars and want to buy Euros, how many Euros will you get for your money? Looking at the Euro and USD exchange rate will give you this information.
But which exchange rate should you consider? EUR/USD or USD/EUR?
How to Read Exchange Rates
Exchange rates are written as currency pairs.
- USD/EUR (US Dollar/European Euro)
- USD/CAD (US Dollar/Canadian Dollar)
- USD/AUD (US Dollar/Australian Dollar)
- USD/JPY (US Dollar/Japanese Yen)
- USD/GBP (US Dollar/British Pound)
In these pairs, the first currency (USD in this case) is called the base currency and the second currency (in this case Euro, Canadian Dollar, etc.) is called the term currency or quote currency.
Let’s say you see a currency exchange rate saying USD/EUR is 0.88, what does this mean?
It means that you need 0.88 Euros to buy 1 US dollar.
Going back to the currency pair, the rate is read as how much of the second currency (quote currency) is needed to buy one unit of the first currency (base currency). In this case, to reiterate, you need 0.88 Euros to buy 1 US dollar.
What if you see a rate written EUR/USD?
You can apply the same process to read this currency pair: how many US dollars do you need to buy 1 Euro. In this case, the exchange rate is 1.13. That is, you need 1.13 US dollars to buy 1 Euro.
You can use the same method to determine the value of all the other pairs:
- USD/CAD (The number of Canadian dollars you need to buy 1 US Dollar)
- USD/AUD (The number of Australian dollars you need to buy 1 US Dollar)
- USD/JPY (The number of Japanese Yen you need to buy 1 US Dollar)
- USD/GBP (The number of British Pounds you need to buy 1 US Dollar)
Now that you know how to read a currency exchange rate let us now turn to how to calculate the exchange rate.
How to Calculate Exchange Rates
The best way to understand how to calculate an exchange rate is to use an example.
Let’s say you run a business in the United States that relies on international suppliers. One of your suppliers, who is in Australia, sent you a shipment worth $35,000 Australian Dollars. How many US dollars should you send them to cover the amount?
In this case, should you look for the USD/AUD rate or the AUD/USD rate? It may sound confusing, but there is an easy way to approach it. Since your supplier wants to be paid in Australian Dollars, you need to buy that currency with your US dollars.
That means you need to find out how many US dollars you need to buy one Australian dollar. Since the Australian Dollar unit is one, then it is the base currency (i.e., the first currency in the pair).
Thus, you will write the pair as AUD/USD, which asks how many USD you need to buy one AUD.
Now go to a currency exchange quote provider online like XE.com and look for the AUD/USD exchange rate.
Currently, it is 0.7.
That means you need 0.7 USD dollars to buy 1 Australian dollar.
Now, multiply the amount you owe by 0.7
$35,000 x 0.7 =$ 24,500
You need $24,500 US dollars to purchase and send $35,000 Australian dollars.
Reversing the Calculation
What if you are the supplier and are owed $35,000 USD by an Australian business?
They would simply reverse the currency pair to USD/AUD (how many Australian dollars are needed to buy 1 US dollar)
In this case, they would need to spend AU$1.43 for every dollar they buy.
$35,000 x 1.43 = $50,000
They would need to spend AU$50,000 to buy and send you US$35,000
A Word on Spreads
When calculating currency exchange rates, it is essential to factor in spreads. Spreads are the extra margin (or percentage points) brokers add to each transaction. Spreads are the reason the rate your local banks quote you will always differ from what you see on the Internet. When calculating and negotiating exchange rates, always keep in mind that these spreads can be quite high and can influence how much of another currency you get for your money.
How Do Currency Exchange Rates Work?
Currency Exchange rates refer to the worth of your currency when converted to a foreign currency. There is no constant exchange rate due to the active trading that goes on with currencies. It is why the rate increases and decreases. Think of it like stock market trading or the sale of valuables. You’ll realize that there isn’t a static rate for them and it is the same with exchange rates.
You might think only people who import and export goods and services should care about exchange rates but that’s not the case. When you travel from one country to another, you’ll need to exchange currencies to the one in use in whatever country you find yourself in. Yet, when you exchange currencies, you’ll notice that you’ll either get more or less of the currency in the country you’re in. Let’s explore why.
Factors That Affect Exchange Rate
Different factors affect the exchange rate. Here are some of them:
Rate of inflation
Market inflation can affect currency exchange rates. A country with a higher inflation rate than the other will witness a depreciation in its currency’s value and vice versa. What this means is that if you try to exchange your currency to another one, you’ll likely get less of the currency you’re changing to because your country’s currency has been suppressed.
The political affairs of a country can affect its currency’s value. A country battling political instability can be a risky investment for foreign investors. It likely means that the foreign capital in the country will decrease over time, and the domestic currency’s value will depreciate.
Many countries in the world are going through and have been going through political instability for some time now. This has led to the currency severely being depreciated because of the lack of foreign investment. Foreign investors may stay away because of widespread corruption and the assumption of too much risk when investing in a politically unstable country.
A recession can have a big impact on a country’s currency. Generally, during a recession, inflation tends to fall and this may lead to an increase in demand for that country’s currency. However, in other instances, when a country falls into a recession, it’s usually a signal to other investors that economic conditions are weak in that country and their currency may ultimately suffer because of this.
Thus, recessions can sometimes have a beneficial or negative effect on a country’s currency.
Reading an Exchange Rate
An exchange rate is usually presented in pairs. You’ll have one currency paired with another one. What this means is the first currency in the pair is the base and the value should be $1. The next figure is how much of that currency it will take to purchase $1 of the base currency.
Here is an example of how to convert currencies: If the EUR/AUD currency pair is 1.56 (just an example), it only means that 1 Euro equals to 1.56 Australian Dollar. Therefore, it shows much AUD (second currency) is needed to buy a single unit of EUR (first currency).
To calculate how much first currency (EUR) you’ll need to purchase the second currency (AUD), you will use this formula: 1/exchange rate.
With the example provided above, it will be 1/1.56=0.6410. It means that it costs 0.6410 Euros to purchase 1 Australian Dollar.
How Exchange Rates Concern You
If you are a traveller going to another country that uses a different currency, exchange rate values concern you. For example, if you an American and the US Dollar is strong at the time of your travel, you’ll enjoy the luxury of purchasing more foreign currency and enjoying a relatively cheaper trip. If it’s the other way round, your journey becomes more expensive and you’ll get less foreign currency.
If you’re a person who does business by importing and exporting goods, exchange rates concern you, as well. If your currency has a higher value than the country you’re buying goods from, you’ll purchase more goods but if it’s lower, you should expect to pay more money for those goods.
Exchange Rate Changes
The foreign exchange market is always active. There is no period of inactivity because it is not time-bound. It operates 24 hours a day, including weekends. Therefore, exchange rates fluctuate based on events and trends.
How to Determine Currency Exchange Rates
Currency rates are deeply rooted in the laws of barter. It works based on supply and demand. A currency that is doing well will be more demanded than other currencies that aren’t particularly strong at the moment. The more demand a currency has, the higher it’s value will be and this will impact its price as well.
Since there is a limited supply of such currencies and a high demand for them, they are valued at high prices. Here’s an example: if the Canadian economy is soaring high, Australian investors might be interested in Canadian dollars. Since Canadian dollars has become the in-demand currency, the Australian investors would have to part with more Australian dollars to purchase Canadian dollars.
Currency exchange rates play a crucial role in the way everyday people live their lives. A favourable exchange rate will often get them more of the currency they are exchanging to. However, a less in-demand currency means they will have to use more of their home country’s currency to exchange for another foreign currency.