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Foreign Exchange Risk

Foreign exchange risk, also known as currency risk, arises from fluctuations in the exchange rates between currencies. This risk affects businesses, investors, and individuals involved in international transactions, as changes in currency values can impact profits, costs, and investment returns. Key types of foreign exchange risk include transaction risk, translation risk, and economic risk, each affecting financial performance differently. Effective management of foreign exchange risk is essential for mitigating potential losses.

Example

A U.S. company imports goods from Europe, paying in euros. If the euro strengthens against the dollar, the company’s costs increase, affecting profitability and pricing strategies.

Key points

• Arises from changes in currency exchange rates.

• Affects businesses with international exposure, investors, and individuals.

• Managed through hedging, diversification, and currency risk analysis.

Quick Answers to Curious Questions

Transaction risk (from foreign currency transactions), translation risk (from consolidating foreign operations), and economic risk (from long-term market exposure).

By using hedging instruments like forwards, options, and swaps, and by diversifying currency exposure across different markets.

It can affect reported earnings, cash flows, and asset valuations, influencing overall financial performance and investor perception.