Currency risk
Encyclopedia
Currency risk or exchange rate risk is a form of financial risk
that arises from the potential change in the exchange rate
of one currency
in relation to another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency.
An exchange rate risk can result in an exchange gain as well as a loss. To neutralize the risk of a loss (but at the same time forgoing any potential exchange gain), some businesses hedge
all their foreign exchange exposure or exposure beyond some predetermined comfort level, which is a way of transferring the risk to another business prepared to carry the risk or has a reverse risk exposure. Hedging can involve the use of a forward contract
.
A currency risk exists regardless of whether investors invest domestically or abroad. If they invest in the home country, and the home currency devalues, investors have lost money. All stock market investments are subject to a currency risk, regardless of the nationality of the investor or the investment, and whether they are in the same or different currency. Some people argue that the only way to avoid currency risk is to invest in commodities (such as gold) which hold value independently of the monetary system.
If a business buys or sells in another currency, then revenue and costs can move upwards or downwards as exchange rates between the transaction currency changes in relation to the home currency. Similarly, if a business borrows funds in another currency, the repayments on the debt could change in terms of the home currency; and if the business has invested overseas, the returns on investment may alter with exchange rate movements.
Currency risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically financed by very large debts nominated in currencies different from the currency of the home country of the owner of the debt. Megaprojects have been shown to be prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen foreign currency and interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to do so. Financial restructuring is typically the consequence and is common for megaprojects.
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
that arises from the potential change in the exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
of one currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
in relation to another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency.
An exchange rate risk can result in an exchange gain as well as a loss. To neutralize the risk of a loss (but at the same time forgoing any potential exchange gain), some businesses hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
all their foreign exchange exposure or exposure beyond some predetermined comfort level, which is a way of transferring the risk to another business prepared to carry the risk or has a reverse risk exposure. Hedging can involve the use of a forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
.
Types of currency risk
There are two basic types of currency risk:- Transaction risk is the risk that an exchange rate will change unfavourably over time.
- Translation risk is an accounting concept. It is proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.
A currency risk exists regardless of whether investors invest domestically or abroad. If they invest in the home country, and the home currency devalues, investors have lost money. All stock market investments are subject to a currency risk, regardless of the nationality of the investor or the investment, and whether they are in the same or different currency. Some people argue that the only way to avoid currency risk is to invest in commodities (such as gold) which hold value independently of the monetary system.
Consequences of risk
The currency risk associated with a foreign denominated instrument is a significant consideration in foreign investment. For example, if a U.S. investor owns stocks in Canada, the return that will be realized is affected by both the change in the price of the stocks and the change of the Canadian dollar against the US dollar. Suppose that the investor realized a return on the stocks of 15% but if the Canadian dollar depreciated 15% against the US dollar, then the movement in the exchange rate would cancel out the realized profit on sale of the stocks.If a business buys or sells in another currency, then revenue and costs can move upwards or downwards as exchange rates between the transaction currency changes in relation to the home currency. Similarly, if a business borrows funds in another currency, the repayments on the debt could change in terms of the home currency; and if the business has invested overseas, the returns on investment may alter with exchange rate movements.
Currency risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically financed by very large debts nominated in currencies different from the currency of the home country of the owner of the debt. Megaprojects have been shown to be prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen foreign currency and interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to do so. Financial restructuring is typically the consequence and is common for megaprojects.