Foreign exchange risk or foreign exchange exposure refers to the financial risk associated with a transaction denominated in a currency alien to the base currency of the firm. It is also known as currency risk or the exchange rate risk which commonly arises in a case where a subsidiary of a multinational company maintains its books of accounts in a currency which is different from the currency in which the consolidated financial statements of the company are prepared. Thus, when such a financial record or statement is converted to the currency in which consolidated statements are prepared it involves foreign exchange risks. The basic essence that forms the basis of this risk is the fact that exchange rate is extremely volatile and dynamic. The exchange rates keep changing minute to minute which affects transactions associated with the exchange rate and leads to risk. Investors, businessmen and other participants in the foreign exchange market can’t stay away from this risk but there are certain techniques to measure and deal with Foreign Exchange Risk. There are various forms of foreign risk exposures (risks) that are prevalent in the market and are faced every now and then.
TYPES OF FOREIGN EXCHANGE RISKS OR EXPOSURES
The various types of foreign exchange risks or exposures that are faced by firms and businesses in the foreign exchange market are:
It is the simplest and the most frequent form of risk that can be faced in the field of foreign exchange. The basic meaning of a transaction risk is the risk associated with the process of transacting business in terms of foreign currency. Since foreign exchange is all about different currencies and the relative exchange rates between them which are highly volatile and keep changing every minute, it is common to face transaction risk. When a transaction in foreign exchange market takes place with the settlement to take place on apre-determined future date at a rate fixed now. This might lead to one of the parties facing gain and the other facing loss due to a fluctuation price making the price different from that fixed on the settlement date. Such a transaction brings along a transaction risk of facing loss. Thus, a transaction risk is the risk associated with the unanticipated change in the rates between the time when an enterprise enters into a transaction and settles it. This kind of an exposure pertains to an actual dealing taking place in business involving foreign currency.
Economic exposure, also known as the forecast risk refers to the degree of a firm’s market value that is affected by unforeseen exchange rate dynamics. Such factors can have tremendous effect on a firm’s market share position, its future cash flows and above all its value. This is a kind of risk that is not specifically associated with foreign exchange only, an organization can be exposed economically due to a range of other factors. A shift in exchange rates influences the demand and supply of the good leading to economic risk for the organizations dealing I that good. The impact of economic risk is much greater than any other kind of risk since it directly hits the value of the firm. The identification and measurement of this type of a risk is a difficult task and can be quite subjective. Thus, an economic risk is measured and interpreted by experienced experts.
Translation exposure is a type of risk that is specifically faced by multinational business houses having the subsidiaries of their business spread round the world. In such business organizations, financial statements are prepared in each subsidiary along with a consolidated set of financial statements begin prepared by the parent company in a pre-determined currency. Translation risk refers to the risk associated with translation of a financial statement prepared by a subsidiary in a currency different from the currency of consolidated set of statements this may lead to a change in value of cash and other assets affecting their representation and leading to misleading results. This risk basically deals with the accounting representation of the organization. This kind of a risk can however be reversed and thus doesn’t require much attention of the management
A contingent situation refers to a situation which may or may not arise. Thus, a contingent risk or contingent exposure is a risk that depends upon happening or non-happening of a particular event. It arises from the potential of an organization to face a not so expected economic or transnational risk that depends upon any contract or negotiation