Foreign exchange risk exposure primarily refers to the financial insecurity or risk that is associated with a transaction that is denominated in a currency which is different from the base currency of the company. Foreign exchange risk is also commonly known as exchange rate risk, FX risk or currency risk which arises from a case where a subsidiary firm of a multi-national company prepares and keeps its books of accounts in a currency which is not the currency in which the consolidated books of accounts of the multi-national are made. Hence, when such a financial document or statement is converted to the base currency or the domestic currency of the multi-national firm for the purpose of preparing consolidated accounts it gives rise to risk related to foreign exchange.
The basic fundamental that forms the foundation of this exposure is the fact that currencies are extremely liquid and the rates of exchange are dynamic and volatile. The rates of exchange keep fluctuating every minute which creates an impact on the transactions that are associated with exchange rates and currencies and this causes risk and financial exposure. Businessmen, Banks, financial institutions, investors, traders and other parties that participate in the foreign exchange market can’t avoid or stay away from the risk involved in this dynamic market. However, there are certain techniques and strategies that can be used to analyze, measure and tackle the risk involved in foreign exchange market. There are various types of foreign exchange market risks and exposures that are faced by participants in everyday trading in the market.
Types of foreign exchange risk & exposures
The various types of risks and exposures in Foreign Exchange Markets that are encountered by the firms and other participants are:
Transaction risk is a simple and hence the most frequent form of exposure that can be faced and experienced in the foreign exchange market. Transaction risk is basically the risk associated with the transacting process of business in terms of currency other than domestic currency i.e. foreign currency.
Another type of exposure in the foreign exchange market is economic exposure. It is also commonly referred to as forecast risk. It is basically the degree of a firm’s market value that is affected by unforeseen exchange rate dynamics. These factors can have a huge impact on the market position of the firm, the future cash flows and the value of the firm. Risks like economic risk are not specifically associated with foreign exchange market alone, a firm can be exposed to economic risks due to plenty of other reasons and factors.
Translation risk is basically the risk that is linked to the translation of a subsidiary’s financial statement in a currency alien to the domestic currency of the multi-national company. Domestic currency here refers to the currency in which the consolidated accounts of the MNC are prepared. The translation of financial records may be affected by the exchange rates and their fluctuations of the currencies involved. Such risk can however be nullified and doesn’t require much of management’s attention.
Contingency is associated with doubt. A contingent situation is a situation which may or may not arise. Contingent risk thus depends upon an event which might or might not take place.
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