The transaction, economic, and translation risks are the three kinds of foreign exchange risk. Therefore, exporters, importers, and businesses that conduct business on international markets need to consider the risk of foreign exchange.
Foreign exchange risk, commonly referred to as exchange rate risk, is the chance that changes in one currency's value will influence one's financial situation. Simply put, foreign exchange risk is the possibility that a company's financial position or performance will be affected by changes in the rates of exchange between currencies.
When a company makes financial transactions or keeps financial statements in a currency other than the one in which it has its headquarters, it runs risk. For instance, a Canadian company doing business in China that reports its financial statements in Canadian dollars and receives financial transactions in the Chinese yuan is exposed to foreign exchange risk.
The financial transactions must be converted from Chinese yuan to Canadian dollars to be included in the company's financial statements. The term "foreign exchange risk" refers to fluctuations in the exchange rate between the domestic Canadian dollar and the Chinese yuan, a foreign currency.
The base currency's appreciation or depreciation, the foreign currency's appreciation or depreciation, or a combination of the two can all contribute to foreign exchange risk. As a result, businesses that trade on international markets and exporters/importers face a significant risk.
2.1 Risk of a transaction
A company's risk when conducting financial transactions between jurisdictions is known as transaction risk. The risk is the variation in the currency rate prior to transaction settlement. Essentially, the source of transaction risk is the delay between the transaction and settlement. Options and forward contracts can be used to lower transaction risk.
For instance, a Canadian company with operations in China wants to transfer CNY600 earnings to its Canadian account. If the currency rate was 1 CAD for 6 CNY at the time of the transaction and then dropped to 1 CAD for 7 CNY before settlement, the outcome would be an expected receipt of CAD100 (CNY600/6), as opposed to CAD86 (CNY600/7).
2.2 Economic hazard
Economic risk, also referred to as forecast risk, is the possibility that a company's market value will be impacted by unavoidable exposure to fluctuations in the exchange rate. Macroeconomic factors like geopolitical instability and/or government regulations typically generate this risk.
If the Canadian currency unexpectedly strengthens, a Canadian furniture company that sells locally will face economic risk from furniture importers.
2.3 Risk of translation
Translation risk, also known as translation exposure, is the risk that a company that has its headquarters in the United States but does business in another country faces when its financial performance is expressed in its domestic currency. Translation risk is higher when a firm holds more of its assets, liabilities, or equity in a foreign currency.
For instance, a parent company that oversees a subsidiary based in China but reports in Canadian dollars runs the risk of having the subsidiary's financial performance, which is reported in Chinese yuan, translated into Canadian dollars.
The Indian government has given the Reserve Bank of India authority to manage the country's foreign exchange reserves and investment. The rules for handling foreign exchange reserves are set down in the Reserve Bank of India Act of 1934.
Diversification does not eliminate market risk. However, diversification can reduce specific risk, also known as unsystematic risk, which is related to the performance of a specific security. For example, changes in interest rates, exchange rates, geopolitical events, and recessions are all examples of market risk.