What is currency risk in finance?
Currency risk can affect investors, companies and analysts whenever money moves across borders or assets are valued in more than one currency.
Key takeaways
Currency risk is:
- The risk that changes in exchange rates can reduce the value of international investments, business revenue or costs.
- Usually grouped into three types: transaction risk, translation risk and economic risk.
- One part of wider market risk, and may be managed with tools such as forward contracts, options or currency-hedged funds.
What is currency risk?
When a company sells products or services across different countries, it often deals with more than one currency. Because exchange rates move over time, the final value of a sale, cost or investment can change once it’s converted back into the company’s home currency.
Currency risk, also called exchange rate risk, is the risk of losing value because one currency changes in price against another. If you invest or do business outside your home country, you may need to convert money from one currency into another, which can expose you to currency risk.
Currency risk definition
The formal definition of currency risk is the potential financial loss an individual, company or investor may face due to adverse movements in currency exchange rates. This risk arises when a transaction, investment or asset value is denominated in a currency other than the person’s or company’s base currency. It can affect reported earnings, portfolio returns and business costs.
Meaning of currency risk explained
To understand what currency risk is, imagine a smartphone app developer based in New York who signs a contract to build a custom mobile platform for a corporate client in London.
The client agrees to pay a fixed price of £10,000 upon delivery in six months. At the time the contract is signed, the exchange rate is £1 to $2. The developer expects to collect $20,000.
Over the next six months, the pound sterling weakens against the US dollar. On delivery day, £1 is worth $1.50.
The developer delivers the project as agreed and receives the exact £10,000 promised. However, converting that cash back into US dollars yields $15,000 rather than the expected $20,000. The $5,000 difference reflects the effect of the exchange rate move.
How does currency risk work?
Currency risk is often discussed in three broad categories:
- Transaction risk
- Translation risk
- Economic risk
Each works in different ways:
Transaction risk
Transaction risk can occur when a company agrees to buy or sell a product or service in a foreign currency at a future date. As shown in the smartphone developer example, the time between agreeing the contract and receiving payment leaves the business exposed to exchange rate movements. This risk can affect importers, exporters, freelancers, suppliers and companies with overseas customers or vendors.
Translation risk
Translation risk can affect multinational companies that own foreign subsidiaries. Imagine a US retail company that owns 50 stores across Europe. At the end of the financial year, the European stores report their values in euros. The parent company then translates those euro balances back into US dollars on its balance sheet. If the euro weakens against the US dollar, the European business may appear less valuable in the parent company’s reporting currency, even if its local operations have not changed.
Economic risk (operating risk)
Economic risk is a longer-term form of currency risk. It can happen when exchange rate movements affect a company’s competitive position over time. For example, if the Japanese yen weakens significantly over several years, Japanese car manufacturers may be able to sell vehicles overseas at lower prices in foreign-currency terms. This could create pressure for competing auto manufacturers based in other countries. The impact isn’t limited to one invoice or reporting period, but may influence pricing, margins and market share over time.
Why is currency risk important?
Currency risk is important because it can affect investors, businesses and financial analysis in different ways.
For investors, it can influence international returns. A portfolio manager might select European stocks that rise in local-currency terms, but a stronger US dollar could reduce those gains once they’re converted back into US dollars.
For businesses, it can affect costs, revenue and planning. Companies that buy materials overseas, sell into foreign markets or operate internationally may need to consider how exchange rate movements could affect margins.
For analysts, currency risk can make it harder to compare performance across periods. Analysts may look at results with and without currency effects to understand whether growth came from the underlying business or from exchange rate movements.
In practice, currency risk can affect:
- The value of overseas investments.
- The cost of imported goods or materials.
- The value of foreign revenue.
- Company earnings reported in another currency.
- The converted profit or loss on a trade.
Currency risk and CFD trading
Currency risk can also affect CFD trading when you trade markets priced in a currency different from your account currency.
For example, if your account is in British pounds and you trade a US share CFD priced in US dollars, changes in GBP/USD may affect the final value of your profit or loss after conversion.
This means the outcome of a CFD trade may be influenced by two factors:
- The price movement of the underlying market.
- The exchange rate between the market currency and your account currency.
A favourable move in the underlying market may be reduced by an unfavourable currency move. A favourable currency move may increase the converted result. The effect depends on the direction and size of both movements.
Traders should understand how currency conversion works, check any applicable conversion fees and consider whether exchange rate exposure fits their wider risk-management approach.
Currency risk example
Imagine a Canadian manufacturing firm that imports high-tech machinery components from a supplier in Germany. The German supplier sends an invoice for €50,000, with payment due in 90 days.
On the day the invoice arrives, the exchange rate is $1.50 CAD per euro. The Canadian firm’s budget planners expect to pay $75,000 CAD (€50,000 × $1.50 CAD).
Over the next 90 days, the euro strengthens against the Canadian dollar. The exchange rate moves to $1.60 CAD per euro.
When payment is due, the Canadian firm must buy €50,000 at the new rate. The final cost rises to $80,000 CAD (€50,000 × $1.60 CAD). The $5,000 CAD difference represents currency risk, as the exchange rate move increased the cost of the imported components.
Past performance is not a reliable indicator of future results.
FAQ
How does currency risk affect investors?
How to manage currency risk?
Investors and businesses can manage currency risk through hedging, although hedging does not remove all risk. Businesses may use forward contracts to lock in an exchange rate for a future payment, or options to help protect against adverse exchange rate moves while keeping some flexibility. Individual investors may use currency-hedged mutual funds or ETFs, where the fund manager handles the currency hedging. These tools may reduce currency exposure, but they can involve costs and may not be suitable for every investor or business.