What is exchange rate risk?

Exchange rate risk is the possibility that the value of an investment will change when the currency is exchanged.

This occurs when there is movement in the exchange rate between placing an order and the transaction being completed. Exchange rate risk is associated with all foreign investments. This is the uncertainty that is inherent in dealing with two or more currencies.

Where have you heard about exchange rate risk?

Exchange rate risk is one of the first things you’ll hear about if you’re making foreign investments. It also affects businesses that import or export goods and services.

For example: if a U.S. investor holds stocks in Canada, the realized return is affected by both the change in stock prices and the change in value of the Canadian dollar against the U.S. dollar. If a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar, the investor breaks even, minus associated trading costs.

What you need to know about exchange rate risk.

There are four types of exposure to exchange rate risk:

Transaction exposure – this is when a contract between two companies with different currencies is affected by fluctuating exchange rates before the transaction is completed.

Economic exposure – this is when a company’s market value is affected by fluctuating exchange rates, influencing its future cash flows and market position against competitors.

Translation exposure – this is when fluctuating exchange rates can affect figures on financial statements when translated from one currency to another.

Contingent exposure - this is when the extent of fluctuating exchange rates on a company’s bid for a contract with a foreign business is unknown until the bid is completed.

Businesses that trade internationally can try to reduce the exchange rate risk by using hedging strategies, such as investing through futures contracts and options.