Currency risk is that type of risk that comes up from the variations of one currency price against another currency price. Every time the companies or investors purchase assets or carry out business activities on a global basis, they are exposed to currency risk if hedging of their positions is not done.
The currency risks can be categorized into the following types:
Translation risk: This is a form of accounting risk and this is related to the asset amount retained in foreign exchange. The exchange rate variations over the passage of time would provide an erroneous report and as a result, the assets are commonly equilibrated with the help of funds taken in that foreign exchange.
Transaction risk: In this type of risk, the foreign exchange rates vary in an unfavorable manner over the passage of time.
However, the hedging of this type of risk can be done by implementing forward currency contracts.The currency risk that is related to a financial instrument in foreign denomination is a fundamental factor in the field of foreign investment.
This risk is emanated from variable fiscal policies and increase in terms of real productivity that leads to variable inflation rates.
If a US investor has some stocks in Canada, the yield received by him is impacted by both the variation in the stock prices, as well as the deviations of the Canadian dollar in relation to the United States dollar. In case that person has received a 15% return on the stocks, however, there has been 15% depreciation in Canadian dollar related to the US dollar, the person will receive no profit at all.
When a business entity is carrying out transactions in various foreign currencies, automatically there is an exposure to currency risk. The risk develops simply due to the reason that the currencies can vary in association to the other currencies.
If a financial institution is purchasing and selling in separate currencies, the expenditures and revenue may go up or go down because the conversion rates between the currencies also vary. If a company has taken a loan in a separate currency, the loan payments can also vary or if the company has made an investment abroad, the yield from the investment can change due to exchange rate fluctuations and this is generally termed as foreign exchange exposure
Last Updated on : 1st July 2013