Currency risk

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Currency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another. Investors or businesses face an exchange rate risk when they have assets or operations across national borders or if they have loans or borrowings in a foreign currency.

An exchange rate risk can result in an exchange gain as well as a loss. To neutralize the risk of a loss (but at the same time forgoing any potential exchange gain), some businesses hedge all their foreign exchange exposure or exposure beyond some predetermined comfort level, which is a way of transferring the risk to another business prepared to carry the risk or has a reverse risk exposure. Hedging can involve the use of a forward contract.

Types of currency risk

There are two basic types of currency risk:

• Transaction risk is the risk that an exchange rate will change unfavourably over time.
• Translation risk is an accounting concept. It is proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.

A currency risk exists regardless of whether investors invest domestically or abroad. If they invest in the home country, and the home currency devalues, investors have lost money. All stock market investments are subject to a currency risk, regardless of the nationality of the investor or the investment, and whether they are in the same or different currency. Some people argue that the only way to avoid currency risk is to invest in commodities (such as gold) which hold value independently of the monetary system.^{[citation needed]}

Consequences of risk

The currency risk associated with a foreign denominated instrument is a significant consideration in foreign investment. For example, if a U.S. investor owns stocks in Canada, the return that will be realized is affected by both the change in the price of the stocks and the change of the Canadian dollar against the US dollar. Suppose that the investor realized a return on the stocks of 15% but if the Canadian dollar depreciated 15% against the US dollar, then the movement in the exchange rate would cancel out the realized profit on sale of the stocks.

If a business buys or sells in another currency, then revenue and costs can move upwards or downwards as exchange rates between the transaction currency changes in relation to the home currency. Similarly, if a business borrows funds in another currency, the repayments on the debt could change in terms of the home currency; and if the business has invested overseas, the returns on investment may alter with exchange rate movements.

Currency risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically financed by very large debts nominated in currencies different from the currency of the home country of the owner of the debt. Megaprojects have been shown to be prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen foreign currency and interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to do so. Financial restructuring is typically the consequence and is common for megaprojects.^[1]

See also

• Foreign exchange hedge
• Foreign exchange derivative

References

1. ^ [Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, 2003, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press).]