Also known as ‘currency risk’, exchange rate risk is the possibility of a business’s operation or an investment value being affected by the change in exchange rate. As this is the era of globalization, there is an increasing amount of mobility of currencies between countries. Due to the heightened volatility of currency, the fluctuations in the exchange rates has a great impact on planning of companies’ operations as well as influence on profitability in different ventures.
The exchange rate does not only affect the big companies that are involved in multinational operations. They also have effect on the small and medium enterprises that do not operate outside their home countries. While full understanding of exchange rate risk is obviously crucial for multinational corporations and SMEs, it is also important for investors to be properly familiar with currency risk as; exchange rate risk impacts their investments as well.
How does it work?
Exchange rate is the value of one nation’s currency as compared to the value of a foreign currency. While calculating the exchange rate, the domestic currency and the foreign currency are quoted directly or indirectly in order to measure the exchange rate. Therefore any company or investors holding bonds that make interest and principal payment in a counter currency (foreign) may lose substantial amount of money for reasons that are irrelevant to the issuer’s ability to pay.
Why does the exchange rate risk matter?
One of the most important reasons for finding the exchange rate risk is because at the end, the currency risk affects the cash the investor’s is going to get in the end. This determines the investor’s money’s final rate of return. Exchange rate risk can also create new openings as the interest rates that between two countries which will reflect the possible fluctuations in the exchange rates between them.
What are the types of exchange rate risk?
Business can be exposed to three types of exchange risk rate, that is:
- Transaction exposure – caused by the effect of currency risk changes have on business’ commitment to make or receive payments that are denominated by counter currency.
- Translation exposure – caused by currency fluctuations’ effect on the organization’s consolidated financial statements.
- Economic exposure – caused by the unexpected change of exchange rate risks which may affect the company’s market value and future cash flows.
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