What Is Foreign Exchange Risk?

What is foreign exchange risk? Foreign exchange risks refer to the risks of investments’ values changing when the currency exchange rates change. They can also be explained as the risks investors will have to take that they may have to close out a long or short position in a foreign currency if there are any adverse conditions affecting the exchange rates. Although it is most likely to affect import/export businesses, it also has an effect on international investments. Investors also refer to this type of risk as currency risk and exchange rate risk.

An investor makes this kind of risk when he or she must convert money into a foreign currency in order to make a certain kind of investment. Changes in the currency exchange rate can cause the investment’s value to either go up or down when the investment is either converted back to the original currency or sold. Since this investing carries such a high level of risk, it is not for all investors.

There are ways to help curb this risk. Foreign exchange risk management helps businesses and investors anticipate and manage possible risks to help preserve the value of currency inflows, investments and loans as well as compete abroad. Managing foreign exchange risk can take place in a number of ways. Diversification is one way to neutralize the risk of currency that may devalue by also carrying a competing currency that gains value. One can diversify in a number of ways.

Hedging foreign exchange risk is one way to diversity a portfolio. Hedging strategies call for anticipating and locking in exchange rates in order to smooth currency fluctuations. Futures contracts and currency swaps are two of the hedging strategies financial managers tend to use. Although these strategies can be useful, they also run the risk that an investor may lose out on other favorable currency movements creating what is called an opportunity cost risk.

Investors can also manage foreign exchange risk by changing profits into different foreign currency reserves and conducting business in many different countries. Investors can also try to settle all their transactions in hard currency if possible. One must also be aware of other factors that can have an adverse effect on currency. For instance, political upheavals can hinder the flow of business on the global level. Political unrest can cause extra taxes on international commerce, seizure of foreign assets and trade wars.