Currency risk

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Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

• Transaction risk is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts;
• Translation risk is an accounting risk, 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.

The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.

For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would realize no gain.

When a firm conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a firm is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If a firm has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements — this is usually known as foreign currency exposure.