Foreign Exchange Risk

It takes three main forms. Transaction risk arises when a firm will pay or receive a foreign currency amount later, and the rate moves in between. Translation risk arises when foreign subsidiaries' accounts are converted into the parent's reporting currency. Economic risk is the longer-term effect of rate shifts on competitiveness, such as exports becoming too costly to sell. Banks face it from customer trades, foreign currency lending and their own positions. Firms manage it by matching currency inflows with outflows, invoicing in their own currency, and using forwards, options or swaps to lock in rates. Limits on open positions are common for banks. A thin-margin importer can lose its entire profit on an order from one unhedged currency move.

An importer agrees to pay a foreign supplier 500,000 in the supplier's currency in three months, while its own sales are in its home currency. If the home currency weakens 4% before payment, the bill costs about 4% more in home-currency terms. The importer instead buys the foreign currency forward today at a fixed rate. The cost is now known, though it gives up any gain if the home currency strengthens.