Question

• Define foreign exchange risks.
• Identify the major types of foreign exchange risks; illustrating with examples.

Answer 1

Foreign exchange risks:- Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. In simple words, foreign exchange risks are the risks which are created due to unfavourable change in exchange rates between the domestic currency and the denominated currency before the transaction date is completed. Foreign exchange risk are also known as currency risk, FX risk, and exchange-rate risk. It may also exist when foreign subsidiary of a company maintains financial statements in other than the domestic currency of Holding company.

Major types of foreign exchange risks are as follows:-

• Transaction risk:- Risk that a company faces when it buy a product from a company located in another country, and two currencies are involved. Then Price of the product will be denominated by the selling company's currency. For example, if Company X in Europe buys a product from Company Y located in U.S and agrees to pay in US dollars. Here the selling company is Y. If the exchange rate for Euros weakens, then Company X will have to spend more Euros to buy the dollars it needs to pay Company Y.

• Translation risk:- A Company's translation risk is the extent to which its financial reporting is affected by exchange-rate movements. It happens when consolidated financial statements are prepared by multinational companies. For example, A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency.

• Economic risk:- In economic risk Market value is influenced by unexpected exchange-rate fluctuations, which can severely affect the firm's market share. Economic risk is also known as forecast risk. For Example, An American company invests money in a manufacturing plant in Spain, the Spanish government might institute changes that negatively impact the American company's ability to operate the plant, such as changing laws is an example of economic risk. Another example might be, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted, leading to economic risk.

Answer 2

Foreign exchange risks refers to losses that an international financial transactions may incur due to currency frustrations. The major types of risks is translation risk,transaction risk and economic risk