What is an Exchange Rate Risk?

Exchange rate risk is the degree of risk that investors take on when investing in businesses that operate in one or more countries around the world. The risk is connected with shifts in foreign exchange rates that may impact the profitability of the business. While some companies attempt to minimize this risk to investors by requiring payment for goods or services rendered in a specific currency regardless of what countries are involved in the transaction, this is not always the case.

While a business such as an export company can somewhat minimize the potential for exchange rate risk, other businesses may find that in order to operate in various countries, there is a need to work with several different currencies. When this is the case, the process of identifying the amount of exchange rate risk involved means understanding what is likely to happen if the currencies involved do undergo some sort of shift in the rate of exchange between the two. While the shift can mean a loss to the investor, it can also mean an increase in return, depending on how that shift is configured.

For example, if an investor based in the United Kingdom chooses to buy shares issued by a company based in the United States, any shifts in the exchange rate between the US dollar and the British pound will result in some type of impact on the value of that investment. That impact may be positive if the dollar should fall against the pound, but would be negative if the pound should fall against the dollar. Here, the investor does incur some degree of exchange rate risk, while also realizing some potential for a higher return, depending on what occurs to change the exchange rate between these two currencies.

Since shifts in the foreign exchange market are somewhat frequent, investors who are considering securities associated with a foreign company would do well to determine how movements in the FOREX market can cause fluctuations in the value of those investments. Understanding the degree of exchange rate risk that is inherent in owning a particular security will make it much easier for investors to determine if the degree of risk is offset by the potential return. This process often requires understanding what type of events could cause changes in currency values, and projecting the likelihood of those events taking place over both the short-term and the long-term. For example, if the political structure or the economy of one of the countries involved is somewhat unstable, this could mean that shifts in the exchange rates are highly likely to occur. At that point, the investor would need to determine if those shifts would increase or decrease the return on the investment before actually acquiring the securities.