Foreign exchange risk, also known as currency risk, is the risk of loss due to changes in foreign currency conversion rates. Companies may be adversely affected by these changes if they hold financial assets denominated in other currencies or if they perform significant amounts of international business.

How Do Exchange Rates Affect Assets & Liabilities?

Two common accounts in particular which may be adversely affected by foreign exchange rates are accounts receivables and accounts payables. When a specific amount in a currency is agreed upon to be paid at a later date, currency changes between the date of the agreement and the payment will lead to a loss for one of the parties involved. This is a very common risk as many companies carry both accounts payables and receivables on their balance sheets. However, other assets and liabilities, such as foreign debt and equity securities, may be affected if they are tied to foreign currencies. This concept is known as transaction risk.

Does Foreign Exchange Risk Affect Financial Statements?

Another way companies may be affected by exchange rates is through a concept known as translation risk. Translation risk affects companies that have foreign subsidiaries doing business with different currencies. The problem arises when the parent company must report its financials for a given period. In order to report its consolidated financials, the parent company must translate its subsidiary’s financials, which are in a foreign currency, back to its reported currency. Due to volatility in exchange rates, revenues and assets may be greater or less than their original worth when they are translated back to the parent’s currency.

Foreign Exchange Economic Risk

Companies that do business in foreign countries face economic risk as a result of exchange rates. When a company’s currency is strong in relation to the currency of its foreign consumers, its products become less affordable. The decline in affordability leads to less demand and of course contracts revenues.

How To Be Protected Against Foreign Exchange Risk

Corporations attempt to protect themselves from these risks using a multitude of hedging strategies. Financial derivatives such as options and futures play a key role in this protection. In simple terms, these securities allow companies to “lock in” the price at which they conduct transactions. The results of hedging securities are reported on a company’s financial statements. However, these strategies present their own risk as they can lead to losses. Hedging against economic risk is more difficult and is ignored as companies view this risk as inherent and in some cases, unpreventable.