exchange rate risk

the risk of suffering loss on converting another currency to the currency of a company’s own country.
Exchange rate risks can be arranged into three primary categories. (1.) Economic exposure: operating costs will rise due to changes in rates and make a product uncompetitive in the world market. Little can be done to reduce this routine business risk that every enterprise must endure. (2.) Translation exposure: the impact of currency exchange rates will reduce a company’s earnings and weaken its balance sheet. To reduce translation exposure, experienced corporate fund managers use a range of techniques known as currency hedging. (3.) Transaction exposure: there will be an unfavorable move in a specific currency between the time when a contract is agreed and the time it is completed, or between the time when a lending or borrowing is initiated and the time the funds are repaid. Transaction exposure can be eased by factoring: transferring title to foreign accounts receivable to a third-party factoring house.
     Although there is no definitive way of forecasting exchange rates, largely because the world’s economies and financial markets are evolving so rapidly, the relationships between exchange rates, interest rates, and inflation rates can serve as leading indicators of changes in risk. These relationships are as follows. Purchasing Power Parity theory (PPP): while it can be expressed differently, the most common expression links the changes in exchange rates to those in relative price indices in two countries:
Rate of change of exchange rate = Difference in inflation rates
     International Fisher Effect (IFE): this holds that an interest-rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions. Practically speaking, the IFE implies that while an investor in a low-interest country can convert funds into the currency of a high-interest country and earn a higher rate, the gain (the interest rate differential) will be offset by the expected loss due to foreign exchange rate changes. The relationship is stated as:
Expected rate of change of the exchange rate = Interest-rate differential
     Unbiased Forward Rate Theory: this holds that the forward exchange rate is the best unbiased estimate of the expected future spot exchange rate.
Expected exchange rate = Forward exchange rate

The ultimate business dictionary. 2015.

Look at other dictionaries:

  • exchange-rate risk — exchange rate exposure …   Accounting dictionary

  • Exchange rate risk — Also called currency risk, the risk of an investment s value changing because of currency exchange rates. The New York Times Financial Glossary …   Financial and business terms

  • exchange rate risk — Also called currency risk; the risk that an investment s value will change because of currency exchange rates. Bloomberg Financial Dictionary …   Financial and business terms

  • foreign-exchange rate risk — exchange rate exposure …   Accounting dictionary

  • exchange-rate exposure — exchange rate risk; = foreign exchange rate risk The risk associated with uncertain exchange rates. The three types of risk are transaction exposure, translation exposure, and economic exposure …   Accounting dictionary

  • exchange-rate exposure — currency risk; exchange rate risk; foreign exchange rate risk The risk associated with uncertain exchange rates …   Big dictionary of business and management

  • exchange rate exposure — UK US noun [U] ► FINANCE a company s risk of losing money because it may have to buy a currency at a higher price using a currency that has fallen in value: »By paying VAT in euros, we have been able to limit our exchange rate exposure …   Financial and business terms

  • interest rate risk — ( IRR) The potential that changes in market rates of interest will reduce earnings and/or capital. The risk that changes in prevailing interest rates will adversely affect assets, liabilities, capital, income, and/or expense at different times or …   Financial and business terms

  • Fixed exchange-rate system — Foreign exchange Exchange rates Currency band Exchange rate Exchange rate regime Exchange rate flexibil …   Wikipedia

  • Principal Exchange Rate Linked Security - PERL — A type of debt security that pays interest semiannually and has a yield that is linked to foreign exchange rates. PERLs are denominated in U.S. dollars, but their repayment is determined by the exchange rate between the dollar and a specific… …   Investment dictionary

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”

We are using cookies for the best presentation of our site. Continuing to use this site, you agree with this.