Foreign exchange risk

Foreign exchange risk — also called currency risk — is the risk that movements in exchange rates will hurt a company or investor with exposure to a foreign currency. If a UK company agrees to pay a US supplier $1 million in three months, and the pound weakens against the dollar before payment is due, the invoice costs more in pounds than expected. The economic terms of the deal never changed; the exchange rate did.

Businesses face this risk in three main forms. Transaction risk arises on individual receivables and payables denominated in a foreign currency, where the rate can move between agreeing a price and settling it. Translation risk arises when a parent company consolidates the accounts of foreign subsidiaries — assets, liabilities, and profits must be restated in the parent's currency, so reported results swing with exchange rates. Economic risk is the longer-term effect of exchange rate trends on a firm's competitiveness and the present value of its future cash flows.

Companies manage foreign exchange risk with a mix of natural hedges (matching foreign currency revenues against foreign currency costs, or borrowing in the same currency as their assets) and financial hedges such as forward contracts, futures, options, and money market hedges that lock in a rate today for a future exchange.

Foreign exchange risk is tested on the CGMA Fundamentals of Business Economics (CIMA Certificate BA) syllabus, which expects candidates to distinguish transaction, translation, and economic risk and to recognize the basic hedging techniques used to manage each.