· What is meant by foreign exchange risk? What specific problems does foreign exchange present in an organization? How could an organization that needs Euros in six months protect itself from currency fluctuations?
When a business/investment has cash flow in foreign currency, the risk of value changing due to fluctuation in currency exchange risk is called foreign exchange risk. Foreign exchange risk affects businesses involved in export/import or having operation in foreign country. It also affects investors making investment in foreign country.
Foreign exchange risk has following components:
a) Exchange rate risk
b) Convertibility risk
c) Transfer risk
Fluctuation in foreign exchange rate may be favorable or unfavorable for the company. Since company publishes financial statements in domestic currency, due to change in foreign exchange rate, its projection gets affected. Sometimes company may be making profit in foreign currency, but due to lower exchange rate, it may be a loss in domestic currency.
Sometimes, the company may be prevented from exchanging domestic currency for foreign currency due to some government policy.(it is called Convertibility risk). Sometimes company may be prevented from transferring foreign exchange out of the country. (it is called Transfer risk)