what is foreign exchange risk

Foreign exchange risk, also known as currency risk or exchange-rate risk, is the risk of financial loss that arises when a financial transaction is denominated in a currency other than the domestic currency of the company. This risk occurs when there is a risk of an unfavorable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed. Foreign exchange risk can affect investors who trade in international markets and businesses engaged in the import/export of products or services to multiple countries. There are three types of foreign exchange risk: transaction risk, translation risk, and economic risk. Transaction risk arises when a company engages in financial transactions denominated in a currency other than the currency where that company is based. Translation risk deals with the risk to a companys equities, assets, liabilities, or income, any of which can change in value due to fluctuating foreign exchange rates when a portion is denominated in a foreign currency. Economic risk arises from the impact of unexpected exchange rate fluctuations on a companys future cash flows and market value. To manage foreign exchange risk, companies can take steps such as hedging, which involves using financial instruments to offset the risk of currency fluctuations.