Exchange rate risk

Exchange rate risk is the situation when a business position may cause a loss or profit in connection with it, because the exchange rate of the product included in it changes.

Any transaction and position that includes a product or service that has a quoted exchange rate can have exchange rate risk. The exchange rate may change in such a way that it adversely affects one of the parties involved in the transaction. (Of course, the exchange rate can change in such a way that the person wins, but here we are talking about risk as a potential loss). Buyers of shares or bonds or other securities assume exchange rate risk, since the price of shares and bonds may fall or even rise. This is the stock market exchange rate risk. 

We run exchange rate risk even when we exchange money, since it is possible that we could have bought the given currency at a better price the next day, that is, we would have been better off if we had postponed the exchange by one day. Now we will talk about the latter, i.e. the financial risks resulting from changes in the currencies. 

The currency and foreign exchange rates of different currencies fluctuate against each other. This can cause many problems in transactions involving multiple currencies. For the sake of simplicity, let's assume that one currency is the dollar and the other is the euro.

If the company, which keeps its books in dollars, orders raw materials from abroad, the price of which must be paid in euros, then exchange rate risk arises. 

If we calculate how many euros this order will cost the company today, but it only has to be paid upon receipt, i.e. say after 30 days, the risk can be quite significant. In 30 days, the dollar can depreciate against the euro, and in that case, expressed in dollars, the company bought the necessary raw material at a significantly higher price than planned. 

Less spectacularly, our company assumes exchange rate risk even if you pay immediately. If the dollar appreciates in the meantime, i.e. less of it has to be given for one euro, then by postponing the order, the company could have gotten the desired raw material cheaper. Indirectly, therefore, the correct inventory policy can also contribute to the reduction of exchange rate risk. 

Exchange rate risk can also arise if the company has a euro account with the amount required for the purchase. We can think that since no money has to be exchanged, the transaction does not represent a risks in this case. This is true as long as the company regularly receives euro income, since in this case the money spent from the euro account can be replaced. However, if the company's revenue is typically generated in dollars and it needs euros again over time, then the exchange rate risk must be taken into account again.

It is important to know that exchange rate risk can be reduced with a relatively small investment, or even completely eliminated with appropriate money market operations. That is why it is advisable to involve a specialist with adequate risk management knowledge in any transaction that exceeds the usual level of corporate exposure and involves multiple means of payment.