Question

Foreign Exchange Market

What is exchange rate risk? Provide one example of a multinational firm, and explain why would the firm be concerned about it.

Answer 1

Exchange Rate Risk or foreign exchange risk is a risk involved in all foreign investments. The risk of chnages in exchange rates during the period of investment/transaction gives rise to the upward or downward risk of change in value of domestic currency with respect to foreign currency invested in. Some types of foreign exchange exposures are economic exposure, transaction exposure and translation exposure.

For example, a multinational organisation would, in most cases, face a translation risk. Translation risk is the risk of fluctuating profits to the parent firm when profit from foreign subsidiaries are consolidated into parent's financial statements. Say a firm A is based in the US but has a subsidiary in India. While incorporating the Indian company's accounts, this firm will face exposure to US-India exchange rate because if USD appreciates against the INR, the firm's inflow will increase and vice versa. To fix this, the firm uses methods of translation that convert currencies at either historical or current or average exchange rates.

Another example may be that a firm in India imports its raw material from the US. If the USD appreciates against the rupee, the firm's outflow will increase, thus decreasing the profit margins. This risk can be mitigated through the use of hedging techniques.