Foreign exchange risk is the risk that an asset or investment’s value will change due to a fluctuation in the value of a foreign currency. Businesses that purchase goods in foreign countries usually buy those goods in that country’s currency. When the foreign currency changes in value compared to the home currency, the value of the goods purchased changes. This change in value is a risk for the company purchasing the goods and for the company selling the goods.
Contracts for the purchase of goods or services are usually denominated in one currency. Both the vendor and purchaser take on a foreign exchange risk because if the currency fluctuates in one direction, the value of the investment improves for one party and the cost increases for the other. Generally, long-term contracts include provisions to manage these currency fluctuations. One-time purchase agreements require that each of the parties manages these risks on its own.
Companies with foreign subsidiaries or investments manage their foreign exchange risk on their corporate balance sheets. Any foreign investments must be converted back into the company’s accounting currency for reporting purposes. Companies with foreign assets might choose to use a financial instrument to manage these types of risk.
Forward exchange contracts allow the company to set certain contractual parameters for a given time period to manage foreign exchange risk. These contracts permit the company to determine the outside risk in a transaction but do not permit the company to gain from a fluctuation in its favor. A foreign currency option contract allows a company to purchase or sell a foreign currency in the future. After paying a fee for this type of contract, the company gets the right to buy or sell, but that does not require that the company complete a transaction. The foreign currency option contract gives the company the ability to manage currency fluctuations in or against its interest.
Paying for goods purchased in a foreign land with a foreign bank account denominated in a given currency is another way that companies manage foreign exchange risk. This form of management works well for companies that complete a number of transactions in a given currency. Maintaining a bank account in a foreign country allows the company to decide when and if it will move funds between the company’s main bank accounts into the foreign currency. The company decides which exchange rate is in its favor and the amount of funds it will transfer at that time.