Understanding Currency Risk & Its Types
- 4 min•
- 5,005•
- Updated 10 Sep 2025
Key Highlights
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Foreign exchange risk refers to the risk that arises due to changes in currency exchange rates and how these changes impact a company's financial performance or position.
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Three categories of foreign exchange risk exist: transaction risk, economic risk, and translation risk.
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Foreign exchange risk is a big concern for exporters/importers and businesses who conduct business in international markets.
What is Currency Risk?
Currency risk, often known as exchange-rate risk, derives from changes in the price of one currency in comparison to another currency. Currency risk exposes investors and firms with assets or commercial activities across national borders to unpredictability in profits and losses.
Many institutional investors, such as hedge funds and mutual funds, as well as multinational corporations, use forex, futures, options contracts, or other derivatives to hedge risk.
Understanding Currency Risk
Currency risk arises when a business deals in multiple currencies – earning, spending, or reporting in one while being headquartered in another. The exposure comes from fluctuations in exchange rates, which can directly impact revenues, costs, and reported earnings.
For example, imagine a Canadian company doing business with a Chinese firm. Payments are received in yuan, but the company must prepare its financial statements in Canadian dollars. Each transaction needs conversion into the local currency. If the yuan weakens against the Canadian dollar, the value of those payments falls once converted, reducing reported income. Conversely, a stronger yuan could boost earnings.
This risk can emerge from movements in the home currency, the foreign currency, or both. It particularly affects exporters, importers, and multinational firms operating across borders. Even small changes in exchange rates can erode profit margins, disrupt cash flows, or alter competitive positioning. That’s why managing currency risk is a key concern in international trade and financial planning.
Types of Foreign Exchange Risk
Currency risk occurs when the value of one currency fluctuates, affecting transactions, investments, or assets denominated in foreign currencies. In a global market, effective management is critical for firms and investors to minimise losses, protect financial positions, and improve performance.
Foreign currency risk can be classified into three types:
Transaction Risk: The risk that a corporation bears while conducting financial transactions between jurisdictions is known as transaction risk. The risk is that the exchange rate will fluctuate before the transaction is completed. The primary driver of transaction risk is the delay between the transaction and settlement. Options and forward contracts can be utilized to lower transaction risk.
Economic risk: The risk that a company's market value will be damaged by inevitable exposure to exchange rate swings is known as economic risk, sometimes known as forecast risk. This type of risk is typically caused by macroeconomic variables such as geopolitical instability and/or government laws.
Translation risk: Translation risk, also known as translation exposure, refers to the risk faced by a firm headquartered in the United States but conducting business in a foreign jurisdiction whose financial performance is reported in the company's home currency. When a company keeps a larger proportion of its assets, liabilities, or stocks in a foreign currency, the risk of translation grows.
| Type of Risk | Definition | Key Driver | Mitigation |
|---|---|---|---|
Transaction Risk | Risk during settlement delay of cross-border transactions | Exchange rate movement between contract and settlement | Forward contracts, options |
Economic Risk | Long-term impact on company value and competitiveness | Macroeconomic shifts, policies, geopolitical events | Diversification, natural hedging |
Translation Risk | Risk in consolidating foreign operations into home currency | Fluctuations in reporting currency vs foreign assets/liabilities | Balance sheet hedging, currency swaps |
Can Businesses Mitigate Currency Risk?
There are certain strategies that businesses can implement to mitigate currency risk. These are:
-Forward Contracts – Lock in an exchange rate today for a future transaction to eliminate uncertainty.
-Currency Options – Provide the right, but not the obligation, to exchange at a predetermined rate, offering flexibility.
-Natural Hedging – Match revenue and expenses in the same currency (e.g., borrowing in the currency of operations).
-Currency Swaps – Exchange principal and interest payments in one currency for another to manage long-term exposure.
-Diversification – Spread operations, suppliers, and markets across multiple regions to reduce dependence on one currency.
-Invoicing in Home Currency – Negotiate contracts so payments are made in the company’s domestic currency.
-Leading and Lagging – Adjust payment timings strategically, paying early or delaying settlements depending on expected rate movements.
-Centralized Treasury Management – Coordinate hedging and cash flow decisions at the group level for efficiency and cost savings.
Conclusion
Currency risk, also known as exchange-rate risk, is a significant concern for businesses involved in international transactions. It involves fluctuations in currency values, which can affect profits and losses. It includes transaction, economic, and translation risks, each requiring specific strategies. Transaction risk involves timing financial transactions between different currencies, while macroeconomic factors influence economic risk. Translation risk occurs when a company reports financials in its home currency. Hedging techniques like forward contracts and options can help mitigate these risks. Proactively managing currency risk is crucial for global businesses.
Also Read:
FAQs on Currency Risk
Which is the safest currency?
The Swiss franc (CHF) is widely regarded as one of the world's safest currencies and is regularly used as a safe-haven asset. The Australian dollar, US dollar, and Norwegian krone are also regarded as safe currencies to invest in.
What causes currency values to change?
Currency values change mainly due to supply and demand influenced by economic indicators, interest rates, inflation, trade balances, and capital flows. Political stability, central bank policies, and global events such as wars or crises also drive sharp exchange rate fluctuations.
What are the types of currency risk?
Currency risk encompasses transaction risk (timing of financial transactions), economic risk (macroeconomic factors), and translation risk (reporting financials in a different currency).
How can business manage currency risk?
To reduce currency risk, hedging strategies, including forward contracts, options, and derivatives, are frequently employed. With the use of these instruments, financial outcomes can be stabilised despite exchange rate swings.
Who is most affected by currency risk?
Companies that do business internationally, like export and import, are at the greatest risk of currency changes. This is because they buy and sell in foreign currencies, which means they can be affected by shifts in exchange.
This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
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