Exchange rate risk is the possibility that changes in currency exchange rates may affect the value of assets or financial transactions. It is common for exchange rates to be reasonably volatile as they are impacted by a broad range of political and economic events. The following are a few examples of exchange rate risks.
1. Foreign AssetsAn individual investor needs to sell their vacation property in a foreign country to help fund their retirement plan. The property has gone up slightly in value in the local market but the country's currency has dropped by 40% over the years. The investor is forced to take a large loss.
2. Foreign SalesAn American luxury brand expands to 27 countries that use 11 different currencies. They report their financial statements in US dollars. After the expansion, the company's net profit becomes volatile from one financial quarter to the next as currencies impact their sales margins.
3. Foreign DebtAn American company issues bonds in Europe to take advantage of a low interest rate environment. They face the risk that the value of the Euro will increase relative to the US dollar before the debt is due for repayment.
4. Foreign ListingA Chinese company lists its stock on a US stock exchange and must therefore report its earnings in US dollars. The company has a good year with net revenue increasing 25% in the local currency. However, the local currency declined 30% relative to the US dollar. As a result, the company must report declining net revenue in its financial statements.
5. Foreign ProcurementA European automobile manufacture signs contracts with part suppliers in the United States with prices in US dollars. The US dollar rises dramatically on a long term basis, making the parts more expensive in Euro. The manufacture needs to pass on these costs to its European customers by increasing prices. As a result of the higher prices its sales decline.
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