Exchange Rate Risk & Forms of Exposure

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  • 0:04 What Is Exchange Rate Risk?
  • 0:57 Short-Run and Long-Run
  • 2:33 Translation Exposure
  • 4:03 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

International businesses face certain risks, including the risk of exchange rates being unfavorable. In this lesson, we'll explore forms of exchange rate exposure, including short-run, long-run, and translation exposure.

What Is Exchange Rate Risk?

Anastasia is head of a large, multinational corporation. That means that her company does business in many different countries, and in many different currencies. From the Indian rupee to the euro to U.S. dollars, Anastasia's company has a lot of different types of money coming in and going out. How do they manage all of it?

International business comes with certain risks. One big risk has to do with the exchange rate, or the value of one currency against another. For example, every U.S. dollar might be worth only .85 euros. Then again, it might be worth more or less.

The business exchange rate risk is the possibility that the exchange rate could be unfavorable and cost the company money. To help Anastasia understand that risk, let's look at the types of exchange rate exposure that her company could have, and the risk associated with each one.

Short-Run and Long-Run

As we've seen, Anastasia's company does business in many different countries and many different currencies. She's worried about exchange rate risk, but she isn't sure what to do about it.

Two main ways of looking at exposure to exchange rate risk have to do with the time period in which a company is going to exchange their money. Short-run exposure is the risk that exchange rates will be unfavorable in the short-term. That is, if Anastasia is going to trade her company's euros for dollars today, tomorrow, or even next week, they have short-run exposure. The risk here is that the short-term fluctuations in the exchange rate could mean an unfavorable exchange rate for current transactions. That is, she might get a bad exchange rate on a specific day and end up losing money.

To help mitigate short-run exposure, some companies lock in a long-term exchange rate called a forward exchange rate. For example, if Anastasia knows that she'll be doing business in India for the next three years, she might lock in a forward exchange rate that they get the same exchange rate for three years, no matter what happens to short-term rates.

Of course, that opens Anastasia's company up to another type of exposure: long-run exposure, or the risk that exchange rates will be unfavorable in the long-term. In this case, the big risk is not that of small fluctuations from day to day, like in short-run exposure, but in future economic events that could negatively impact the exchange rate. For example, if India's economy becomes very strong in the next three years, Anastasia could find that, at the end of her forward rate contract, she is left with an exchange rate that is a steep drop-off from what she had during the contract.

Translation Exposure

With all the exchange rate risk, Anastasia's head is swimming. Maybe it's better to just keep the money the company makes in local currency and not bother with exchange rates at all. For example, the company can keep the Indian rupees that they make and invest it in the company or other Indian assets, and not exchange it into U.S. dollars. They could do the same thing with the euros they make.

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