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What is the significance of foreign exchange rate risk and how can this risk be mitigated?
Foreign exchange risk is the level of uncertainty that a company must manage for changes in foreign exchange rates that will adversely affect the money the company receives for goods and services over a period.
For example, a company sells goods to a foreign company. They ship the goods today, but will not receive payment for several days, weeks or months. During this grace period, the exchange rates fluctuate. At the time of settlement, when the foreign company pays the domestic company for the goods, the rates may have traveled to a level that is less than what the company contemplated. As a result, the company may suffer a loss or the profits may erode.
To minimize or manage the risk, companies enter into contracts to buy foreign currency at a specified rate. This allows the companies to minimize the uncertainty of the risk, so that they can price their products accordingly.
