Meaning and definition of currency risk
Currency risk refers to a risk form arising from the changes price of one currency as compared to another currency. Whenever companies or investors possess assets or business operations across national boundaries, they experience currency risk if their positions are not prevaricated. Currency risk is also referred as exchange rate risk. Putting it simple, currency risk can be defined as the possibility that currency depreciation will show negative effect on the value of assets, investments, and their related interest and dividend payment streams, specifically those securities denominated in foreign currency.
As illustrated by Investopedia through an example, if a US investor has stock in Canada, the return realized by you will be affected by the change in [price of stock as well as the change in value of Canadian dollar against the US dollar. Therefore, if a 15% return is realized on the Canadian stock but the Canadian dollar deflates 15% against the US dollar, this will generate no profit at all. Moreover, as per the academic studies of currency risk, although without complete certainty, that investors facing currency risk are not rewarded with greater potential returns, implying that it is essentially an unnecessary risk to bear.
Types of currency risk
Generally, there are two basic types of currency risk:
- Transaction risk
This type of risk is the one related to an unfavorable change in the exchange rate over a certain time period.
- Translation risk
This risk type is an accounting concept. It is relative to the amount of assets held in foreign currencies. Alterations in exchange rate over a certain period will provide an inaccurate report, and thus the assets are generally balanced by borrowings in the specific currency.
Consequences of currency risk
Currency risk has been demonstrated to be predominantly significant and damaging for very large, rarity investment projects, generally referred as ‘megaprojects.’ This is for the reason that such projects are generally financed by huge debts nominated in currencies distinctive from the currency of the home country of the debt owner. These type of megaprojects have been demonstrated as prone to ending up as what is commonly known as ‘debt trap’ resulting from currency risk, i.e. unexpected changes in the exchange rates.