Currency risk - Financial definition

Currency risk, also known as exchange rate risk, arises from the uncertainty surrounding the future movement of exchange rates, impacting the value of investments denominated in foreign currencies. This risk affects various market participants, including multinational corporations, investors holding foreign assets, and businesses engaged in international trade, as they may experience gains or losses in their investments or operations when converting foreign currencies back into their domestic currency.

Hedging strategies, such as forward contracts, currency options, and currency swaps, are commonly employed to mitigate currency risk exposure and protect against adverse movements in exchange rates. For instance, a US-based investor holding European stocks faces currency risk if the euro weakens against the US dollar, potentially reducing the returns on their investment when converted back into dollars. Similarly, multinational companies with operations in multiple countries must manage currency risk to preserve the value of their earnings and cash flows, often using financial derivatives to hedge against adverse currency movements. Overall, currency risk management plays a crucial role in mitigating financial uncertainties and ensuring stability in international financial markets.