What does 'foreign exchange risk' refer to?

Foreign exchange risk specifically pertains to the potential for an investor or company to experience losses because of changes in currency exchange rates. This type of risk is particularly relevant for businesses involved in international transactions, investments, or trade, as fluctuations in exchange rates can significantly impact cash flows, profitability, and overall financial health.

When the value of one currency relative to another changes, it can lead to gains or losses when converting earnings from one currency back to the home currency. For example, if a U.S. company exports goods to Europe and receives payment in euros, a decline in the euro's value against the dollar at the time of conversion would reduce the company’s revenue in dollars, thus representing foreign exchange risk. This is why understanding and managing foreign exchange risk is crucial for businesses engaged in international operations.