Foreign exchange risk is the risk faced by a company when it does business in currencies other than its home currency. For example, an American company using U.S. dollars faces foreign exchange risk when it engages in business or trade with other countries. The risk is quantified by determining how much money can be lost in U.S. dollar terms if the dollar weakens, or loses value, in terms of a specific foreign currency.
Calculate Foreign Currency at Risk
Calculate how much foreign currency a company uses annually. If an American company buys goods in Europe where it pays for the goods using Euros, then express the annual cost in terms of Euros. For example, assume that the company spends 10 million Euros annually for goods in Europe.
Find the Exchange Rate Now
Locate the exchange rate between U.S. dollars and Euros in a major newspaper or on the Internet. For example, assume that the rate is 0.90 Euros per $1.
Convert the Euros into U.S. dollars by dividing the Euro rate into the amount, or 10,000,000 / .90 = $11,111,111. This is the amount that the purchased goods cost now in terms of dollars.
Estimate Potential Losses
Calculate the cost to the company caused by the dollar losing value against the Euro during the year by changing the exchange rate by a percentage and calculating the additional cost. For example, to determine the risk posed by the dollar losing 10 percent of its value against the Euro during the year, multiply 10 percent, or .10 x .90 = 0.09.
Determine New Dollar Cost
Subtract 0.09 from .90 to get 0.81, which would be the new exchange rate if the dollar loses 10 percent of its value.
Divide 0.81 into 10,000,000. This equals $12,345,679, or the new amount of dollars that the European goods would cost.
Calculate Dollar Risk
Subtract $11,111,111 from $12,345,679 to get $1,234,568. This is the foreign exchange risk in dollar terms for an American company doing business in Euros if the dollar were to lose 10 percent of its value in a year.