Question : What is meant by the term "exchange rate risk"?

Option 1: The risk of currency counterfeiting
 

Option 2: The risk of a country defaulting on its debt
 

Option 3: The risk of changes in exchange rates affecting the value of investments

 

Option 4: The risk of a country's central bank losing control over its currency

Correct Answer: The risk of changes in exchange rates affecting the value of investments

Solution : Correct Answer is c) The risk of changes in exchange rates affecting the value of investments

Exchange rate risk refers to the potential impact of fluctuations in exchange rates on the value of investments, assets, liabilities, or cash flows denominated in different currencies. It arises from the fact that exchange rates between currencies are not fixed and can fluctuate due to various factors such as economic conditions, interest rates, inflation rates, geopolitical events, and market sentiment.

When an investor or a company holds investments or conducts business in a currency other than their domestic currency, they are exposed to exchange rate risk. For example, if an investor holds foreign stocks or bonds, the returns on those investments will be influenced by changes in the exchange rates between the foreign currency and the investor's domestic currency. If the value of the foreign currency decreases relative to the investor's currency, the investor may experience a loss when converting the investment back into their domestic currency.

Exchange rate risk can impact businesses engaged in international trade as well. Fluctuations in exchange rates can affect the cost of imported goods, the competitiveness of exports, and the profitability of foreign operations. Companies with significant exposure to exchange rate risk may employ various strategies to manage or hedge against this risk, such as entering into currency forward contracts or using financial derivatives.

It's important to note that while exchange rate risk can have both positive and negative impacts, it introduces uncertainty and can lead to financial gains or losses depending on the direction and magnitude of currency fluctuations.