Foreign exchange risk is the possibility of gain or loss to a firm that occurs due to unexpected changes in exchange rate. Exchange rates are considered by MNC’s as crucially important factor affecting their profitability. Because exchange rate fluctuations directly impact the sales revenue of firms exporting goods & service. Future payments in a foreign currency carry the risk that the foreign currency will depreciate in value before the foreign currency payment is received & is exchanged into Indian rupees.

For example, if an Indian firm imports goods & pays in foreign currency (says dollars), its outflow is in dollars, and thus it is exposed to foreign exchange risk. If the value of the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay more domestic currency to get the required amount of foreign currency.

Foreign exchange risks, therefore, pose one of the greatest challenges to a multinational company. These risks arise because MNC’s operate in multiple currencies. Infact, many times firms who have a diversified portfolio find that the negative effect of exchange rate changes on one currency are offset by gains in others i.e. exchange risk is diversifiable.

The beginning of the floating exchange rate regime, since the early 1970’s, has sharp the interest of MNC’s in developing techniques & strategies for foreign exchange exposure management. The primary goal is to protect corporate profits from the negative impact of exchange rate fluctuations.