In a short essay, explain the concept of currency risk. How can inflation and interest create currency risk?

What will be an ideal response?

Complications in international transactions create currency risk, the potential harm that can arise from changes in the price of one currency relative to another. If you buy from a supplier whose currency is appreciating against yours, you may need to pay a larger amount of your currency to complete the purchase. If you expect payment from a customer whose currency is depreciating against your own, currency risk also arises, because you may receive a smaller amount of your currency if the sale price was expressed in the currency of the customer. Of course, if the foreign currency fluctuates in your favor, you may gain a windfall. Exporters and licensors also face risk because foreign buyers must either pay in a foreign currency or convert their currency into that of the vendor.

Inflation is an increase in the price of goods and services, so that money buys less than in preceding years. Inflation and interest can create currency risk because they are closely related. In countries with high inflation, interest rates tend to be high because investors expect to be compensated for the inflation-induced decline in the value of their money. For example, inflation is running at 10 percent, for example, banks must pay more than 10 percent interest to attract customers to open savings accounts.