Abstract
This chapter considers the issue of foreign exchange risk, which is the presence of risk that arises from uncertainty regarding the future exchange rate; this uncertainty makes forecasting necessary. If future exchange rates were known with certainty, there would be no foreign exchange risk. The various types of foreign exchange risk are explored by working through a real-world example. The effects of foreign exchange risk on the determination of forward exchange rates are then explored, clarifying the terms risk and risk aversion. Market efficiency is defined for the foreign exchange market, meaning that spot and forward exchange rates quickly adjust to any new information. Since future exchange rates are uncertain, forecasts must be made; the authors conclude the chapter with a worked-through forecasting example.
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