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Exchange rate risk is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own. The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries. A U.S. investor who buys Japanese stock denominated in yen must consider not only the uncertainty of the return in yen but also any change in the exchange value of the yen relative to the U.S. dollar. That is, in addition to the foreign firm’s business and financial risk and the security’s liquidity risk, the investor must consider the additional uncertainty of the return on this Japanese stock when it is converted from yen to U.S. dollars.
As an example of exchange rate risk, assume that you buy 100 shares of Mitsubishi Electric at 1,050 yen when the exchange rate is 115 yen to the dollar. The dollar cost of this investment would be about $9.13 per share (1,050/115). A year later you sell the 100 shares at 1,200 yen when the exchange rate is 130 yen to the dollar. When you calculate the HPY in yen, you find the stock has increased in value by about 14 percent (1,200/1,050), but this is the HPY for a Japanese investor. A U.S. investor receives a much lower rate of return, because during this period the yen has weakened relative to the dollar by about 13 percent (that is, it requires more yen to buy a dollar—130 versus 115). At the new exchange rate, the stock is worth $9.23 per share (1,200/130). Therefore, the return to you as a U.S. investor would be only about 1 percent ($9.23/$9.13) versus 14 percent for the Japanese investor. The difference in return for the Japanese investor and U.S. investor is caused by the decline in the value of the yen relative to the dollar. Clearly, the exchange rate could have gone in the other direction, the dollar weakening against the yen. In this case, as a U.S. investor, you would have experienced the 14 percent return measured in yen, as well as a gain from the exchange rate change.
The more volatile the exchange rate between two countries, the less certain you would be regarding the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium you would require.
There can also be exchange rate risk for a U.S. firm that is extensively multinational in terms of sales and components (costs). In this case, the firm’s foreign earnings can be affected by changes in the exchange rate. As will be discussed, this risk can generally be hedged at a cost.

An asset whose payments are not in the domestic currency of the investor has unknown cash flows in the domestic currency. The cash flows in the investor’s domestic currency are dependent on the exchange rate at the time the payments are received from the asset. For example, suppose an investor’s domestic currency is the U.S. dollar and that the investor purchases an asset whose payments are in euros. If the euro depreciates relative to the U.S. dollar at the time a euro payment is received, then fewer U.S. dollars will be received.
The risk of receiving less of the domestic currency than is expected at the time of purchase when an asset makes payments in a currency other than the investor’s domestic currency is called exchange rate risk or currency risk.

Our goal is to determine the market value of the derivative transaction of interest, in this case, swaps. At the start of a swap, the market value is set to zero.
The process of pricing the swap involves finding the terms that force that market value to zero. To determine the market value of a swap, we replicate the swap using other instruments that produce the same cash flows. Knowing the values of these other instruments, we are able to value the swap. This value can be thought of as what the swap is worth if we were to sell it to someone else. In addition, we can think of the value as what we might assign to it on our balance sheet. The swap can have a positive value, making it an asset, or a negative value, making it a liability.
Swaps are equivalent to a variety of instruments, but we prefer to use the simplest instruments to replicate the swap. The simplest instruments are the underlying assets: bonds, stocks, and currencies. Therefore, we shall use these underlying instruments to replicate the swap.
To understand the pricing of currency, interest rate, and equity swaps, we shall have to first take a brief digression to examine an instrument that plays an important role in their pricing. We shall see that the floating-rate security will have a value of 1.0, its par, at the start and on any coupon reset date. Recall that we have made numerous references to floating rates and floating payments. Accordingly, we must first obtain a solid understanding of floating-rate notes.