What are Exchange Rate Risks?

Any company paying or receiving foreign currencies faces what's called FX or exchange rate risk.

Risk arises and runs between the time of issuing invoices or signing contracts and when payment is received.

Example: A Hong Kong-based company imports cheese from France and distributes it to both Hong Kong and Mainland China.

This company pays its French supplier in EUR and receives payment from its Chinese client in RMB.

It is therefore exposed to both EUR/HKD and RMB/HKD fluctuations.

There are two common situations that should be considered here:

Exchange rate risk when overseas subsidiaries are reporting in foreign currencies

When a parent company deals with subsidiaries or financial reporting in foreign currencies, it will be exposed to FX volatility.

Hence the exchange rate risk is higher.

Example: An Australia-headquartered company with subsidiaries in Hong Kong and Bangkok will have to convert the Hong Kong subsidiary’s financial statements from HKD to AUD and the Bangkok subsidiary’s financial statements from THB to AUD.

When exchange rate risk impacts competitiveness

This is a market risk that is not directly linked to a company itself. FX volatility can affect the competitiveness of an entire industry.

Example: A Hong Kong-based company sells goods in multiple markets, including Europe.

The company sources its products from China and pays them in USD while receiving EUR from its customers in Europe.

The company competes with companies based in Europe and in Asia.

How does FX affect competitiveness?

• The value of EUR/USD. If the EUR is too low against the USD, it will make the USD-denominated item too expensive for European customers, who might look for alternative options from competitors.
• The hedging policy might also have an impact. If a company sends a price quote to a customer based on a EUR/USD rate of 1.1500, this company will be competing with other Hong Kong-based companies, which are also sensitive to EUR/USD (because the HKD is pegged to the USD).

FX Risk Example

The three companies below are bidding for a USD 50,000 contract and send their price quotes using a EUR/USD rate at:

• 1.1400 for Company A, pricing at EUR 43,859
• 1.1300 for Company B, pricing at EUR 44,248
• 1.1200 for Company C, pricing at EUR 44,643

All other parameters being equal, Company A wins the contract.

Company A was able to offer the lowest quote by entering into an FX contract and locking the rate at 1.14.

By doing so, it also protects its profit margin.

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Was this article not relevant to you because you're a small business? This is actually relevant to you too! We go into depth here on how small businesses can hedge when trading currency.