The potential for a business’s finances to be affected negatively by fluctuations in currency exchange rates.
International businesses face pressure not just from shifting demand and availability of materials and products but also from changes in currency exchange rates. Fluctuations in currency value and the uncertainty of how those fluctuations will impact a company's expenses and profits are known as foreign exchange risk, and they can impact a company’s profits significantly.
Understanding the most common ways your company is at risk of these economic changes is the first step in efficiently operating in multiple markets and multiple currencies. So, ready to learn about these risks and how to avoid them? Let’s get started.
Types of Foreign Exchange Risk
Foreign exchange risk comes in three forms: transaction, translation, and economic. While each type is related to fluctuations in currency exchange rates, the mechanisms that cause them are different. Large and small businesses have exchange rate risks if they work with multiple currencies.
Transaction risk is a type of risk that happens when a company buys something from another company in a different country in the supplier company’s currency. If the supplier country’s currency appreciates, the buyer ends up paying a higher price.
For example, a furniture company in India placed an order with a supplier in Mexico in January. In May, the value of the Mexican peso appreciated by 10%. When the order is ready to ship at the end of May, the company in India will pay an extra 10% on the balance of their bill.
When a company operates subsidiaries in a foreign country but bases its financial performance on its own currency, it faces translation risk. If the foreign currency is weaker than the domestic currency, the company’s earnings will look poor when translated from the subsidiary currency to the domestic currency. A company can take measures using the financial instruments (including forward contracts and currency options) available in the foreign exchange market to hedge against these risks,
For example, an American company controls several manufacturing plants in South Korea. While the South Korean won is relatively strong, the American company’s financial statements will show a lower value on the assets in South Korea even though they haven't actually dropped because the dollar is stronger than the won.
Economic Exposure/Operating Exposure
Economic risk, also known as operating exposure, occurs when surprise currency fluctuations impact earnings as well as future cash flows and investments in foreign markets. This is generally a more long-term problem than a transaction or translation risk.
For example, a French drug manufacturer faces operating exposure if it only sells its medicine in the EU, especially during a time when drug manufacturing and importation are increasing from countries outside of Europe. Increased competition and lower prices of foreign medication put the French company at significant economic risk over time.
4 FX Risk Management Strategies for Reducing Exchange Rate Risk
Even though foreign currencies can fluctuate, it doesn’t mean your business has no recourse. With proper planning, help from experts, and other strategies, it is possible to not only negate many of the negative impacts of foreign exchange risks, but to actually benefit from these shifting markets.
1. Work With a Bank or Foreign Exchange Provider
Foreign exchange (FX) providers and banks can help reduce economic exposure by providing businesses with expertise, advice, and insights. Because these institutions understand how currency markets shift, they will work with a business by evaluating their needs and risk tolerance to find appropriate hedging solutions for that business.
2. Use a Forward Exchange Contract or Currency Options
A forward exchange contract is a financial instrument that lets you lock in an exchange rate at a specific time and then transfer money into that currency in the future at that rate. The ability to exchange funds at a set rate allows your company to minimize the risks of foreign currency exposure.
Foreign exchange contracts can be a good fit for companies that need to hedge against losses when converting currencies. If your business is vulnerable to translation or transaction risks, a forward exchange contract lessens or eliminates potential losses.
Currency options are similar to forward exchange contracts in that they let businesses sell or buy a currency at a set rate — what makes them different from a contract is that you aren’t required to trade currencies during that period. To have the right to trade at a set rate, you pay a premium for the option.
Currency options could be the right choice for businesses that deal with historically volatile companies or currencies. Currency options are also a good choice for businesses that have some flexibility when dealing with foreign currencies.
3. Look for Ways To Transact Using Your Own Currency
One of the best ways for your business to minimize foreign exchange risk is to find ways to transact in your native currency. This might mean working with suppliers or buyers domestically or having contracts written in a way that makes the other party accept or pay in your country’s currency.
Transacting in your currency can mean less volatility if your currency is generally stable, but a valuable currency can drive up the prices you pay. It also potentially limits the number of options available to you. For example, if you’re an American company that wants to sell to other American companies that will pay in USD, there may be fewer buyers due to a limited market and higher costs. Foreign companies may also not want to pay in USD because of its value.
4. Use Natural Foreign Exchange Hedging
Natural foreign exchange hedging is a strategy businesses can use to take advantage of the assets it owns as well as the way they operate in other countries to lower exchange risks. By diversifying operations into multiple countries, a company can offset the losses it faces with one currency with gains it makes in a different currency. For example, a company with operations in India and the U.K. can offset losses faced by the Indian part of its business with gains in the British pound.
Setting prices individually across different markets is another natural hedge that can help offset losses. Businesses can also work with suppliers in other countries and buy in the supplier's currency to match inflows and outflows that occur as currency fluctuates.
Armed with the answer to the question, “What is exchange rate risk?” your company can look for ways to take advantage of favorable currency exchange rates or protect against foreign exchange risk. At Statrys, we are ready to help. Contact us today to learn how we can help you hedge against fluctuations.
Who faces exchange rate risks?
How does FX affect competitiveness?
Why is it important to use exchange rate risk management techniques?