Foreign Exchange Risk: 5 Strategies You Need To Know About

As companies frequently do business across borders, foreign exchange risk becomes unavoidable. It can significantly impact your bottom line if you don’t have effective risk management strategies in place. Therefore, understanding the most common ways your company is at risk of these changes is the first step in efficiently operating in multiple markets and multiple currencies.

This article will cover foreign exchange risk and its various types and provide actionable strategies for managing these risks and protecting your margins.

Foreign exchange risk (also known as currency risk, FX risk, or FX exposure) is the possibility of losing money from international trades due to changes in currency exchange rates.

The global currency market is constantly changing, and it’s a highly volatile financial market. Exchange rates can swing due to various factors, such as supply and demand for a particular currency, a country's economic health, political events, and even overall investor confidence.

These ups and downs can seriously impact your bottom line. For example:

• Importing gets pricier: If the foreign currency your supplier uses gets stronger, you'll pay more for those imported materials.
• Export earnings shrink: If the currency your customer uses weakens, you'll receive less in your home currency for your exported goods.

Next, let’s take a look at the types of FX risks.

Foreign exchange risk (sometimes called foreign exchange exposure) comes in 3 forms: transaction, translation, and economic risks. 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 strengthens, the buyers end up paying a higher price.

For example, a furniture company in India placed an order with a supplier in China in January. In May, the value of the Chinese yuan 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 the home currency, it faces translation risk. 

If the foreign currency is weaker than the home currency, the company’s earnings will look poor when translated from the subsidiary currency to the home 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 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.

Now that you've grasped the basics, let's explore what you can do to ensure your business’s financial health.

Banks and Forex providers can help reduce FX 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.

A forward exchange contract lets you lock in an exchange rate for a future date, allowing you to convert money at that rate when needed. The ability to exchange money 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 contracts but offer more flexibility. They enable companies to buy or sell currency at a set rate but aren’t required to trade currencies during that period. To secure this option, you pay a premium.

Currency options could be the right choice for businesses that deal with historically volatile companies or currencies and for businesses that need some flexibility when dealing with foreign currencies. They provide a safety net while allowing you to benefit from favorable exchange rate movements.

One of the best ways to minimize foreign exchange risk is to transact in your home 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.

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 another. For example, a company with operations in India and the U.K. can balance 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.

Maintaining foreign currency accounts is another good hedging strategy for international businesses. Foreign currency accounts offer more than just protection against foreign exchange (FX) fluctuations, including:

• Multi-currency Flexibility: Hold, receive, and send money in multiple currencies from one account, reducing the need to convert currencies for every transaction and helping improve cash flow management.
• Cost-Efficiency: Transact in the same currency in which you receive payments, which can significantly lower the costs associated with currency conversion.
• Simplify Your Finances: Manage all your currencies in one place, reducing the need for multiple banking relationships and simplifying your financial operations.

While foreign currency accounts offer benefits, it's important to compare bank fees and maintenance costs to your transaction volume and potential savings. Consider exploring alternative solutions like multi-currency platforms, payment service providers, or neobanks to potentially reduce overall costs.

Managing currency risk is essential for staying competitive in global markets. Stay proactive and regularly review your risk management practices to reduce potential losses and keep your finances stable.