3 Types of FX Risk (and How to Mitigate Them)

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Thursday, March 31, 2022

Businesses operating internationally will have to manage the risk that comes from currency exchange. Here are three of the most common, and how to mitigate them.

Article 4 Minutes
3 Types of FX Risk (and How to Mitigate Them)

Foreign exchange (FX) risks all stem from the same issue: the fluctuating values of different currencies. Any organization doing business internationally will likely run up against this problem at some point in its lifetime, as the money made in different locales will have a different value depending on when the transactions take place.

For example, if a US-based business made a sale in the UK for £1,000 on December 20th 2021, it would convert to around $1,320. However, that same transaction would be worth roughly $1,420 in May 2021, when the pound reached a higher value against the dollar than it had for several years. While most FX risks take place over a much shorter time period - and therefore the fluctuations between currencies can be smaller - this illustrates how the time a transaction is made can affect how much profit a business actually makes.

While this is the most basic way of looking at FX risks, there are actually several different types that businesses have to deal with. This can get quite complex - especially when entering the world of FX trading. Here are three types of risk that are the most common for any companies trading internationally.

1.  Transaction risk

Transaction risk is the closest to the above example of FX risk. In this case, the fluctuation in currency value comes in between when a transaction is completed and when it is settled. For example, a 10,000-yuan transaction between an US and Chinese business might be agreed when the US dollar is worth 6.5 yuan. However, it is not settled for several days, and when the money is sent over the dollar is worth 6.3 yuan. In those few days, the amount of money the US firm receives will have dropped by almost $50.

There are a few options for mitigating this risk. The first is simply to agree deals in the currency of your business’ location, which moves the risk onto the other party in the transaction. However, this is not always possible and also prevents you from benefiting if the exchange rate moves in your favour.

Another option that still allows you to take advantage of FX fluctuations is what Investopedia calls a “forward contract”. This simply involves making an agreement to buy or sell an asset ahead of time at a fixed price. If you think a currency is likely to move in a way that would reduce your profits, this is a way of insuring against that ahead of time.

2.  Translation exposure

Transactions are not the only things that can be affected by exchange rate fluctuations. The value of your company can also change, and be impacted negatively. The Corporate Finance Institute offers up an example of this happening, in which a US company buys a building in Austria for €100,000 on September 1st 2019. At that time, the exchange rate is €1 = $1.20, making the building worth $120,000.

However, the exchange rate then changes to €1 = $1.15, making the building worth only $115,000. In a short period of time, $5,000 has been wiped off the value of the company. If this is happening in multiple circumstances, businesses can potentially go into the red.

There are a few ways to hedge this kind of risk, one of which is a currency swap. This simply involves borrowing currency from another organization at a set exchange rate, then paying it back at a later date. Because this can potentially be more favourable than exchange rates, it can be a good way to mitigate risk and increase stability. It’s a tactic used by some nations, with one such agreement between South Korea and the US coming to an end on December 31st 2021.

3.  Economic exposure

Finally, there’s the impact FX rates can have on entire economies. For example, your US company might decide to manufacture in India to reduce operating costs. However, over a period of time the strength of the Indian rupee increases, wiping out a lot of the savings you expected to make and potentially even making the move financially unviable.

This risk even applies to companies that don’t trade overseas. A US company competing against European imports will lose out if the value of the dollar rises, making those imported products even cheaper and therefore more competitive.

Unfortunately, this risk is a lot harder to mitigate. Currency swaps can sometimes help offset any losses, but international CFO Paul Ainsworth points out that ultimately the way your business is set up can make all the difference here. Sometimes, it will be more viable to create a “natural foreign exchange hedge” by matching revenues in a currency with a purchase in the same currency. This is harder to manage on a balance sheet, but can be less risky overall.

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