What Is Foreign Exchange Risk and How Can It Be Managed?

Understanding foreign exchange risk

Foreign exchange risk occurs when companies are engaged in international trade or have branches in other countries.

• For instance, the head office of a company is situated in Europe and provides all financial reports in euro. The company also has a branch in the United States, where all transactions are in US dollars. All financial transactions must be converted to euros for reporting purposes. Any fluctuations in currency will lead to changes in financial indicators.

• Another example is if a company purchases important components or raw materials for its production from another country in the local currency. A rise in the value of the local currency will lead to an increase in the cost of production as a whole and, as a result, will be reflected in the value of shares and financial indicators.

Currency fluctuations can be affected by political and economic factors, including civil unrest, change of power, inflation, and many others.

Types of foreign exchange risk

There are three main types of foreign exchange risk: transaction risk, translation risk and economic risk.

1. Transaction risk is the risk faced by companies that purchase goods from another country in a foreign currency. If the seller’s national currency appreciates relative to the buyer’s national currency, the buyer will suffer financial losses, as it will need to pay more in its domestic currency to reach the agreed upon price. Typically, this risk affects only one side of the transaction, the one that transacts in the foreign currency. There are no such risks for companies that transact in their national currency.

2. Translation risk affects companies that have branches or subsidiaries in other countries. For example, say a company’s head office is situated in Germany, while its subsidiary is in China, and the subsidiary conducts transactions in yuan, while the parent company in Germany presents all financial reports in euro. If the yuan appreciates against the euro, the financial statements will go out of whack when converted from yuan to euros. The company will consequently suffer a loss as a result of the change in the exchange rate.

3. Economic risk is also known as “operating exposure.” This is the long term risk that impacts on financial reports, company profits, stock prices, investments and even a company’s market value. It occurs because of unexpected currency fluctuations. Large companies with offices in different countries are particularly exposed to economic risk. Globalization has increased economic risk for all companies.

What are the causes of foreign exchange risk?

It is not possible to completely mitigate exchange rate volatility. Knowing what causes it gives you an advantage when planning investments. Several factors can cause foreign exchange risk.

1. Economic changes affect things like inflation and the GDP (gross domestic product). For instance, the higher a country’s GDP, the more stable the country’s economy, and the more attractive the country therefore is to investors. A stable economy leads to strengthening of the national currency, as exports will become more expensive in this country, and imports will become cheaper. This factor greatly affects companies operating on the international market.

2. Government actions and political instability refer to changes made by the government of a country. These might be changes in import-export duties, taxes, or even geopolitics. The more unstable the political landscape of the country, the more investors jump ship, and hence the weaker the national currency becomes.

3. Counterparty default occurs when the other side in an international transaction does not make their required payment. This is also known as credit risk. Counterparties’ business activities must be monitored so business transactions are closed at the right time without risk of default.

How to manage foreign exchange risk

The main objective of a foreign risk management strategy is to protect company’s or individual’s earnings and cash flows from the volatility of exchange rates. All hedging techniques can be divided into two big groups: internal and external.

• Netting exposures between subsidiaries involves offsetting exposure in one currency with exposure in the same or another similar currency.

• Leading and lagging payments involve an intentional acceleration or delay of a transaction. For example, if the local currency is expected to appreciate in the future, the company will make an accelerated payment. If the exchange rate is expected to decline, the payment may be deferred.

• Currency diversification means that a company owns assets in several different currencies. If one currency weakens, the others might strengthen, helping to offset losses and maintain overall stability.

• Forward contracts are agreements between the parties to fix the exchange rate for future payments. That way, companies know exactly how much they will receive or pay in the national currency. Forward contracts provide certainty and stability for future transactions.

• Futures contracts are similar to forward contracts, among other things, in that they also fix the exchange rate for future payments. The only difference is that the price of a futures contract is adjusted daily and the futures contract is always traded on an exchange. A forward contract cannot be cancelled, while a futures contract can be renegotiated.

• Option contracts give the buyer the right to make a transaction on a certain date at a predetermined price. A futures contract is obligatory for execution under any circumstances, while an option contract is not. The buyer might not exercise the option if the conditions are unfavorable for them.

• Currency swaps are agreements between companies to exchange cash flows in different currencies. In this method, one party agrees to pay a fixed interest rate in one currency and receive a fixed interest rate in another currency, and vice versa. The amount of debt is swapped at the beginning of the contract and at the end.

How to choose the right hedging strategy

Selecting the appropriate hedging approach depends on the type of foreign exchange risk you face, your tolerance for risk, and the associated costs, as well as your operational capacity, market outlook, and regulatory factors. For short-term exposure, forward contracts or futures provide certainty, while options offer flexibility and potential upside if the market moves in your favor. If you're managing long-term risks, currency swaps might be the best option for larger transactions.

Real life case study of foreign exchange risk

Imagine a US company sells products to a European customer for 10 000 Euro with a 3 month payment deferment. The exchange rate today is 1 EUR = 1.10 USD. The company expects $11 000. If in 3 months the euro weakens and becomes 1 EUR = 1.05 USD, the company only receives $10 500. As a result, the loss from currency fluctuations is $500.

How to manage that foreign exchange risk

The US company from the example can protect itself from foreign exchange risk in several ways:

1. Hedge with a forward contract. The company should lock in today’s rate (1 EUR = 1.10 USD) to guarantee $11 000 in 3 months, even if the euro weakens.

2. Use currency options. Paying a small fee for the right (but not the obligation) locks in the opportunity to exchange at 1.10 USD/EUR in 3 months. The company is also protected against a drop while benefiting if the euro rises.

3. Invoice in USD. The European buyer pays in dollars.