Understanding Foreign Exchange Risk

What is Foreign Exchange Risk?

Put simply, foreign exchange risk refers to the chance that an investment’s value could decrease due to changes in currency exchange rates. 

When dealing with foreign currencies, business owners often tap into currency forecasts to anticipate potential market fluctuations, but it is no easy task. Regardless of the size of your business venture, understanding and mitigating foreign exchange risk should be a high priority when planning for successful cross-border transactions. 

How does Foreign Exchange Risk affect international transfers?

Foreign exchange risk can impact the financial positioning of a business and there is the potential for risk whenever a business deals with currency conversion. This is because the rate could change between the time of the transaction and the time the payment has been received and converted into local currency. 

Companies that make mass international payments for business – to pay foreign suppliers, contractors or employees – are most vulnerable to substantial foreign exchange risk. 

Investors, who engage in international trading in multiple countries, may also be affected as their financial transactions will be denominated in a currency other than the local currency where the investor or business is based.

The different types of Foreign Exchange Risk

Next we will run through the three main types of risk experienced by business owners or investors. 

1. Transaction Risk: This risk involves real cash flow movements when setting up a business transaction or investment in a foreign currency. The value of the base currency is exposed from the time between entitlement and payment as changes in the foreign exchange rates mean these payments could change in value
2. Translation Risk: This refers to the exchange rate risk associated with investors or businesses that deal in foreign currencies and list foreign assets on their balance sheets. Anyone dealing with foreign assets are required to convert the value from foreign currency into the local currency of the business or investor 
3. Economic/Operating Risk: This type of risk refers to the long-term market value of a company or investor’s assets. It is caused by the effect of unexpected changes to the currency which may impact a company’s or investor’s cash flows.
   
   

How to mitigate foreign exchange risk

Companies counter the risk of market fluctuations affecting their international transfers and payments by adopting the following foreign exchange instruments: 

1. Spot Exchange Rate: These allow an individual or firm to buy the required foreign currency at a so-called Spot Rate at time of transaction. This eradicates the time gap when agreeing on a price and making a payment.
   For instance, if X were to agree to buy goods from Y in INR, X could simultaneously sign the contract and buy INR to pay Y even if the payment was not due for a few weeks, thus removing the risk of INR depreciating in the intervening period

2. Hedge Exchange:  Hedge Exchange is an agreement between two parties to make a foreign currency trade in the future, with the cost of that transaction being agreed beforehand. The sole purpose of a Hedge Exchange is to protect a current position or upcoming international transaction. One of the most common Hedge Exchange options is a Forward Contract. 
3. Currency Swap: In essence, a currency swap is an interest rate derivative whereby two parties exchange the principal amount of a loan and the interest in one currency, for the principal and interest in another currency. For instance, if a British company needs EUR and a French company needs a similar amount of GBP, the British company could borrow GBP while the French company borrows EUR. The companies will then swap the currencies, as per the prearranged terms, giving each company the foreign currency it needs while allowing each party to pay back the loan in its local currency, thus eliminating foreign exchange rate risk. 

Bottom line

Foreign exchange risk poses a very real threat to the value of international business transfers, as outlined in the scenarios on this page. With our help, you can save yourself money and stress, by familiarising yourself with the possible outcomes and implementing the recommended tools detailed in this guide. We strive to equip our readers with a range of money management and FX trading skills; find out what else you can learn from our other Sending Money guides today.

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