Understanding Foreign Exchange Risk

What is Foreign Exchange Risk?

Foreign exchange risk is the chance that a company will lose money on international trade because of currency fluctuations. Also known as currency risk, FX risk and exchange rate risk, it describes the possibility that an investment’s value may decrease due to changes in the relative value of the involved currencies. It affects investors and any business involved in international trade. 

The risk occurs when a contract between two parties specifies exact prices for goods or services as well as delivery dates. If a currency’s value fluctuates between the date the contract is signed and the delivery date, a loss for one of the parties could result.

Types of Foreign Exchange Risk

There are three main types of foreign exchange risk, also known as foreign exchange exposure: transaction risk, translation risk, and economic risk. A fourth – jurisdiction risk – arises when laws unexpectedly change in the country where the exporter is doing business. This is less common and exists primarily in unstable countries. 

Transaction Risk

Occurs when a company buys products from a supplier in another country, and price is provided in the supplier’s currency. If the supplier’s currency appreciates vs. the buyer’s currency, the buyer will have to pay more in its base currency to meet the contracted price. 

The risk of transaction exposure typically impacts one side of a transaction: the business that completes the transaction in a foreign currency. The company receiving or paying a bill using its home currency is not subjected to the same risk. 

While a high level of exposure to exchange rates can lead to major losses, savvy finance professionals hedge or mitigate those risks. 

Translation Risk

Refers to how a foreign exchange transaction will impact financial reporting; i.e., the risk that a company’s equities, assets, liabilities or income will change in value as a result of exchange rate changes.

This risk occurs because subsidiaries of a parent company in another country denominate their currency in the countries where they are located. The parent company faces potential losses when it must translate the subsidiaries’ financial statements into its own country’s currency. 

Economic Risk  

Also known as operating exposure, this refers to the impact on a company’s market value from exposure to unexpected currency fluctuations. This can affect a company’s future cash flows, foreign investments and earnings. 

Economic exposure can have a substantial impact on a company’s market value:

• Exposure is greater for multinational companies with many overseas subsidiaries and a large number of transactions involving foreign currencies.
• Globalization has increased economic exposure for all companies. 
• Effects are far-reaching and long-term in nature.
• Economic exposure is difficult to measure precisely.

Because of this, hedging against economic exposure can be challenging as it deals with unexpected changes in foreign exchange rates. However, there are way to mitigate this risk.

Ways to Mitigate Economic Exposure

*Refers to conducting business transactions and borrowing in one currency to better match cash outflows and inflows. 

**Where two companies borrow each other’s currencies for a period of time.

2 Examples of Foreign Exchange Risk

How you exchange foreign currency can affect the results from expanding your business globally. Here are two examples.

1. An American equipment distributor agrees to buy 100 cases of equipment from a Spanish supplier at 500 euros per case, or 50,000 euros total, with payment due upon delivery. 

• The U.S. dollar and Euro are at parity: $1 = 1 Euro 
• The American company expects to pay the agreed-upon amount of 50,000 euros upon delivery, when value of the purchase was $50,000 
• Due to production problems, delivery is delayed three months, and the value of the U.S. dollar depreciates against the Euro during that time, so 1 euro now equals $1.10. 
• The contracted price remains 50,000 Euro, but the dollar amount that the U.S. company must pay is $55,000.

2. A U.S.-based company intends to purchase a product from a supplier in England.

·         The American company agrees to negotiate the deal when the pound/dollar exchange rate is at a 1-to-1.3 ratio (1 pound = $1.30).

·         Once the agreement is complete, the sale could take place in days, weeks, or months. During that time, the exchange rate may change, for better or worse to the American company.

·         When the sale is completed and payment due, the exchange rate ratio might have shifted to a more favorable 1-to-$1.25 rate or a less favorable 1-to-$1.40 rate.

In these examples, despite any change in value of the dollar relative to the euro or pound, neither the supplier in Spain or England would experience any transaction exposure because the deal took place in their local currencies. These companies are not affected if it costs the U.S. company more dollars to complete the transactions because the prices, as dictated by the sales agreements, were set in euros and pounds, respectively.

Foreign Exchange Trading

Yet another currency risk mitigation strategy is foreign exchange trading, where companies are trading in the currency of different countries. Also known as hedging, this financial strategy helps manage exposure and foreign exchange risk and financial loss. Hedging offsets a potential loss from foreign exchange trading by taking an opposite position in a related currency.

Example: A U.S. company plans to buy products from France at a future date. The dollar and franc are equal, but the franc is expected to appreciate against the dollar.

Hedging strategy: The company buys francs at the current price, which is at parity with the dollar. It then makes its future purchases in francs.

Causes of Foreign Exchange Risk

Foreign exchange risk is caused by fluctuations in international currencies. There are several causes of these fluctuations 

• Macroeconomic factors such as significant swings in exchange rates

• Government policies
  • Can result in a dip or hike in market movement
  • Changes in inflation, interest rates, import-export duties and taxes impact the exchange rate

• Sovereign risk: that a government is unable to repay its debt and defaults on its payments
  • Can have a direct impact on investment rates as repercussions can trigger other business-related troubles. 
  • Includes political unrest and even a change in government policies, which can impact the exchange rate and, in turn, affect business transactions.

• Collapse of a foreign government

• Credit risk: that the counterparty will default in making the obligations it owes
  • Out of a seller’s control as it depends on another party’s commitment to pay its debts
  • Counterparty’s business activities must be monitored so business transactions are closed at the right time without risk of default

3 Ways to Manage Foreign Exchange Risk

For U.S. companies, there are three ways to manage and mitigate foreign exchange risk.

1. Establish a forward contract with a bank or foreign exchange service provider. 

As the most direct and common method for managing foreign exchange risk, this option ensures that a U.S. exporter will receive a predetermined payment in U.S. dollars even if the rate fluctuates. To set one up, the exporter must know three things: the foreign currency amount; date the importer will pay, and the currency exchange delivery date.

Setting up a forward contract involves several steps:  

• Exporter agrees to accept payment in a different currency, such as euros.
• Exporter contacts a bank or foreign exchange service provider to negotiate a 60-day forward rate. (Fees for forward contracts, along with their rates and terms, vary.) 
• Exporter and importer finalize sales price and payment terms with a commitment from the bank.
• Exporter then enters into a forward contract with its bank to lock in the rate and commit to a delivery date to exchange euros for U.S. dollars.
• Finally, the importer pays the exporter on time.
• Exporter delivers the euros to its bank in exchange for U.S. dollars.

If the exporter is uncertain when the importer will pay, an alternative is to request a window forward contract with the bank or service provider. This gives the exporter a window of delivery between the two dates.

2. The exporter accepts foreign currency payments only with cash in advance. 

This option is ideal for small transactions as well as for new relationships with importers. It is simple, ensures full payment, and is most risk-free. But some importers may balk, as cash in advance is their least desirable method of payment.

3. Match foreign currency receipts with expenditures. 

Here, the exporter sets up a foreign currency bank account to conduct transactions and eliminate currency conversion fees. This is ideal for U.S. exporters that use the same foreign currency with different trading partners. 

With this option, it’s important to assess the cost and effort required to maintain a banking account in a foreign currency and record gains and losses resulting from currency conversions in financial statements. These can be fairly significant drawbacks.

Finally, before agreeing to an importer’s foreign currency requests, you’ll want to consult with a bank to learn:

1. When should an exporter consider selling in a foreign country?
2. How common is it for a small exporter to set prices in a foreign currency?
3. What type of transactions are most suitable for foreign exchange?
4. What are the fees for using a forward contract?

Tips on Converting Currency in Foreign Trade

Foreign exchange risk is a consequence of international trade. Here are some important considerations to help you limit that risk. 

• Trade in fully convertible currencies that are common in international trade such as the U.S. dollar, euro, Japanese yen and British pound. 
• Avoid transacting in partially convertible currencies where governments limit the amount that can exit or enter the country. This includes the South Korean won and Chinese yuan. 
• Consider digital currencies such as bitcoin and ether. Although unregulated, they can serve as a substitute for legally recognized currency. El Salvador became the first country in the world to accept bitcoin as legal tender, and other countries are expected to follow its lead.

Know Your Risks to Justify the Rewards

Selling internationally greatly enhances the competitiveness and profitability of U.S. companies. When carefully executed, it can significantly increase your bottom line. As this article shows, however, knowledge, planning and the development of risk mitigation strategies must precede any international trade efforts. Otherwise, you could fail to realize the benefits, and profits, from a global business expansion.