Foreign Exchange Risk: What It Is, Why It Happens, and How to Reduce It

What is Foreign Exchange Risk?

Foreign Exchange Risk (also called currency risk or FX risk) is the potential for financial loss caused by fluctuations in exchange rates between two different currencies. It affects any company or investor involved in global transactions or holdings.

A recent survey revealed that 90% of U.S. businesses intended to purchase more currency options to hedge against FX exposure. They also hedged 48% of their currency exposure in the second quarter, up from 46% in the previous quarter.

Imagine a U.S.-based company agreeing to buy machinery from a German supplier for €1 million, payable in 90 days. If the euro strengthens against the dollar in that time, the business will have to pay more in USD than initially expected. This could potentially increase costs and cut into profits. 

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 these currency exchange rate risks exist primarily in unstable countries.

Transaction Risk

This occurs when a company buys products from a supplier in another country, and the price is in the supplier’s currency. If the supplier’s currency appreciates compared to the buyer’s, 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 subject to the same risk. 

While high exposure to exchange rates can lead to significant losses, savvy finance professionals hedge or mitigate those risks. 

Translation Risk

Refers to how a foreign exchange transaction will impact financial reporting and balance sheets; i.e., the risk that a company’s equities, assets, liabilities, or income will change in value due to 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 its subsidiaries’ financial statements into its 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 and multi-entity companies with many overseas subsidiaries and international transactions involving foreign currencies.
• Globalization has increased economic exposure for all companies in real-time. 
• 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 when dealing with unexpected changes in foreign exchange rates and currency value. However, there are ways to mitigate this risk.

Types of Foreign Exchange Risk

Ways to Mitigate Economic Exposure

Economic exposure—operating exposure—reflects how long-term exchange rate movements can affect a company’s future cash flows and competitive position. Unlike transaction exposure, which involves specific payments, economic exposure requires broader tools.

Operational Strategies

1. Diversify Production Facilities

Operating in different countries means companies can naturally hedge their cost structures.

For example, Toyota manufactures cars in Japan and the U.S. to offset currency swings between the yen and the USD.

2. End Product Markets

Selling in multiple currency markets spreads exchange rate risk and reduces dependency on one currency.

For example, Apple has revenue in dozens of currencies, balancing out any currency fluctuations.

3. Financing Sources

Borrowing in the market’s currency, where revenues are built, helps align income and debt repayments.

For example, a Brazilian exporter borrows U.S. dollars to match its dollar-based revenues.

4. Use Different Currencies

Engaging in contracts and financial transactions in a basket of currencies rather than a single foreign currency can reduce risk concentration.

For example, a multinational trader pricing out future contracts in USD, EUR, JPY, or other amount of foreign currency.

Currency Risk Mitigation

1. Matching Currency Flows

Aligning cash inflows and outflows in the same currency will ensure natural hedging.

For example, a U.K. firm exporting to the U.S. may purchase raw materials from U.S. suppliers in USD.

2. Risk-Sharing Agreements

These agreements enable both parties in a contract to share the impact of currency fluctuations.

For example, a European supplier and a U.S. buyer agree to split currency movement fees beyond a certain threshold.

3. Currency Swaps

Two companies exchange principal and interest payments in different currencies, helping stabilize cash flows.

For example, IBM and the World Bank used currency swaps in the 80s to effectively manage their debt exposure.

4. Hedging Instruments

Businesses use contracts like forwards, options, and futures to lock in exchange rates.

For example, a Canadian company that is expecting EUR revenues may sign a forward contract to sell euros at a fixed rate.

5. Invoicing in Your Home Currency

By invoicing exports in the home currency, firms shift the FX risk to their buyers.

For example, a U.S. exporter invoicing foreign customers in USD to avoid bearing exchange rate volatility.

Causes of Foreign Exchange Risk

Fluctuations in international currencies cause foreign exchange risk. There are several causes of these fluctuations. 

• Macroeconomic factors such as significant swings in exchange rates
  • Example: If interest rates rise relative to Japan’s, the USD may appreciate against the JPY, impacting the value of international contracts.
• Government policies
  • Can result in a dip or hike in market movement
  • Changes in inflation, interest rates, depreciation, import-export duties, and taxes impact the exchange rate
  • Example: The Swiss National Bank’s decision to unpeg the Swiss franc from the euro caused a 30% surge in CHF value overnight. 
• Sovereign risk: that a government is unable to repay its debt and defaults on its payments
  • It can directly impact 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. In 2025, the U.S. Dollar fell by more than 8%, reaching its lowest level in three years. This was attributed to uncertainties over tariff policies, recession fears, and reduced global demand.
  • Example: Argentina’s repeated defaults have led to peso devaluations and investor flight.
• Collapse of a foreign government
  • Example: Political unrest in Turkey has often led to lira volatility.
• 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 that business transactions are closed at the right time without risk of default
  • Example: A late payment in a weakening currency means receiving less real value than expected.

Two Examples of Foreign Exchange Risk

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

#1) An American equipment distributor agrees to buy 100 equipment cases 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 the value of the purchase was $50,000 

Due to production problems, delivery is delayed by three months, and 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 occur 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 is due, the exchange rate ratio shifts 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 the dollar’s value relative to the euro or pound, neither the supplier in Spain nor England would experience any transaction exposure because the deal occurred in their local currencies. 

These companies are unaffected 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.

3 Ways to Manage Foreign Exchange Risk

There are three ways to manage and mitigate foreign exchange risk for U.S. companies and their bottom line.

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

As the most direct and standard 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, the 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 and 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 delivery window between the two dates.

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

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

3. Match foreign currency receipts with expenditures. 

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, assessing the cost and effort required to maintain a banking account in a foreign currency and recording gains and losses resulting from currency conversions in financial statements is essential. These are significant drawbacks.

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

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

Tips on Converting Currency in Foreign Trade

Foreign exchange risk is an inherent consequence of making global payments. Here are key considerations to help global finance teams and B2B organizations manage that risk effectively:

• Transact in fully convertible currencies widely accepted in international trade, such as the U.S. dollar (USD), euro (EUR), Japanese yen (JPY), and British pound (GBP), to ensure liquidity, stability, and ease of settlement across borders.
• Avoid partially convertible currencies where governments restrict capital flows, which can delay or complicate fund repatriation. Common examples include the South Korean won (KRW) and Chinese yuan (CNY), which may be subject to tight foreign exchange controls.
• Explore digital currencies cautiously, such as Bitcoin (BTC) and Ether (ETH). While still unregulated in many jurisdictions, cryptocurrencies may serve as alternative settlement methods in select B2B contexts. For instance, El Salvador became the first country to adopt bitcoin as legal tender—a signal that digital currencies could play a growing role in cross-border trade.
• Consider accounts payable software for global FX management.

Frequently Asked Questions

Know Your Risks to Justify the Rewards

Selling globally and making international FX payments can significantly enhance the competitiveness and profitability of companies in the United States. When carefully executed, international expansion can drive substantial revenue growth and long-term resilience. 

However, your success hinges on preparation, specifically, the ability to identify and manage foreign exchange risk.

To recap, there are three primary types of FX risks to plan for:

• Transaction Risk – Exposure from cross-border payments and receivables.
• Translation Risk – Risk from converting foreign financial statements into the home currency.
• Economic Risk – Long-term impact of currency shifts on market value and cash flow.

Even well-intentioned global ventures can underperform if you lack a clear risk mitigation strategy.

Tipalti offers integrated FX tools that help businesses manage multi-currency payables, reduce transaction risk, and improve global cash flow visibility. Learn more about how Tipalti can support your currency management in your global payment processes by downloading our eBook, “How to Eliminate Currency & Forex Challenges in Payables.”