A foreign exchange risk arises in international trade when transactions are conducted in two different currencies. Companies have various options to minimise this risk. Here we show you what these are and how the foreign exchange risk arises in the first place.
Foreign exchange risk: Definition
Foreign exchange risk is the term used to describe losses incurred through transactions in foreign currency when the exchange rate is unfavourable. This can have a negative impact on the value of investments made in foreign currency.
For this reason, hedging foreign exchange risks is an important part of financial controlling in a company that operates internationally. Exchange rates and the influences on them must be kept in mind, and appropriate solutions or strategies must be developed to reduce the foreign exchange risk to a minimum.
Causes of foreign exchange risk
Foreign exchange risks always arise when transactions are conducted in foreign currencies. For example, if a British company invests in the USA, it trades there in US dollars. However, its home currency is Pound Sterling. Depending on the current exchange rate between the US dollar and sterling, an investment can be favourable or unfavourable.
The same problem is faced not only by companies but also by investors who invest in markets where trading takes place in a currency other than their home currency.
Major types of foreign exchange risk
A distinction is made between three types of foreign exchange risk: Transaction risk: This risk arises when purchasing goods or using services that are settled in foreign currency.
Translation risk: This risk arises when a group has a subsidiary in another country and the balance sheet is in a different currency. If the subsidiary makes losses and the exchange rate is unfavourable, this has a negative impact on the group's balance sheet.
Economic risk: This risk exists when the market value of a company is strongly influenced by exchange rate fluctuations.
Foreign exchange risk examples
A British company buys goods in the USA. The price of the goods is quoted in US dollars as $100,000. As sterling is the home currency of the British company, it is the exchange rate that determines what the cost to the company will be.
At an exchange rate of 1 USD = 0.83 GBP, the company has to pay £83,000 for the purchase of goods. If the exchange rate is more favourable, for example 1 USD = 0.78 GBP, the company only has to pay £78,000.
The foreign exchange risk is particularly high if payment is not due until delivery, i.e. several weeks or months after the contract is concluded. If the contract is concluded at a time when the exchange rate of 1 USD = 0.78 GBP applies, but payment is not made until several weeks later, when the exchange rate is 1 USD = 0.83 GBP, the British company will have to pay £83,000.
Foreign exchange risk management: How does it work?
To avoid scenarios like the one above, companies often use hedging to keep their foreign exchange risk as low as possible.
Hedging foreign exchange risk
In hedging, the company enters into a contract (e.g. with a broker) that it can purchase a foreign currency at a predetermined exchange rate at a certain future date - regardless of the future exchange rate.
Example A UK company wants to buy goods from a trader in the USA to the value of $100,000 purchase. Delivery is in six months and payment is due on delivery. At the moment the exchange rate is 1 USD = 0.78 GBP.
To secure this exchange rate, the company enters into a futures contract. This stipulates that in six months' time it will exchange £78,000 for $100,000 US dollars and then use it to pay the trader.
If the exchange rate is 1 USD = 0.83 GBP in six months, the company will only have to pay £78,000. If it had not entered into a hedging contract, it would have to pay £83,000.
However, if the exchange rate is 1 USD = 0.75 GBP in six months' time, the company will still have to raise £78,000 rather than £75,000, so there is always the risk of missing out on an even more favourable exchange rate when hedging.
Invoicing in home currency to minimise foreign exchange risk
Another method of hedging foreign exchange risk is to agree with one's business partners to trade in a particular currency. A British company can suggest to the US trader that the deal be done in pounds sterling. If the trader agrees to this, the foreign exchange risk lies with him and not with the company.
Where the UK company provides goods or services to companies in other countries, it may insist that payment is made in pounds sterling rather than in the home currency of the other companies in order to eliminate its foreign exchange risk.
