Foreign Exchange Risk: What It Is And How To Reduce It

Foreign exchange (FX) risk is a necessary component of conducting business internationally. Major currencies’ exchange rates are continually fluctuating, which leaves your company’s income unclear. By securing future exchange rates, many firms choose to get rid of this uncertainty. However, some companies see fluctuations in currency rates as a financial opportunity.

Foreign exchange risk is the risk presented to a company’s financial performance by fluctuations in currency exchange rates. By reducing margins, these shifting exchange rates can harm a company’s profitability.

Any currency may go through times of extreme volatility. The present COVID-19 scenario is causing foreign exchange markets to see levels of volatility not seen since the 2008 Global Financial Crisis.

A company that depends on importing or exporting commodities may be made or broken by these levels of volatility, but you can reduce these risks by putting the proper safeguards in place.

Reducing The Risk Of Currency Exchange

Spot Transactions

The simplest way to control foreign investment risk is probably through spot transactions or spot agreements. A single foreign exchange transaction is known as a “spot transaction” and involves buying something and paying for it immediately (or rather, within two business days). If you’re satisfied with the current foreign exchange rate, you may book in a conversion with a spot transaction since it gives you very little notice time and a smaller window for risk. Even if you could miss out on a better rate in the future, you will reduce the chance that your chosen foreign currency will fluctuate in the future right now.

Natural Hedge

Foreign currency bank accounts can also be an excellent method to offer a natural hedging for companies who currently sell internationally (for instance, in the US). For these companies, you can leave your USD balance in your USD foreign currency account rather than receiving in USD and converting it to AUD. This is especially useful if you have expenditures that are also in USD because you can protect yourself from any AUD changes by just keeping USD in your account. Additionally, you avoid any possible double conversion costs that the banks may impose (for example, converting from AUD to USD and then back to AUD).

Transact In Your Own Currency

Businesses with a large identity that sell a product or service may only be able to conduct business in one currency. For instance, a US business operating internationally may be allowed to insist on receiving invoices and payments in USD. By doing this, the exchange risk is transferred to the local client/supplier. This may be challenging in practice since some expenses, including taxes and salaries, must be paid in local currency, but it could be feasible for a business that conducts most of its business online.

Inspect Your Contracts

From the standpoint of FX risk, your present contracts may be improved. Can you, for example, add protection to business contracts? There may be a chance to add FX terms to the contract that give a return should exchange rates diverge more than an agreed amount, especially when it comes to long-term contracts. Or, is it possible to shorten the time between a contract and payment? This will lessen the impact of significant exchange rate fluctuations.

Foreign Currency Bank Accounts

Creating a foreign currency account is an easy approach to control the risk associated with foreign exchange. Simply deposit the needed amount (plus a designated surplus) into the account to act as a risk hedge. By converting and storing the foreign currency until the time comes to make the payment, this strategy enables you to take advantage of favorable FX rates when they are there. Additionally, it guarantees the appropriate cash will always be accessible and accounts for possible currency changes.

Recognize That Your Currency Movements Are Distinct

 

Every firm is different, and this can be seen in both your money flows and the organization of your assets and liabilities. The impact of currency swings must be understood, and whether to hedge or not is not a simple matter of rolling the dice.

Forward Exchange Contract (FEC)

A FEC enables your company to protect itself from price changes by securing an exchange rate at the current rate, which is effective until a date you choose. This contract gives you the assurance that you won’t actively lose money on your foreign exchange, but it also prevents you from profiting from any rise in exchange rates. The costs associated with this contract are another drawback. A FEC secures a certain amount of money. There is a contractual cost to cancel the remaining amount, for instance, if you lock in US$10,000 but only require US$8,500 at the conclusion of the contract.

Include Protection In All Of Your Business Dealings And Contracts

Many businesses that manage major infrastructure projects, including those in the oil and gas, power, or mining sectors, are frequently bound by long-term contracts that might include a sizable foreign currency component. These contracts might run for many years, and if the exchange rate changes after the price have been agreed upon and the contract is signed, it could risk profitability. Foreign exchange provisions that provide for income to be recovered in the event that currency rates diverge more than an agreed amount may be incorporated into the contract. Naturally, this shifts any further foreign exchange risk on the customer or supplier and will need to be discussed, just like any other contract clause.

Avoid Letting Hedges Consume All of Your Operating Capital

The main benefit of a hedge is that it safeguards your earnings against unfavorable changes in the foreign exchange rate. The disadvantage is that your bank will want collateral for whatever FX facility it grants you, which it will typically take from your operating line. Less working capital will result from this, which is never a good thing. The Foreign Exchange Facility Guarantee is an EDC solution created specifically for this circumstance (FXG). An FXG offers a complete assurance of the security your bank needs in order to grant you an FX facility. You will have complete access to your working capital once the guarantee is in place since the bank won’t be required to take the security from your operating line.

Bottom Line

Creating a successful FX risk management strategy for your business involves time, effort, and customization—just like organizing a vacation abroad. As your business expands internationally, a sound strategy may help you avoid costly mistakes and uncover unexpected possibilities.