Globalisation has been a blessing to business owners as it has opened the doors to new markets that otherwise would never have been possible. Over the years of infrastructure development, businesses now have the means to expand overseas without much hassle, access a much wider range of consumers, and collaborate for better innovation from anywhere in the world.
However, there is one price to pay — the constant fluctuation of foreign currency exchange (FX) rates.
Managed properly, companies can turn exchange rate fluctuations into opportunities; but if managed improperly, can cost a substantial amount to the business.
In this article, we’ll be diving into the risks of foreign exchange volatility, identifying FX exposures, and how to reduce FX risks for your business.
Understanding foreign exchange (FX) risk
Foreign exchange risk, from a business perspective, is the potential financial loss that an international business may incur due to fluctuations in foreign currency exchange rates. Foreign exchange risk is also referred to as currency risk, FX risk, and exchange rate risk.
Often, FX risk is led by macroeconomic factors such as inflation, interest rates, political stability, and trade policies. Check out our full article here.
Breaking this down even further, there are three types of foreign exchange risk:
Transaction risk
Transaction risks are the risks faced by a company during a financial transaction between jurisdictions where there may be a change in exchange rates before the transaction settlement.
For instance, a US company with operations in Singapore is planning a $1,500 SGD transaction to its US-based account. If the transaction at the time of originating was 1 USD for 1.5 SGD, an5420d the rate drops to 1 USD for 2 SGD before settlement, the business will incur a loss on the difference.
The expected receipt, which is $1,000 USD ($1,500 SGD/1.5) would instead only be $750 USD ($1,500 SGD/2).
Translation risk
Translation risk, or translation exposure, is the risk faced by a company headquartered in one jurisdiction while conducting business in another jurisdiction. To be specific, this type of risk refers to how the fluctuations of foreign exchange rates impact a company’s assets, equities, liabilities, or income, and consequently, influence financial reporting.
Take a conglomerate for example — if the subsidiary companies are located in a different country and denominate their business transactions in the local currency, this causes the parent company to be vulnerable to translation risks because the parent company must translate the subsidiaries’ financial statements into its local currency.
Economic risk
Economic risks are also referred to as operating exposure or forecast risk and represent a company’s market value due to currency fluctuations. As such, economic risks are heavily impacted by macroeconomic factors such as geopolitical conditions, government regulations, or monetary policies.
Not just that, the exposure to economic risks is also greater for multinational companies operating in many different countries, which involves a large number of foreign currency transactions, and it can be difficult to measure precisely. Because of this, hedging against economic risks can be more challenging.
Identifying your business's FX exposures
Foreign exchange risk can impact businesses in a variety of ways, depending on the currencies they use and the nature of their business. To manage this risk effectively, it is important to first identify your FX exposures.
This involves assessing how different currencies can impact the business, and considering factors such as FX volatility. By analysing these factors, businesses can better understand their FX risks and develop appropriate risk management strategies.
Factors to consider in identifying FX exposures | Example |
Operating in multiple countries with different currencies | A company that exports goods to the US and Europe, while purchasing raw materials from Asia |
Carrying out transactions in foreign currencies | A company that invoices customers in Euros, but pays suppliers in US dollars |
Investing or holding assets in foreign currencies | A company that holds investments denominated in Japanese Yen |
Once businesses have identified their specific FX exposures, they can use this information to develop appropriate FX hedging strategies. By doing so, businesses can better protect themselves against foreign exchange risk and ensure their long-term profitability.
How to mitigate FX risks
Thanks to a variety of solutions in the market today, managing foreign exchange risk now ranges from simple (and low cost) to complex and advanced strategies. Here are five ways to reduce your business’s FX risks:
1. Transact in your local currency
Transacting in your own currency passes the exchange risk on to your counterparts.
For example, a Singaporean-based company may be able to insist on invoicing and payment in SGD from suppliers or foreign partners.
However, the caveat is that this predominantly applies to companies that are in a strong competitive position to negotiate to transact in only one currency. In addition, it can also be a challenge as there are certain costs that must be paid in local currencies, such as taxes and salaries.
2. Establishing boundaries within partnership contracts
For certain industries that are import/export-heavy, such as manufacturing, agriculture, mining, and global e-commerce, the FX risk exposure is typically larger than average as the element of foreign currencies plays a large role in the transaction. And within these groups of industries, certain partnership contracts may last for a few years.
In these cases, it may be possible to build foreign exchange clauses into the contract that allows the transactions to be recouped in the event that exchange rates deviate further than the initial range.
3. Forward contracts
Forward contracts are agreements to lock in a prevailing currency exchange rate for a set period. This is one of the most commonly used contracts to manage FX risks due to its simplicity. Essentially, a forward contract ensures that the exporter receives a pre-determined payment in their local currency despite the currency fluctuations.
The intent of this contract is to hedge a foreign exchange position to avoid a loss. However, a third party or an intermediary is needed to ensure both parties deliver on their promises, and subsequently, this would incur a small additional cost.
4. Currency options
Currency options give the holder the right, but not the obligation, to buy or sell the underlying currency at a specific rate before the expiry date. These are similar to forward contracts, however, the holders (which are businesses) are not required to exercise these contracts.
In simple words, if the contract’s exchange rate is unfavourable, the business does not have to execute the contract in exchange for foreign currencies. But, if the exchange rate is favourable, the business can choose to exercise its currency option contracts and pocket the difference between the initial strike price and the spot market price.
Here’s how it works:
- Assuming a company wants to use a currency option instead of a forward contract, they will have a pay a premium. For this example, let’s use $5,000 USD.
- If USD weakens against SGD from 1.1 to 1.2, then the company can exercise the option and avoid the exchange rate loss of $10,000.
- But if USD strengthens against SGD from 1.1 to 0.95, then the business can let the option expire. However, due to an increase in the exchange rate, the business will have gained a total of $15,000 (before deducting the $5,000 premium for the option contract).
5. A multi-currency wallet
A multi-currency account is a type of account that allows you to send, receive, and store multiple currencies in one account. In the context of this article, this means you can better manage different currencies and don’t have to make any FX conversions during periods of unfavourable rates.
Practically, this helps in safeguarding the profit margins of your foreign operations instead of letting the volatility of FX rates erode them.
It's also worth noting that no single hedging strategy is foolproof or suitable for all businesses. The key is to assess the business's specific needs, risk tolerance, and goals before choosing a hedging strategy. It's also important to monitor the effectiveness of the strategy and adjust it as necessary.
Check out Wallex’s Multi-Currency Wallet here.
Final notes
International businesses must be aware of the potential risks associated with fluctuating exchange rates. Fortunately, there is an abundance of strategies to help mitigate the exposure to these risks. Ergo, with the right payment service provider, businesses can essentially protect themselves from potential losses and set themselves up for long-term success.
At Wallex, supporting your business is our business. If you’re looking for a global payments partner to streamline your international expansion, please feel free to contact our team and we’ll make sure you have everything you need!
