The foreign exchange market is an area that carries risk due to frequent variations in the price of international currencies. It is nevertheless possible for businesses to analyse and assess risk when they make foreign exchange transactions.
With careful consideration, you can ensure that your company spends money and receives payments in the most efficient and cost-effective way.
What Is Foreign Exchange Risk?
Foreign exchange risk is any loss in value that can come with performing an international transaction. It is also called FTX risk or currency risk.
This sort of risk is something that businesses which transact globally should be aware of in order to make the most of each transaction. Fortunately, there are plenty of ways to ensure that your business is protected from foreign exchange risk.
Here's what you should know.
Types of Corporate Foreign Exchange Risk:
Transaction risk is a specific type of loss that a business might face if it makes a purchase from a company in another country.
It occurs when the seller's currency gains value against the buyer's currency. In this event, the company making the purchase will need to spend more money than it otherwise would - thus incurring the risk.
Translation risk is another type of risk. It occurs when a company needs to convert the funds of an international subsidiary into another currency.
Translation between currencies almost always involves conversion fees and varying exchange rates. As a result, a company may lose value on its money when it needs to translate funds to another currency.
Economic risk is also known as forecast risk. It occurs whenever a company's open market valuation (or market cap) is exposed to fluctuating currency prices.
How to Protect Against Foreign Exchange Risk
There are plenty of ways to protect against foreign exchange risk, but you'll need to consider your transactions carefully. Here's what you should try to do.
Transact in Your Own Currency
By transacting in your home country's own currency - or in the currency that you intend to spend - you can avoid price fluctuations. Because you won't need to convert funds, you won't lose value through conversion and banking fees.
Unfortunately, this strategy is not always possible, especially if you work with customers and businesses in more than one country.
You may be able to have customers pay in your preferred currency. However, many will choose not to make a purchase if they find out that the cost of conversion falls on them. As such, this approach involves a trade-off.
Plus, you may also be unable to transact entirely in your own currency if you have to pay foreign taxes and salaries according to local laws.
Build Protection into Contracts and Commercial Relationships
You can use written contracts to protect against foreign exchange risk. Such contracts can be negotiated to ensure that business partners transact at a fair or favourable exchange rate, even after actual market rates change.
This strategy comes with a downside. Creating and reviewing a contract generally comes with legal costs. Plus, some potential business partners will chose not to sign such a contract, possibly causing you to lose business and revenue.
Otherwise, contracts can be an effective long-term solution that lasts for years.
You can additionally create arrangements through forward contracts and currency options. In forward contracts, businesses agree to buy or sell an amount of foreign currency on a date. In currency options, companies can buy or sell a currency on or before a date at a specified rate without obligation.
Though these arrangements are common, they are complex. Without a close understanding of the market, they may not be to your benefit.
Foreign Exchange Natural Hedging
Companies can engage in natural hedging and avoid exposure to the forex market by investing in assets that are negatively correlated. In other words, businesses can cancel out some losses in value in this way.
An alternate approach to natural hedging involves spending an asset that your business typically receives (such as the Chinese yuan) on a product or service in the relevant country (in this example, China).
These strategies require extensive work from a financial team. As such, they may not be appropriate for small businesses with limited staff.
Foreign Currency Bank Accounts
In order to pursue the above strategies, you can transact through a bank account or multi-currency account that supports foreign currency.
At Payset, we provide a multi-currency bank account with an IBAN number plus support for 38 currencies. We serve customers in over 200 countries.
We prepare conversion fees on request. If you transact in a currency that is different from the one that you received, you'll pay transaction fees as low as 0.45% plus a conversion fee. And, if you choose to hold money as you receive it, you won't have to pay any conversion fees at all.
Causes of Foreign Exchange Risk:
When companies participate in the global economy, they affect the economies of their own countries as well as the economies of others.
Currently, the global economy provides companies with access to labour pools and a variety of other opportunities. Consumers and businesses alike are now able to buy products and services from virtually anywhere in the world.
These trends mean that some countries have benefited while others have not, while many others exist in uncertain conditions. The state of the global economy at any given time affects the value of each and every country's currency.
Government policies can directly or indirectly affect the financial market. For example, governments can make changes to fiscal policy (ie. spending), monetary policy, inflation, interest rates, taxation, and much more.
All of these factors can affect the exchange rate of the local currency that you use, weakening it or strengthening it against other foreign currencies.
Sovereign risk is the likelihood that a country will miss or default on a debt obligation. This can occur when country leaves a trade union, experiences inflation, or does not have enough resources when bonds mature.
The issue extends to the banking system and can devalue a country's own native currency. This, in turn, can affect general investors.
Credit risk refers to the possibility that one party involved in a foreign exchange transaction will fail to satisfy an agreement or an arranged transaction.
One counterparty may default on an agreement, which consequently can impose costs on the other party if they are forced to return funds to the market. This makes up the final type of foreign exchange risk.
Foreign Exchange Trading: The Danger for Businesses
Foreign exchange trading comes with risks - not just the risk of value loss, but also the risk that your company will lose business if risks are not handled correctly.
However, following the advice above will give you a way to minimise or eliminate risk. Business always comes with costs, but accounting for these risks and transacting in a savvy way can help your company survive in the international market.
Regardless of which strategies you pursue, you'll need a bank account or multi-currency account in order to make cross-border transactions.
To apply for a Payset account, click below.