Foreign exchange risk refers to the risk that fluctuations in currency exchange rates will impact a business’s financial performance or position. This risk is greatest when a business fx is involved; which means that the business deals in more than one currency. Business foreign exchange risk can also be indirectly incurred by other businesses that rely on imported goods and services.
Managing foreign exchange risk is important where business profitability is affected by exchange rate fluctuations. Businesses, where the core operation is not financial services, should manage the risk in such a way as not to expose the business to any financial risks while focusing on its core products or services.
Methods to managing the exposure to financial risks
Following the identification and measurement of potential exposure, the next step is to manage it.
The business can accomplish this through several means, but it should first identify whether its key stakeholders, such as its directors, are willing to take the risk. This will lead to a better understanding of what method is most suitable.
In general, there are four main methods:
- Forward exchange contract: Companies can lock in a fixed exchange rate until a specified date in order to protect themselves from adverse movement in exchange rates. Deliveries are made on the agreed date. However, this method creates a problem because the firm is locked into the contract price, even when rate changes are to its advantage.
The importer can protect themselves from any downward movement of the local currency against the other currency for the price of a premium by using a foreign currency option. However, the importer may benefit from any increases in the local currency against the other currency.
It is important for exporters to enter into foreign currency options protecting them from upward movements in the local currency. They can use the spot price of the currency in the event of downward movement in the local currency by abandoning the option.
The foreign currency option essentially works like an insurance policy against adverse exchange rate movements. It is usually necessary to pay a premium to conduct this transaction, which can be relatively expensive.
- Foreign currency options: They allow an entity to buy or sell foreign currency under a contract that provides them with the right but not the requirement to carry out the transaction at a later date.
For example, if an importer purchases goods denominated in AUD dollars for delivery within four months, then contracts a forward exchange contract with their bank, the importer then contractually must accept the AUDs they purchased at the rate available on the agreed-upon date for local currency. It is still the importer’s responsibility to honour the contract if the local currency strengthens against the US dollar, even if the agreed exchange rate is less favourable than today’s rate.
- Perfect hedge: You can use this method by matching any payments you make in foreign currencies with the incoming foreign currency inflows received at the same time. Due to the uncertainty of cash flow timing, this method is rarely used. In order to provide a ‘perfect’ hedge, both inflows and outflows must occur simultaneously.
- Bank accounts or loan facilities in foreign currencies: This can be used as an alternative method to manage foreign exchange risk when foreign exchange inflows and outflows don’t coincide. In order to manage the timing issues, foreign currency surpluses can be deposited into foreign currency accounts for later use, or foreign currency can be borrowed to pay for foreign currency purchases, and the foreign currency can then be used to repay the loan.
Similar to planning anything in the business and financial area, it takes time, effort, and customization to develop an effective strategy for managing FX risk for your company. As your company expands globally, a solid plan can aid in avoiding costly mistakes and helping you discover new opportunities. Openpayd can help you understand the risks involved with business fx, and knowing the proper methods to manage the exposure to these financial risks will keep your company protected and able to excel in the business sphere.