Running a business inherently carries some risk. Operating your business internationally and sending and receiving payments in more than a single currency increases your risk.
In today’s competitive, international marketplace, it pays to be aware of the risks involved with performing transactions in multiple currencies, and how foreign exchange risks can affect your bottom line.
What is Foreign Exchange Risk?
Foreign exchange risk is when the value of the currencies you’re exchanging fluctuates, resulting in a financial impact.
If you purchase a product in another country and payment happens minutes later, the exchange rate probably won’t change much, or at all. Most of the time, the rate fluctuation over the course of a few minutes is minimal to nothing. So, the rate you expect to pay is what you end up paying.
However, often transactions are contracted in advance, and happen later. Let’s look at another example.
Suppose your company is located in the U.S. and you agree to buy 100 boxes of avocados from a company in Mexico, for 1000 MXN per box. When you sign the purchase agreement, the exchange rate is 1 USD to 20 MXN, so you expect to pay 50 USD per box. However, you don’t make payment on the shipment until you take delivery, which is three months later. During this time, the exchange rate has changed and is now 1 USD to 19 MXN, so you’re now paying 52.63 USD per box. The rate could go the other direction, also. If the exchange rate changed to 1 USD to 21 MXN, you’d pay 47.61 USD per box.
Either way, buying a product in another currency at a later date increases the risk that the exchange rate will change. If the exchange rate between two currencies you’re using changes and you lose money on a transaction or series of transactions, you run the risk of negatively impacting your business’s profit.
While you may do your best to estimate what currencies will do in the future, foreign exchange rates can be volatile. Rates can change quickly as a result of world events, trade policies, elections, or even the weather.
Three Types of Foreign Exchange Risk
There are three main types of foreign exchange risk that can affect your business.
Transaction Risk – Transaction risk is the simplest and most common foreign exchange risk. It occurs when the actual transaction takes place. The risk comes from the possibility of the rates changing so that the value of the currency is different than when the transaction started. Transaction risk is directly related to the delay between committing to a deal and actually making payment. The longer the time period between the agreement to make payment and the payment actually occurring, the greater the risk of the value of your currency going down, so that you end up paying more than what you initially intended.
Economic Risk – This is also known as operating exposure. Economic risk is the risk of a company’s value being affected by changing currency rates, and is the most complex type of foreign exchange risk. Any organization that does business internationally will be exposed to economic risk. However, a company must take measures to protect itself from fluctuations, or it carries the risk of depreciating currency and value. There can be a considerable impact on a company’s market value due to the possibility of volatile movement in the foreign currency market.
Translation Risk – This is also known as accounting exposure and affects multinational companies that have holdings or are operating in other countries. Translation risk happens due to the translation of the books into the home currency from another currency. Changes in the exchange rate between the currency in which a company reports and the currency in which it has its assets and liabilities can lead to big impacts on the balance sheet. Translation risk occurs during financial reporting of foreign operations that are reported in the home currency. While translation risk can have a large negative impact on a company’s financial results, balance sheet hedging can mitigate this risk.
How to Reduce Foreign Exchange Risk
There’s no way to entirely avoid foreign currency risk in international business. However, there are many strategies used to reduce it so that you can protect your profits and protect your bottom line. You may even be able to use exchange rates to benefit your business.
These strategies are known as hedging. They can help you reduce exposure to exchange rate fluctuations and manage your risk. They can be used alone or in combination with others, and can be tailored to fit your business. Some examples of hedging strategies are:
Currency Forwards lets you buy currency now and pay for it in the future.
Market Orders allow you to set a rate you want to pay and will execute an automatic transaction.
Multicurrency Accounts enable you to hold multiple currencies in a single account.
Spot Transactions let you quickly purchase and send over 130 currencies at the live rate.
You can learn more about hedging on the Monex USA website, or contact us today to speak to a foreign currency expert. We’re ready to help you with a custom solution for your international business.
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