Foreign exchange risk: What causes it and how to reduce it

Key takeaways

• Foreign exchange risk is the risk of currency exchange rates fluctuating, which can affect your business’ bottom line. 

• Solutions that can help mitigate foreign exchange risk include forward contracts, hedging strategies, and multi-currency accounts.

• Fintechs like Airwallex offer simple ways to mitigate FX risk, with multi-currency solutions and scheduled conversions.

Imagine you run a US company that imports goods from Europe. If the euro strengthens against the dollar, you’ll have to pay more in USD for your imports. And if your business operates globally, managing multiple currencies can expose you to greater currency fluctuations. Foreign currencies fluctuate day-to-day, so the cost of supplies can fluctuate from one day to the next. This fluctuation is known as foreign exchange risk.

Foreign exchange risk, also known as currency risk or exchange rate risk, can impact your business' profitability and financial stability. Read on to find out what causes foreign exchange risk, and how to mitigate these risks.

What is foreign exchange risk?

Foreign exchange risk is the risk of currency exchange rates fluctuating, which can affect the value of your business transactions and assets.

For example, when a US-based company imports goods from Europe, it faces the risk that the euro will strengthen against the US dollar, making the goods more expensive. On the other hand, if the euro weakens against the dollar, goods will become less expensive. These fluctuations can cause you to gain or lose monetary value, so it's important to understand and manage this risk.

If your business operates internationally, you may often have to pay for goods, services, or investments in foreign currencies. When exchange rates move unfavourably, it increases costs, reduces profit margins, and even affects long-term strategic decisions. That’s why it’s important to have strategies in place to mitigate against foreign exchange risks and other cross-border fees.

The main types of foreign exchange risk

Let’s look at the three main types of foreign exchange risk:

Transaction risk

Transaction risks occur when you convert one currency into another to complete a transaction. For example, if a US company agrees to sell goods to a customer in Europe for €100,000, and the exchange rate between the US dollar and the euro fluctuates between the contract's signing and the payment date, the company could end up with less than expected. This could diminish profit margins and introduce financial instability. This could hurt your profit margins. To counter this fluctuation, you can fix exchange rates with tools, such as forward contracts or scheduled conversions.

Economic risk

Economic risk refers to the potential losses or gains that you might face due to changes in exchange rates. These fluctuations can directly influence your competitiveness. For example, your costs could rise in a foreign market due to a stronger local currency, making your company less competitive against local producers. This could lead to a loss of market share and reduced future earnings. While economic risk is more challenging to manage, strategies like diversifying your business’ operations across markets and thoughtful pricing can help.

Translation risk

Translation risk occurs when exchange rate fluctuations distort your financial reporting figures. It can happen when you consolidate your financial statements across foreign subsidiaries. Your financial statements might be denominated in different currencies, and when you convert them into your home currency, exchange rate fluctuations can affect their value.

For example, imagine you run a US company with a subsidiary in the UK. If you report your UK subsidiary’s profits in pounds, and the pound weakens against the dollar, your UK profit will appear smaller when consolidated into your US financial statements. While translation risk doesn’t directly affect your cash flow, it can impact your financial reporting and investor perceptions.

What causes exchange rate volatility 

If you've ever dealt with cross-border payments and transactions, you’ll know that it isn’t always possible to secure favourable exchange rates. While it’s not possible to completely mitigate exchange rate volatility, knowing what causes them can help you better prepare your business. Here are the main causes of exchange rate volatility:

Economic performance, like GDP and inflation

Exchange rate volatility is often influenced by a country's economic performance, as seen in indicators like GDP (Gross Domestic Product) and inflation. A strong economy typically leads to a stronger currency because investors feel more confident about its stability and growth. For example, if a country has a higher GDP growth rate than its trading partners, its currency might strengthen, making exports more expensive and imports cheaper. This can significantly affect businesses operating in global markets.

Political events and instability, such as elections and policy changes

Political events and instability can cause sudden and unpredictable changes in currency values. Elections, policy changes, and geopolitical tensions are common triggers. A political scandal or a change in government can reduce investor confidence, leading to a sell-off of the country’s currency. Trade disputes and sanctions can also disrupt international trade, causing immediate and severe exchange rate changes.

Central bank policies, such as interest rate adjustments

Central bank policies can significantly impact exchange rate volatility. Raising interest rates can attract foreign investment, causing the currency to appreciate. Lowering interest rates can stimulate domestic spending and investment but may weaken the currency. If you have foreign loans to support your global operations, central bank policies can impact you. If there’s a sudden interest rate hike, it'll make it more expensive for you to repay that loan.

Global occurrences, such as pandemics and natural disasters

Major global events can strongly impact exchange rates. These events can disrupt supply chains, reduce consumer demand, and create economic uncertainty. During the Covid-19 pandemic, many currencies fluctuated significantly due to lockdowns and economic stimulus measures. The resulting changes in trade volumes and investment flows caused currencies to rise or fall sharply.

Speculation and trading activities

Speculation and trading activities by financial institutions can add to the unpredictability of exchange rates. Traders and investors often make decisions based on market sentiment and expectations, which can amplify the effects of economic and political events. This speculative behaviour can lead to rapid and sometimes irrational movements in currency values.

Four ways exchange rates can affect your business 

Exchange rates can affect your import costs, the value of your foreign investments, and your tourism and export activities. Here, we break down the key ways exchange rates can impact your business:

1. Exchange rates can impact the price of imports

When your local currency weakens against foreign currencies, the cost of imported goods and services rises. This increase can lead to higher production costs, which in turn may squeeze profit margins. On the other hand, if your local currency strengthens, you can benefit from lower import costs, potentially increasing your profitability.

2. Exchange rates can impact the price of exports

If your home currency appreciates, your products become more expensive in the international market, potentially reducing your competitive edge. This price increase can lead to reduced sales and market share. On the other hand, a weaker currency can make your exports more affordable and competitive, driving up demand and increasing sales. This volatility can make it challenging ‌for you to plan and budget effectively, as sudden changes can alter your pricing and cost structures.

3. Exchange rates can impact the value of foreign assets

If you have assets in a foreign country, the value of those assets can appreciate or depreciate based on the exchange rate. For example, if your home currency is US dollars and you hold assets in euros, a stronger US dollar can make your euro assets worth less when converted back into US dollars.

4. Exchange rates can impact international travel costs

Exchange rate fluctuations can affect both inbound and outbound tourism. When a country’s currency weakens, it becomes more attractive for international tourists to visit, boosting the local tourism industry. But if your business relies on outbound tourism, a stronger local currency can make travel more expensive for your customers, reducing bookings and revenue.

Example: How foreign exchange risk can affect your business

Imagine you run a craft brewery and you source high-quality hops from Germany. You agree to buy a shipment of hops for €3,000, with the payment due in 30 days. At the time, the exchange rate is 1 EUR to 1.15 USD, so you expect to pay around US$3,450.

But 30 days later, the euro strengthens, and 1 EUR now buys 1.20 USD. Now, you need to pay US$3,600 for the same €3,000 shipment. The 0.05 change in the exchange rate has cost you an additional US$150.

This extra US$150 might seem small, but if your craft brewery operates on tight margins, it can make a big difference. You might have planned to use that money for marketing, new equipment, or even just keeping a healthy cash flow. Instead, it's now tied up in a higher payment for the same goods.

The unpredictability can make it hard for you to forecast future expenses and revenues, and make you more cautious about long-term investments. To manage these risks, many businesses use foreign exchange risk management strategies, like hedging, to lock in current exchange rates and minimise the impact of market volatility. These types of strategies can help you keep the cost of future shipments stable for more predictable financial outcomes. It can also help you maintain a competitive edge so you can continue to offer your customers high-quality, cost-effective beer.

Ways to mitigate foreign exchange risk

When you’re operating globally, exchange rate fluctuations can make it hard to maintain stable cash flow. But with the right tools, you can mitigate the impacts of sudden currency changes.

Forward contracts

Forward contracts let you lock in an exchange rate for the future. It’s like making a deal now to buy or sell a specific amount of currency at a fixed rate on a future date. By using forward contracts, you can avoid the surprises that come with market movements and keep your costs stable. Some fintechs, like Airwallex, offer similar offerings, such as scheduled conversions, with more flexibility and smaller prepayment amounts than those offered by traditional banks.

Example: Example: You need to buy €3,000 worth of hops from Germany in 30 days. You agree to a forward contract today that locks in the exchange rate at 1.15 USD to 1 EUR, with 3,450 USD buying you 3,000 EUR. No matter what happens to the exchange rate over the next 30 days, you’ll pay US$3,450 when the shipment arrives.

• Pros: You know exactly how much you’ll pay, which helps with budgeting and financial forecasting. It also reduces the uncertainty of future exchange rate movements, making it easier to plan long-term.

• Cons: If the exchange rate moves in your favour, you’re still locked into the agreed rate. There might also be a small fee or premium to enter into a forward contract.

Hedging strategies

Hedging involves using financial derivatives to minimise potential losses from exchange rate fluctuations. Some common hedging tools include futures, options, and swaps. For example, currency futures let you enter into a contract to buy or sell currency at a future date, much like forward contracts but on a regulated exchange. Currency swaps, on the other hand, involve exchanging principal and interest payments in one currency for the same in another, which can be useful for long-term risk management.

Example: You decide to use a currency futures contract to hedge your risk. You agree to buy €3,000 worth of hops in 30 days at a future exchange rate of 1.15 USD to 1 EUR. If the actual rate goes up to 1.20, you can use the futures contract to buy the euros at the lower rate, saving you money. If the rate goes down, you can choose to buy at the market rate instead.

• Pros: You’re protected from significant losses if the exchange rate moves in your favour. Futures contracts are also traded on regulated exchanges, which adds a layer of security.

• Cons: Hedging can be more complex and might require more financial expertise to manage. There are also transaction fees and potential margin requirements for futures contracts.

Natural hedging

Natural hedging is a simpler and often more cost-effective way to manage risk. The idea is to align your import and export currencies to offset each other. If you import raw materials in one currency and sell your finished products in the same currency, you'll naturally minimise the exchange rate risk. You'll need to plan carefully for this strategy, and might not always align with your business model, but it can be a great way to keep your risk in check without involving more complex tools.

Example: You import hops from Germany in euros and also sell your beer to a distributor in Germany, receiving payment in euros. By aligning your import and export currencies, you naturally offset the exchange rate risk. If the euro strengthens, the cost of your imports goes up, but the value of your exports also increases, balancing out the impact.

• Pros: It’s a straightforward and cost-effective way to manage risk, and you don’t need to pay for financial instruments or contracts.

• Cons: You can’t always control the currencies you receive or pay in, especially if you deal with multiple currencies. It might also not align with your import and export strategies.

Multi-currency accounts

One of the simplest ways to manage foreign currency risk is to hold a multi-currency account. Multi-currency accounts let you hold and manage multiple currencies in one place. You can receive, hold, and spend funds in multiple currencies, without having to convert currencies. They also allow you to easily transfer funds between different currencies, with some accounts offering favourable exchange rates.

Example: You run a US business and open a multi-currency account with your financial provider or a modern fintech. When you receive payment in euros from your German distributor, you can hold the payment in euros in your account until you need to pay your hops supplier. This way, you avoid the immediate cost of converting to USD and back, and you can wait for a more favourable exchange rate when you need to convert.

Fintechs, like Airwallex, offer multicurrency accounts integrated with both corporate cards and payment processing on one platform. These products let you collect multi-currency payments via diverse payment methods, as well as pay international vendors from the same balances.

• Pros: It’s easier to manage multiple currencies in one account. You can also save on conversion and foreign transaction fees, and take advantage of better rates when you do need to convert funds.

• Cons: You’ll still need to monitor exchange rates to decide when to convert currencies. However, some accounts offer favourable rates so you can access low interbank rates anytime without having to manage complex contracts or hedging strategies.

Manage foreign exchange risk simply with Airwallex

Get multi-currency solutions and schedule conversions on one platform

The right financial partner can help you expand your global operations while reducing foreign exchange risk. With an Airwallex Business Account, you can make and receive global payments without having to navigate the complex requirements of traditional banks to set up FX risk management strategies.

Our Business Accounts let you:

• Open local currency accounts with local bank details in 60+ countries.

• Settle payments directly into your wallet in the currency you receive them in, without having to convert currencies. Together with Airwallex Payments, you can accept payments in 180+ countries via diverse payment methods including credit cards, digital wallets, and bank transfers.

• Pay suppliers in their local currency from your multi-currency balances via local rails or corporate cards, saving you on foreign transaction and conversion fees. 

• Hold funds in multiple currencies to shield yourself from the risks of fluctuating exchange rates.

• Convert funds only when you need to with 60+ trade currencies and access to interbank rates.

• Schedule conversions in advance with a confirmed FX rate, with just a prepayment of 5–10% of the total conversion amount. This feature is currently being rolled out across our global markets.

Whether you’re paying suppliers or receiving payments, our platform can help you expand globally while minimising foreign exchange risk.

Frequently asked questions about foreign exchange risk

What’s the difference between currency risk and foreign exchange risk?

Currency risk refers to the potential loss or gain from fluctuations in the value of one currency relative to another. Foreign exchange risk, on the other hand, includes not only the risk of exchange rate changes but also the impact on cash flows, profits, and the overall financial health of a business. In short, foreign exchange risk is a more comprehensive term that includes currency risk as one of its components.

Why is foreign exchange risk important for companies operating globally?

Currency rate fluctuations can lead to unexpected financial outcomes, impacting a company’s financial health. For instance, a US-based company importing goods from Europe would have to pay more if the euro were to strengthen suddenly against the dollar, potentially reducing profit margins. Managing foreign exchange risk stabilises cash flows, safeguards profits, and maintains long-term financial health.

What are the common tools used for hedging currency risk?

Some of the most common tools include forward contracts, futures contracts, and options. Forward contracts let businesses lock in an exchange rate for a future transaction, providing certainty and reducing exposure. Futures contracts, traded on exchanges, offer similar protection but are more standardised and liquid. Options give the right, but not the obligation, to buy or sell a currency at a specified rate within a certain period. Companies can also use swaps and other derivatives to manage their foreign exchange risk more effectively.

How can small businesses manage their foreign exchange exposure?

One effective approach is to partner with financial providers like Airwallex to manage foreign currencies. Airwallex Business Accounts allow businesses to open currency accounts with local bank details in 60+ countries.

What are the factors that can influence exchange rate movements?

Economic indicators like interest rates, political stability, and market sentiment can all influence exchange rates. For example, a country with higher interest rates might attract more foreign investment, leading to a stronger currency. Political stability and government policies, such as trade agreements and fiscal measures, also play a role. Market sentiment, driven by investor confidence and global events, can cause sudden and unpredictable changes in exchange rates.