What every business should know about currency risk

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What every business should know about currency risk
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If your business operates across borders – with suppliers, customers, staff and operations spread across more than one country – currency risk is a concept you should be familiar with. The value of currencies is constantly fluctuating, and this can lead to unpredictable profits and losses if the business’s financial team is not actively managing and hedging this risk.

This article will look at currency volatility and provide an in-depth guide to mitigating currency risk. This understanding can help ensure your company’s finances are secure, even if unexpected changes take place within the global economy.

What is currency risk?

Currency risk, also known as exchange-rate risk or foreign-exchange (FX) risk, relates to the changing value of one currency in relation to another. Without mitigating this risk, businesses that are active in overseas markets are in danger of losing money due to an unfavourable shift in the foreign exchange rate.

As an example, in the 1990s, the management of currency risk became a hot topic after the Mexican peso dramatically dropped in value in 1994. This followed the assassination of a presidential candidate, which sparked fears of a currency sell-off. The situation quickly spiralled out of control as interest rates rose, GDP fell, debt rose and foreign reserves were exhausted.

When currency crises happen, investors often lose confidence in an economy’s stability and withdraw their investments in the country’s currency. This decreases confidence yet further, creating a vicious cycle of devaluing currency.

If a business is heavily invested in the currency of a country that experiences a currency crisis, it can be catastrophic. That’s why it’s now more commonplace to mitigate currency risk by hedging, forecasting, or through financial tools like futures and options contracts.

What factors impact a business’s currency risk?

How exposed is your business to currency risk? Is this something that can be managed, and if so, how? To answer these questions, we’ll first need to examine the different types of currency risk:

Transaction risk: This is the most obvious form of currency risk, and the simplest to manage. The value of one currency in relation to another can fluctuate after the terms of a payment has been agreed but before the transaction has actually been completed. This can cause difficulties with financial planning, unless hedging programmes are put in place.

Economic risk: Also called operating exposure or forecast risk, this is the risk of a company’s value being affected by changes in currency rates. For example, this may involve a domestic company being undercut by cheaper exports or a company selling abroad losing sales thanks to a weakening currency in their target market.

Translation risk: If a company receives money in one currency, but their financial statements are in another, the perceived value of that company is vulnerable to FX movements. This can negatively impact investment in the company. This type of risk is also known as accounting exposure.

What factors influence exchange rates?

A highly valued currency is seen as an indicator of the economic health of a country, or at least the perception that the economy is on the rise. A strong economy is the result of many factors, which should be monitored as part of a strategy to mitigate currency risk. These include:

Interest rates and inflation

These are interlinked, and also impact currency valuation. Central banks tend to aim for an optimal level of inflation (the rate at which the price of goods is rising domestically) and interest rates (the percentage of a debt that is paid to lenders as a fee.) High interest rates attract foreign investment but make it harder to borrow. A certain amount of inflation is considered healthy, but too much puts a strain on the cost of living. Central banks can tweak interest rates in an attempt to maintain this balance.

Trade

Countries that export more than they import (a trade surplus) typically have stronger currencies than those with trade deficits. For this reason, the creation or collapse of trade deals can have an impact on currency valuation.

Geopolitical stability

Foreign investors want reassurance that the country in which they are investing is stable and there is little likelihood of a sudden shift in trade, inflation, interest rates, and so on. Political turmoil and conflict, as well as natural disasters, can create instability in these areas, putting off investment and thus having a negative impact on currency valuation.

How to manage currency risk

The good news is that it’s possible to mitigate and manage currency risk, either by tweaking aspects of your operations and financial flows, putting agreements in place or hedging on the financial market. Here are some of the key ways you can manage your company’s currency risk: 

  • Multi-currency banking: It can be beneficial to have suppliers, service providers or employees in the same foreign country as customers. This way, if that country’s currency dips in value, the loss in profits will be balanced by lowered costs. By holding money in that country’s currency, it is then also possible to accept payments and pay out that money without converting it to domestic currency, thereby cutting fees. Multi-currency accounts (such as the Airwallex Global Account) also allow companies to hold several currencies at one time and convert currencies at a time that is beneficial for the company. Essentially mitigating their currency risk by diversifying the currencies they are holding. 

  • Forward contracts: These ensure that a certain amount is agreed for foreign exports in domestic currency, even if the FX rate fluctuates between the agreement of sale and the transaction’s completion. Rates can be locked in for a certain term.

  • Options contracts: These give holders the option (but not the obligation) to buy a set amount of a currency before a specified expiration date. These can protect against adverse exchange-rate movements while allowing the company to benefit from favourable movements.

  • Currency futures: Investors can bet on the direction in which a currency will move by investing in futures contracts on the stock market. They can be used as a form of hedging against currency risk.  

  • Money market hedge: Currency exposure can be reduced by borrowing and investing in different currencies.

  • Diversification: By spreading revenue sources, supply chains and operations across multiple countries and currencies, the impact of an adverse FX movement in any one currency can be reduced.

Monitor and reduce your FX exposure

Before you dive into any of the mitigation strategies mentioned above, it’s important to first assess your company’s level of currency risk, and implement a process for monitoring movements as part of your ongoing operational strategy. Recommended steps include the following:

  1. Understand the degree and duration of your currency exposure. Look at your cash flows, assets, liabilities and earnings that are affected by changes in FX rates. Assess how much of a foreign currency you expect to receive or pay and the wait time between agreeing the deal and settling the transaction. This will give you an idea of your FX risk level.

  2. Analyse the volatility of the foreign currency in which you are invested in relation to your domestic currency. The higher the volatility, the higher the currency risk.

  3. Set up tools for monitoring the factors that impact exchange-rate movements and forecasting future fluctuations. This is now possible to do easily with AI software, although remember that no forecasting software can be 100% accurate in its predictions. Don’t underestimate the utility of conversations with colleagues on the ground in the foreign country in giving you a sense of any underlying economic uncertainties or predicted changes.

  4. Consider the strategic changes you would make in response to specific types of currency movement, such as a sudden dip in the value of a currency in which you receive a large proportion of your income. Can you invoice in your home currency, focus on a different market or hedge using financial instruments, for example?

Manage currency risk with Airwallex

Airwallex is a payments and financial platform designed for global businesses. With Airwallex, your business can avoid unnecessary currency conversions on your international transactions by opening local currency accounts in 60+ countries and 23+ currencies. When currency conversion is needed, Airwallex gives your business access to the interbank rate. Learn more about Airwallex Global Accounts today. 

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