Understanding Foreign Exchange Rate Risk: Types, Strategies and Examples

Introduction

Imagine your business navigating through a complex maze. Each turn and twist presents new challenges. The right turn can propel you forward, and the wrong turn can leave you astray. Understanding and minimizing Foreign Exchange (FX) Risk is crucial to ensure your way out is smooth. 

Over the past few years, the significance of foreign exchange (FX) risk management has increased significantly due to globalization, increased market volatility, and new regulations. As a result, treasurers are more actively monitoring FX exposures and refining policies more frequently. Companies of all sizes and industries are expanding internationally, seeking new sales opportunities, and expanding supply chains. Consequently, treasurers are managing risks of increased proportions spanning multiple currencies, which adds to the operational and financial complexity.

Market volatility is prevalent due to economic fluctuations, supply chain disruptions, and global geopolitical uncertainties. It has become a top priority for treasurers to gain real-time, accurate, and complete visibility over risks and adopt more flexible exchange risk hedging solutions to manage them effectively. Read more about how a cash flow forecasting system can help treasurers manage soaring $ and FX volatility.

Understanding Foreign Exchange Risk and How to Minimize It

Foreign exchange rate risk refers to potential losses from currency fluctuations in international transactions. Investing in fast-paced foreign countries may seem lucrative, but exchange risk can unexpectedly impact returns. With high market volatility, CFOs are monitoring FX exposures and policies.

There are three types of foreign exchange risk that businesses usually face – transaction, translation, and economic risk. Here’s an example highlighting how transaction risk can directly impact a company’s purchasing power and profit margins.

Imagine a U.S.-based electronics retailer, TechGlobe, which imports gadgets from Europe. In January, TechGlobe placed an order for €100,000 worth of products, with payment due in three months. At the time of the order, the exchange rate was 1.10 USD/EUR, making the order worth $110,000. If the exchange rate shifts to 1.20 USD/EUR by April, TechGlobe will have to pay $120,000 for the same order, incurring a $10,000 loss due to FX fluctuation.

What is Foreign Exchange Risk?

Foreign Exchange Risk is the chance of incurring a loss when one currency is exchanged for another. If one or both of the currencies fluctuate, the investment value of the business declines. It occurs when a transaction is denoted in a currency other than the company’s base currency.

This variance can affect companies engaged in international business activities, such as importing and exporting goods, investing in foreign assets, or borrowing money in foreign currencies. This risk is inherent in transactions involving multiple currencies, whether trade-related, investment-related, or financial operations across borders. The dynamic nature of the global economy, influenced by political events, economic policies, market sentiments, and unforeseen global events, makes FX rates volatile, affecting the value of foreign currency cash flows. FX risk has several dimensions, reflecting how currency fluctuations impact a company’s financial health. Effective forex risk awareness is crucial to avoid any potential impact.

Types of Foreign Exchange Risk

There are three major types of foreign exchange risk: transaction, translation, and economic risk. There’s also a fourth one – jurisdiction risk that arises when laws unexpectedly change in the country where the company is doing business. This one’s rare and primarily exists in unstable countries.

By understanding these types of exchange rate risks, businesses and investors can better strategize to mitigate their exposure through various financial instruments and operational adjustments. Effective foreign exchange risk management involves not only recognizing the type of risk but also implementing tailored strategies that align with the company’s overall financial and operational goals.

A general guideline on how to manage foreign exchange risk in international investments suggests that investors should know when and how to hedge foreign exchange risk and their exposure when their home currency is losing value against the currency of their foreign investments. However, if their home currency is gaining value against the currency they have invested in, it makes sense to implement hedging strategies to protect against potential losses. Here’s a more detailed look at each type:

Transaction Risk

Transaction risk occurs when there is a delay between entering into a contract and settling it. During this period, exchange rates can fluctuate, affecting the actual cost or revenue in the home currency. For businesses, this means the cost of buying goods or services from abroad could rise, or the revenue from selling goods or services internationally could fall, directly impacting profit margins.

Translation Risk

Translation risk, or accounting risk, occurs when a company owns assets and liabilities or conducts operations in another country, requiring financial statements to be consolidated into the parent company’s reporting currency. Changes in exchange rates can affect the home currency value of foreign income, assets, and liabilities, leading to potential impacts on reported earnings and equity. This risk doesn’t directly affect a company’s cash flow but can influence investor perception and stock price.

Economic Risk

Economic or operating or forecast risk involves the long-term effects of currency rate changes on a company’s future international cash flows and market value. It captures the potential for currency fluctuations to alter the company’s competitive position, potentially affecting future revenues, costs, and market share. Unlike transaction and translation risks, economic risk can have strategic implications, influencing where a company operates and competes.

Jurisdiction Risk

Although less common, jurisdiction risk emerges from unexpected legal or regulatory changes in a country where business is conducted. This can lead to sudden and unfavorable shifts in currency values, affecting the profitability and feasibility of international operations. It is most often encountered in countries with unstable political climates or those experiencing significant economic turmoil. 

Examples of Foreign Exchange Risk

In the world of finance, FX risk stands out as a significant concern for businesses. Fluctuating exchange rates profoundly impact profitability and cash flow. To illustrate the practical implications of FX risk, let’s explore some real-world examples – Devaluation in Argentinian Peso and Levi Strauss.

Devaluation in Argentinian Peso

One in four Argentinians live in poverty. 

Inflation has reached 161% in Argentina, and its economy is shrinking partly due to a devastating drought. Over the past five years, the country’s currency exchange rate has experienced a depreciation of approximately 90% against the U.S. dollar. The weight of its debts, which includes a $45 billion debt to the International Monetary Fund, is suffocating.

Several major companies, including Adidas, BBVA, Citi, Dow Chemical, Halliburton, Puma, and Sherwin-Williams, have recently reported significant foreign exchange losses due to the devaluation of the Argentine peso during the second half of 2023. These losses have amounted to more than $3.3 billion for the companies mentioned.

The global economic conditions, including interest rate increases in major economies like the United States, have also impacted the Peso. As major central banks tighten monetary policy to combat inflation, emerging market currencies like the Argentine Peso become less attractive to investors, leading to depreciation. The devaluation of the Argentinian Peso in 2023 is a complex phenomenon rooted in economic, fiscal, and political challenges. Addressing these underlying issues is crucial for stabilizing the currency and fostering sustainable economic growth in Argentina. 

Soft demand for Levi Strauss & Co.

In January 2024, Levi Strauss & Co. announced a significant reduction in its workforce as part of a strategic move to address a challenging economic outlook and a fragile wholesale business environment. This decision underscores exchange rate fluctuations, especially when Russian wholesalers are a significant part of the business. Currency volatility can affect pricing competitiveness and demand stability from these international clients in navigating a complex and rapidly evolving retail landscape.

Levi Strauss & Co. (LS&Co.) is a well-known clothing company that specializes in denim. Its popular brands include Levi’s®, Signature by Levi Strauss & Co.™, Denizen®, Dockers®, and Beyond Yoga®. The products are available in over 110 countries through channels such as chain retailers, department stores, online sites, and a global network of around 3,200 retail stores and shop-in-shops. Last year, Levi Strauss & Co. reported net revenues of $6.2 billion.

Levi is ready to cut 10% to 15% of global corporate jobs as the denim maker seeks to rein in costs amid weak numbers in the wholesale business. It attributed the inaccurate cash forecast to the exit of its Denizen brand, cutting back on off-price sales, and weaker foreign currency exchange rates in Russia. Sales in Levi’s total wholesale business, which accounted for about 62% of its net revenue in 2022, dipped 3% on a constant-currency basis in the quarter ended Nov 26.

Causes of Foreign Exchange Risk

Foreign exchange rate risk is influenced by a complex interplay of factors. By understanding these causes, businesses and investors can better navigate the uncertainties of international finance and curate forex risk management strategies. Here are some primary drivers:

Interest rate fluctuations

Interest rates affect the demand for a country’s currency, influencing its value. A higher interest rate provides higher returns on investments in that country’s currency, making it more attractive to foreign investors. This demand can cause the currency’s value to rise.

For example, if country X increases its interest rates by 2% while country Y’s rates remain unchanged, investments in country X could become more attractive, leading to a 5% appreciation of country X’s currency against country Y’s currency. This change impacts investors and companies exposed to these currencies, affecting their investment returns and operational costs.

Inflation

Inflation plays a crucial role in determining exchange rates. Typically, countries with lower inflation rates see an appreciation in the value of their currency compared to those with higher inflation rates. For instance, if country A has an inflation rate of 2% while country B’s inflation rate is 10%, over time, country B’s currency will depreciate against country A’s currency.

Political stability & economic performance

Political events and economic policies can significantly impact investor confidence and currency stability. Countries perceived as politically stable and with strong economic performance tend to attract more foreign investment, strengthening their currency. 

For example, after a stable government comes into power in country Z, proposing economic reforms to boost growth, foreign investment increases by 20%. This surge in investment leads to a 4% appreciation of country Z’s currency against a basket of major currencies, affecting the exchange rate risk for businesses operating internationally. 

Speculation

When investors anticipate an increase in a country’s currency value, they will want to purchase more of that currency to make a profit in the near future. This higher demand for the currency will then cause its value to appreciate. Consequently, the exchange rate and the currency’s value will also increase. 

For example, Speculation leads to a rapid 15% appreciation in the currency of Country Q within three months, influenced by rumors of significant oil discovery. This speculative movement impacts companies involved in international trade with Country Q, as the cost of importing goods from Country Q rises sharply.

3 Ways to Manage Foreign Exchange Risk

Managing foreign exchange risk is crucial for businesses and investors engaged in international transactions. Here’s a section outlining various strategies to manage this risk:

• Consider creating a forward contract with a bank or foreign exchange service provider
• Choose natural hedging: match inflows and outflows to offset risk
• Currency options: exchange risk hedging against rate volatility

Consider creating a forward contract with a bank or foreign exchange service provider

Forward contracts allow businesses to lock in an exchange rate for a future date. Using forward contracts, companies can protect themselves against adverse exchange rate movements. To set one up, the exporter must know the foreign currency amount, the date the importer will pay, and the currency exchange delivery date.

Choose natural hedging: match inflows and outflows to offset risk

Natural hedging involves matching foreign currency inflows and outflows to offset the risk of exchange rate fluctuations. For example, a company that generates revenue in a foreign currency and has expenses in the same currency can reduce its exposure to exchange rate risk. HighRadius Cash Management Software helps mitigate risk by providing treasury teams 100% cash visibility across different currencies through its integrations with all major banks, including real-time foreign exchange rates. These rates are updated regularly to reflect the current market conditions.

For investors in the United States, it’s crucial to hedge against exchange rate fluctuations significantly when the U.S. dollar strengthens. This is because increases in the value of the dollar can diminish the returns on investments made outside of the country. 

Conversely, for investors from other countries investing in the U.S., a weakening of their home currency relative to the USD can enhance their investment returns. Exchange rate fluctuations can have a significant impact on a country’s GDP. When a country’s currency depreciates, it can boost its exports by making them cheaper for foreign buyers. This, in turn, can lead to an increase in GDP as export revenues rise. Since the exchange rate movement benefits the investor in these scenarios, the advisable strategy is not to hedge against these fluctuations.

Currency options: exchange risk hedging against rate volatility

Currency options provide businesses with the right, but not the obligation, to buy or sell a specified amount of currency at a predetermined exchange rate (the strike price) on or before a specified date (the expiration date). There are two types of currency options: call options and put options.

Currency options can be a cost-effective insurance policy against adverse exchange rate movements, especially when the premium cost is lower than the potential losses from unfavorable rate changes. Unlike forward contracts, where the business is obligated to execute the transaction at the agreed-upon rate, options provide the right but not the obligation. This limits the risk to the premium paid for the option.

5 Tips on Converting Currency in Foreign Trade

In foreign trade, currency conversion becomes integral to financial management, affecting pricing, profits, and overall financial stability. Understanding what is forex risk and how to manage currency conversion effectively can help businesses protect their bottom lines and take advantage of favorable exchange rates. Here are some tips on converting currency in foreign trade: 

1. Understand the market

• Stay Informed: Regularly monitor foreign exchange markets to stay informed about current exchange rates and trends. This knowledge can help in making informed decisions about when to convert currency.
• Use Forward Contracts: Secure a favorable exchange rate today for a transaction that will occur in the future. This can help protect against unfavorable shifts in currency values.

2. Leverage currency choice

• Leverage Currency Choice: Opt to transact in the most favorable currency to your business (the U.S. dollar, euro, Japanese yen, and British pound), depending on the current and projected strength of your home currency versus the foreign currency.

3. Leverage technology

• Automate Payments and Transfers: HighRadius cash management solution streamlines managing multiple currencies, automating payments, and optimizing cash flows. The platform helps you make informed decisions by providing real-time analytics and predictive insights on currency and payment trends, allowing for strategic planning and execution.

4. Consider hedging strategies

• Options and Futures: Hedging foreign exchange risk using financial instruments like options and futures contracts can provide the right or obligation to exchange currency at a predetermined rate, offering protection against adverse movements in exchange rates.
• Consult with Experts: Engaging with financial advisors or treasury management services can provide insights and strategies tailored to your specific needs and risk tolerance.

5. Regularly review and adjust strategies

• Monitor and Analyze: Review your currency conversion strategies and their outcomes. Market conditions change, and what worked well in one period may not be the best approach in another. 

Foreign Exchange Risk Management Strategies

Forex risk management is a crucial strategy that involves setting rules to minimize the negative impacts of unforeseen circumstances that can affect forex trading. This strategy requires a lot of planning and effort to ensure that the right risk management plan is put in place. While it may seem like an unnecessary step to many, it is essential to have a risk management plan to ensure that losses are kept to a minimum in the unpredictable world of trading. 

7 Forex risk management strategies

Currency hedging can help manage the risks associated with changes in FX markets, including reducing earnings volatility and protecting the value of future cash flows or asset values.

Leveraging AI-Powered Forecasting for Exchange Risk Hedging

FX hedging strategies

Hedging is essential for managing foreign exchange (FX) risk. This approach helps to stabilize a company’s working capital against the unpredictable nature of currency markets. Treasury management services assist in designing and implementing hedging strategies to minimize exposure to various financial risks, such as interest rate risk, foreign exchange risk, and commodity price risk. Read more about how AI can revolutionize cash forecasting in 2024.

Integration of ERP and treasury management systems

ERP systems are crucial for cash management, providing a centralized platform for tracking transactions, enhancing visibility into cash flows, and enabling better forecasting. Use of a treasury management system can further enhance this capability. A TMS encompasses a range of activities to optimize cash flow, mitigate risks, and maximize returns. The process involves various tasks, including cash forecasting, liquidity management, payment processing, and investment management.

Accuracy and workflow 

Treasury management is greatly affected by the volatility in financial markets, which can pose significant challenges. Fluctuations in interest rates, foreign exchange rates, and commodity prices can impact the overall financial stability of an organization. For example, exchange rate fluctuations can result in significant gains or losses when dealing with foreign currencies, challenging forecasting and managing currency risk.

With AI and ML algorithms and their ability to continuously learn and adapt to market fluctuations, predicting FX cash flow becomes more accessible. This helps businesses make data-driven decisions responding to real-time market changes, leading to more accurate and dynamic predictions.

AI’s impact on the accuracy of cash flow forecasts is significant. By reducing the impact of market volatility, AI provides a reliable financial outlook. 

Elevate your FX cash flow forecasting with HighRadius cash forecasting software

Cash forecasts are critical for growth since they lead strategic financial and investment decisions, changing the company’s future and increasing profits. 

As a part of Forex risk management, currency rates are typically maintained through integration with a third-party service on HighRadius software that provides real-time foreign exchange rates. These rates are updated regularly to reflect the current market conditions.

HighRadius cash flow forecast can help you benefit in the following ways.

FAQs

1. Why is foreign exchange important?

Foreign exchange is crucial for facilitating international trade and investment, allowing businesses to buy and sell goods and services across borders. It also plays a key role in determining a country’s economic health and stability.

2. What is foreign exchange policy?

Foreign exchange policy refers to a government or central bank’s strategy for managing its currency’s value in the foreign exchange market. It includes measures to stabilize exchange rates, such as interventions and setting monetary policy.

3. How to calculate foreign exchange?

Foreign exchange rates are typically quoted as the amount of one currency that can be exchanged for another. To calculate the exchange rate, divide the amount of the base currency by the amount of the target currency. For example, if 1 USD equals 1.20 EUR, the exchange rate is 1.20.

4. How do banks manage FX risk?

Banks manage FX risk through various strategies, including using forward contracts to lock in exchange rates, diversifying currency holdings, and using derivatives like options and futures to hedge against currency fluctuations.