In this article, we’ll discuss what FX risks are, the different types of currency exposure your business could face, and the FX risk management solutions that can help protect the value of your international payments.

When a business makes or receives cross-border payments, either to buy materials or goods, settle shipping costs, or pay for staff or services, they frequently have to exchange currencies. When they buy or sell these currencies, their transactions come up against FX risk (also known as foreign exchange risk, currency risk or transaction exposure).

Throughout, we’ll show you an example of a business that is exposed to FX risk and the risk management solutions it can use to hedge against currency market volatility.

What is foreign exchange risk?

Foreign exchange risk arises when a business undertakes financial transactions which require it to exchange currencies.

The foreign exchange market is the world’s largest financial market. Decentralised and open five and a half days a week, the currency market sees trillions traded daily. It’s a continuous, non-stop market that is in a constant state of flux.

What causes currency volatility?

The sheer number of stimuli that cause currency market volatility runs too large to fully cover here. However, some of the principal causes include black swan events (seismic, unexpected instances that have a massive effect on the FX market), inflation, the monetary policies of central banks, and the state of the equity and bond markets.

One thing’s for sure. The position of the foreign exchange market is out of any corporation’s control. If your business has currency exposure, currency volatility will likely have an impact on the value of your transactions. Often this can be detrimental.

Also read: What are nonfarm payrolls and how do they affect FX?

What are the different types of FX risk?

There are several different types of FX risk. The kind of risk your business faces depends on its size and nature. We’ll go into them here:

Transaction risk

One of the most common types of FX risk, transaction risk occurs when a business buys a product or service that’s denominated in another currency from the buyer’s home currency. The issue comes when the end currency appreciates against the home currency.

In these cases, the buying business will end up having to pay more for the product than originally agreed, due to the movement in the exchange rate.

Imagine a UK-based business that buys car parts from Germany. To purchase the materials, the company must exchange pounds for euros.

In these circumstances, there’s usually a gap in time between agreeing on the price and settling the invoice. The euro could appreciate against the pound in this period. If this happens, the company could end up paying more in pounds to settle the transaction.

Translation risk

This type of FX risk affects larger companies. Translation risk happens when the revenues of a parent company and a subsidiary company are denominated in different currencies.

If the currency of the parent company appreciates against the currency of the subsidiary company, then the subsidiary company’s assets could lose value’ when they’re translated back to the parent company

The company then has to absorb these currency differentials into its balance sheet and profit and loss statement.

Economic risk

A longer-term issue, economic risk occurs when a listed company’s market value is exposed to currency volatility.

Economic risk particularly affects import/export businesses. If a business imports goods that are denominated in a different currency to its home currency, then those goods can become more expensive if the seller currency appreciates against the buyer currency.

The buyer business then has a choice. Either it can absorb the higher costs into its profit margin, or it can decide to offset the revenue decrease by passing the costs onto its customers. Doing the latter can make the company less competitive in the market.

What is FX risk management?

As we’ve noted, there’s nothing a business can do to influence where the foreign exchange market will go. If a company undertakes cross-border financial activities, they will have currency exposure, and therefore face some form of foreign exchange risk.

Yet, this is not to say that companies are defenceless to the whims of the currency markets. Over time, financial entities and businesses have used increasingly effective FX hedging techniques to combat some of the adverse effects of currency volatility.

We’ll discuss the kind of risk management solutions that some of Privalgo’s corporate clients use below.

Forward contracts

Privalgo’s forward contracts enable you to agree to a specific exchange rate for delivery at a future date.* Hedging all, a large percentage or a portion of your requirements like this can remove the risk of market volatility and provide you with a level of certainty.

As an example, let’s go back to the British business buying car parts from Germany. At the time of agreeing on a price, the pound-euro exchange rate is at 1.19, a favourable rate for the buyer.

Now let’s say that the British buyer isn’t required to pay for the goods until two months after they’ve been imported. In that period, the logic of currency volatility means that the euro could appreciate against the pound.

If the exchange rate moves to 1.16 in that time (the pound is now weaker), then it will cost the UK buyer more to purchase the goods. As we’ve noted, this is defined as transaction risk.

A forward contract would allow the British company to agree to – essentially lock in – a favourable exchange rate to be used at the date of payment. For instance, if the company agreed to a forward rate of 1.19, then it won’t matter where GBP/EUR will go, as the agreed rate will remain constant.

Rolling hedges

When protecting against currency volatility over the long term, businesses can risk over-hedging. This happens when a hedged rate is no longer competitive when compared to the market rate.

A rolling hedge can be the solution to this issue. While using cover already in place, this technique allows your business to add further hedges in line with the movements of the FX market.

Going back to our UK business example, imagine that the company must buy 500k euros every quarter to settle its invoices with the German car part company.

In the first quarter, the UK business agrees to hedge 50% of its funds at 1.19. But in the next quarter, the pound has appreciated against the euro, and the GBP/EUR rate rises to 1.22. Now an agreed forward of 1.19 would be of less value to the UK company.

A rolling hedge would enable the business to reduce its original hedge of 1.19 to 20% of its funds and hedge the remaining 30% at 1.22. This allows the company to stick close to the market price while simultaneously maintaining a layer of protection should GBP/EUR rate move against it.

The company can then rinse and repeat this process; all the time adapting to the fluctuations of the FX market.

Mitigating risk with Privalgo

As we’ve seen, FX risk affects entities that handle cross-border financial transactions. It’s a fact of life. Depending on what kind of transactions these are, the entity may be affected by different varieties of currency risk.

There are, however, certain short and long-term methods that corporations can use to hedge against these risks. Forwards contracts and rolling hedges can enable businesses to protect themselves from the unplanned higher costs and revenue losses that are often elicited by currency exposure.

At Privalgo, not only do we offer intelligent and effective risk mitigation solutions, but we also shape our services to best suit your business’s needs.

As a client of ours, you will be assigned a personal Relationship Manager: an expert who will understand your specific currency exposure and construct an FX strategy that fits your requirements

Stop leaving your financial activity to the mercy of the currency market. Request a callback from Privalgo today.

*FX forwards offered by us are a contractual agreement with Privalgo to lock in an exchange rate for two currencies for an agreed future date and are not intended to be an investment product. In exchange for removing potentially costly currency fluctuations you are locking in an agreed rate and will not be able to change that rate and will not get the market rate on the day the contract ends. Privalgo will ask for an initial deposit and depending on currency fluctuations we may request further deposit payments during the life of your contract. Privalgo Limited is a private limited company (number 11219580) registered in England with their registered office at 25 Eastcheap, London, EC3M 1DE, United Kingdom.