Understanding the types of foreign exchange risk
Recent currency market volatility across many of the major corridors is becoming a growing concern for multinational businesses. With the Chinese yuan depreciating to levels not seen since 2008, interest rate cuts around the globe and the ongoing US-China trade war, there’s a lot triggering currency fluctuations. And in-turn, revenue and profit for businesses with operations abroad. This effect is often known as foreign exchange (FX) risk.
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What is foreign exchange risk?
Put simply, foreign exchange (FX) risk is the risk that a business’s financial performance or position will be affected by fluctuations in the exchange rates between currencies. Currency fluctuations can have a significant impact on a company and should be managed where fluctuations impact on a business’s profitability.
Steps to managing foreign exchange risk:
- Understanding what type of FX risk your business is exposed to (transaction risk, economic risk and translation risk)
- Understand how much FX risk your business can tolerate in volatile currency markets
- Set objectives to manage long-term exposure to FX risk
Understanding the 3 types of foreign exchange risk
Transaction risk
Transaction risk is the risk a company faces when it’s buying or selling a product from a company located in another country. The risk being the adverse effect that the FX rate can have on a completed transaction prior to settlement.
If a vendor’s currency were to appreciate versus the buyer’s currency, then the buyer will have to make a larger payment in their domestic currency to meet the contracted price.
This risk generally increases when there is a longer period of time between entering a contract and settling it as there is more opportunity for the currencies to fluctuate. Mitigating transaction risk can generally be done through utilising forward contracts and FX options.
For example, a US company with operations in Germany would need to bring their euro earnings to the US account. If the agreed rate was 1.20 USD to 1 euro, and the US exchange rate falls to 1.00 prior to the payment settlement, the company expecting $1,200 USD in return would instead receive $1,000 USD.
Economic risk
This refers to the way in which a company’s market value is impacted by an unavoidable exposure to currency fluctuations and shifts in the economic landscape. It’s also commonly known as ‘forecast risk’.
This risk can be created by macroeconomic conditions like exchange rates, government regulations and geopolitical stability. It’s one of the reasons why international investment can be more risky than domestic investment and it typically affects the shareholders and bondholders of a company.
An example of economic risk in 2019 is that potentially faced by Hong Kong. Protests dominated the landscape with people taking to the streets to express their displeasure over the proposed Extradition Bill. This would enable almost anyone who enters Hong Kong – whether in transit, to visit or as a resident, to be extradited to China.
The fear is that Hong Kong’s standing as a safe and reliable commercial hub will face irreparable damage in the wake of the conflict. So those with businesses that operate in the region are faced with unprecedented uncertainty.
Adam Ismail, Asia Dealing Manager at OFX in Hong Kong, said in the OFX Currency Outlook, “there are a lot of international businesses here who have expressed concerns about this law; transparency, trust and stability are the foundations that have made Hong Kong a financial hub and attractive to foreign firms to begin with.”
Translation risk
Translation risk, also known as ‘translation exposure’, refers to a situation where a parent company owns a subsidiary in another country and the subsidiary’s revenue or profits are converted to the parent company’s currency at a lower value. As exchange rates change constantly, there can often be variances in the reported figures between quarterly financial statements, which can impact a company’s stock price.
This creates risk for a company because the volume of currency to translate back to the reporting currency can vary. In real terms, if a company has a greater proportion of assets, liabilities or equities denominated in a foreign currency, and if the currency is more volatile, the translation risk is higher.
A real world example of translation risk being handled well is BMW Group which, while based in Munich, has received a significant increase in sales in the Asia region – with China as their fasted-growing market. Despite the rise in sales, the exchange rates often eroded into their reported earnings.
To mitigate this, BMW Group set up regional treasury centres in the US, UK and Singapore, and used forward contracts to lock in favourable rates.
What happens when risk is handled badly?
An instance of how transactional risk can impact a businesses was evident in how Unilever’s company turnover was impacted in 2018. Turnover decreased by 8.9% as a result of a strengthening euro against almost all of their major currency corridors.
Similarly, back in 2015, Apple’s revenue was demolished by the strengthening US dollar, which saw revenue down by 5%, or US$3.73 billion – more money than what Google makes in one quarter.
An article from EY also showed that survey respondents from US companies in a report from FiREapps for Q4 in 2015 reported a record level of foreign exchange setbacks. These companies generate most of their sales overseas, and despite some seeing up to 10% growth in volume of sales, the value of that depreciated when the effects of a stronger US dollar fed through.
These companies had for a long time benefitted from a weakening US dollar and so hedging against any risk in the long-term didn’t doesn’t feel necessary until the effects of macroeconomic changes became evident.
Hedge your currency exposure with OFX
OFX is a money transfer service that gets your business. Our OFXperts are on hand 24/7 to help your business. Whether you need to pay international suppliers or overseas staff, set a transfer date or protect against moving currency markets. Your OFXpert can help you with your currency needs all in a single place.
By partnering with a global money transfer specialist, such as OFX, you can take advantage of tools designed for mitigating currency risk. Forward Exchange Contracts for example, allow you to lock in a favourable exchange rate and then transfer the funds at a later date, even up to 12 months in the future. Another tool are Limit Orders, which allow you to pick a target rate and the OFXperts monitor the markets for you. If that target rate is hit, we’ll notify you via email or SMS.
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IMPORTANT: The contents of this blog do not constitute financial advice and are provided for general information purposes only without taking into account the investment objectives, financial situation and particular needs of any particular person. OzForex Limited (trading as OFX) and its affiliated entities make no recommendation as to the merits of any financial strategy or product referred to in the blog. OFX makes no warranty, express or implied, concerning the suitability, completeness, quality or exactness of the information and models provided in this blog.
