Thursday, 5 October 2023, 4 minute read
In today's world, where economies are connected globally, both businesses and individuals are exposed to something called "currency risk." Often called foreign exchange risk or forex risk, currency risk refers to the financial losses that can be caused by exchange rate fluctuations. These ups and downs can have a huge impact on your business’ profits, investments and overall financial well-being - meaning that currency risk management is something every business should know about.
To keep your finances safe in the world of international finance, you need to manage currency risk. In today’s article, we’ll be breaking down what currency risk is and how you can protect your money from it.
Types of currency risk
Currency risk can manifest in various forms, each with its unique characteristics. There are three main types of currency risk:
Transaction risk: This happens when changing exchange rates impact specific transactions, such as importing goods, exporting products or receiving foreign payments. It's the most visible type of currency risk and the easiest to understand and control.
Translation risk: Large corporations with operations in different countries often face this risk, also known as exchange rate exposure, when they convert financial statements (such as P&L or balance sheet) from foreign currencies into their own. Exchange rate changes can affect the overall financial health of the parent company. This is why the parent company has to provide a consolidated set of accounts in its reporting for all of its branches.
Economic risk: This kind of risk, also known as operating risk, is about how exchange rate changes can affect a company's competitiveness and position in the market. These fluctuations can create challenges by affecting companies’ pricing, demand for products and overall business strategy.
The impact of currency risk
Currency risk can have serious consequences for businesses and individuals:
Reduced profit margins: When exchange rates work against you, it can eat into your profits - or even turn a deal into a loss if you're involved in international trade.
Financial uncertainty: Exchange rate swings can make it tough to plan for long-term financial goals because they introduce a lot of unpredictability and volatility into your investments.
Reduced competitiveness: Businesses facing economic risk may find themselves at a competitive disadvantage, as changes in exchange rates can make it harder to price products competitively in international markets.
Financial distress: Severe currency risk exposure can lead to financial distress or even bankruptcy for companies that fail to manage it effectively.
Read more: How to work out exchange rates?
Strategies for currency risk management
How do you protect yourself and your business from those unpleasant consequences? That’s where currency risk management comes in.
You can protect your and your business’ finances from currency risk with various strategies, grouped into two categories: risk mitigation and risk avoidance.
Our top five risk mitigation strategies:
Forward contracts: A forward contract is an agreement to buy or sell a specific amount of currency at a predetermined exchange rate on a future date. This strategy allows you to lock in exchange rates and protect against adverse currency movements, but it also means you can't benefit if the rates get better.
Currency options: Currency options give businesses the right but not the obligation to buy or sell currency at a predetermined rate within a specified time frame. This provides great flexibility, but fewer risks can’t be free, and your company will need to pay an option premium.
Currency hedging: This involves using financial tools to offset currency risk. You can do this with currency futures, options, or other more complicated financial instruments like currency swaps.
Natural hedging: This strategy involves matching your income and expenses in the same currency to minimise currency risk exposure. For example, if a company generates revenue in a foreign currency, it may also hold expenses or debt in that same currency. However, it does make life harder for your finance team because they will have to manage a multiple currency P&L and balance sheet alongside the traditional books of account.
Diversification: You can spread your investments across different currencies or regions to reduce the impact of exchange rate fluctuations.
Crezco can help
Crezco is an open banking payment platform that lets you make and collect international payments quickly, securely and affordably. Crezco ensures you get the most competitive rates when making international payments, and helps you avoid any extra charges or hidden fees.
Our top five risk avoidance strategies
Invoice in your home currency: When doing business internationally, try to get paid in your currency. This shifts the risk to the local customer. Crezco can help you by automatically adding a payment link to your invoice in your local currency.
Currency clauses: Include terms in contracts that let you adjust prices or payments if exchange rates fluctuate a lot. This is a good strategy for long-term contracts with a foreign currency component, but it’s important that the contractual language is clear and robust.
Geographical diversification: Expanding your business to different countries can help reduce economic risk by making you less dependent on one currency or market.
Knowledge and expertise: Developing in-house expertise on currency markets and exchange rate trends can help you make more informed decisions and adapt to changing market conditions.
Monitoring and analysis: Regularly monitoring currency markets and staying informed about geopolitical events and economic data releases can help individuals and businesses make timely decisions to mitigate risk.
The 5 steps to managing your currency risk
Identify your exposure to currency risk: Analyse all of your financial transactions, investments or operations involving foreign currencies. Consider both direct transactions (like importing, exporting and foreign investments) and indirect exposure (like currency impacts on the broader economy).
Quantify the extent of your currency risk: Use financial tools and models to assess the potential financial impact of exchange rate fluctuations on your portfolio, income or expenses. Understand the historical volatility of the currencies you deal with.
Choose appropriate risk mitigation strategies: Pick the strategies that best suit your needs and goals.
Put your chosen risk management strategies into action: This may involve executing hedging contracts, diversifying investments or monitoring economic indicators that impact exchange rates.
Monitor and review: Currency risk is dynamic, so continuous monitoring is crucial. Regularly review your risk exposure and the effectiveness of your risk mitigation strategies, and be ready to adapt.
Currency risk management is essential to financial planning in today's globalised world. Failure to address currency risk can result in some big financial losses.
However, by understanding the different types of currency risk, its effects, and using effective risk management strategies, you can keep your money safe in the global economy. That’s why managing currency risk is vital for your financial stability and success.