Understanding forex risk

Forex risk, often referred to as currency risk, is the potential financial loss that can result from fluctuations in the exchange rates between two different currencies. It arises when a business engages in transactions involving more than one currency, or from the value of assets and cash it holds in multiple currencies.

Before we look into the different types of risks and mitigation strategies, let’s take a step back and give you a brief background on forex markets.

Brief background on the forex market

The forex market is the largest and most liquid financial market in the world. Daily trading averages somewhere between $6.5-7.5bn. Though forex trading is as old as international trade itself, the modern forex market began to take shape in the 1970s when the Bretton Woods system of fixed exchange rates was abandoned, leading to the adoption of floating exchange rates.

Forex markets involve a wide range of participants, including central banks, commercial banks, financial institutions, multinational corporations, governments, speculators, and individual retail traders. The interbank market, where major financial institutions trade currencies with each other, forms the core of the forex market.

Forex markets operate 24 hours a day, five days a week. The major trading centres are located in Tokyo, London, and New York, each with its own active trading hours, creating continuous trading opportunities.

Currencies are traded in pairs, with one currency being exchanged for another. The first currency in the pair is known as the ‘base’ currency, while the second is the ‘quote’ currency. The most common currency pairs include EUR/USD (Euro/US Dollar), GBP/JPY (British Pound/Japanese Yen), and USD/JPY (US Dollar/Japanese Yen).

As with all markets, the forex market can be prone to periods of volatility, when the price of currencies fluctuate more dramatically than normal. Volatility is influenced by various factors, including economic data releases (e.g. GDP, employment, interest rates), geopolitical events, and market sentiment. High volatility can present opportunities for traders to profit from price movements, but it also carries higher risk. Conversely, periods of stability, where currency prices move slower, reduces speculative trading, but creates more predictable (and so less risky) conditions for exchanges. 

Why forex matters for international businesses

One of the primary reasons why forex risk matters so much for international businesses is its potential to significantly impact profitability. Here's why:

• Unpredictable profit margins: When a business engages in international trade, it often conducts transactions in foreign currencies. Fluctuations in exchange rates can directly affect the value of these transactions. If a company buys goods in one currency and sells them in another, a sudden devaluation of the selling currency can reduce the profit margins, or even lead to losses.
• Cash flow uncertainty: Currency fluctuations introduce uncertainty into a company's cash flows. This uncertainty creates short term liquidity challenges, and can make it difficult to plan for future expenses and investments.
• Debt servicing: If a company has loans or debt in foreign currencies, currency fluctuations can affect the cost of servicing that debt. When the domestic currency strengthens relative to the currency of the debt, it becomes more expensive to service that debt. 
• Pricing competitiveness: When a company’s domestic currency strengthens relative to others, their products become more expensive for foreign buyers. This can lead to a loss of market share. 
• Global supply chains: Many international businesses operate complex global supply chains. Currency fluctuations can impact the cost of inputs and raw materials sourced from other countries. This not only affects the overall costs of production, but may incur additional expenses from sourcing and onboarding alternative suppliers. 
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‍Real world examples of forex risk to businesses

There are no shortages of examples where global companies have been negatively impacted by adverse movements of currency prices. Here are some examples:

• Tesco: The British retail giant Tesco reported a record loss of £6.4 billion in 2015, partly due to currency devaluations in some of its markets, such as Thailand and Poland, that reduced the value of its overseas operations and assets. 
• Swiss franc shock: The unexpected and rapid appreciation of the Swiss franc in January 2015 had a profound impact on many businesses. The Swiss National Bank's decision to abandon its peg to the euro caused the Swiss franc to surge in value. Companies that had not adequately hedged their Swiss franc exposure faced sudden increases in their debt and operating costs. FXCM, a major retail foreign exchange broker, suffered significant losses due to its clients' positions in the Swiss franc. The company had to be bailed out to prevent bankruptcy.
• Tata Motors: In 2016 Tata Motors, the Indian automotive manufacturer, was hit by forex losses of 22.96 billion rupees (£258.41 million), mainly due to the pound depreciation after the Brexit vote. The company's subsidiary, Jaguar Land Rover (JLR), generates a substantial portion of its revenue in foreign currencies, primarily the British pound
• Valeo: Valeo, a French automotive supplier, suffered significant losses due to forex risk in 2018. The company's management had not hedged its currency exposure adequately. When the euro appreciated sharply against the US dollar, Valeo's profits were severely impacted, leading to a loss of over €500million. 
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These examples illustrate the implications of forex risk. In the next section, we will look more closely at different risks, including transaction risk, translation risk, and economic risk; and how these risks emerge, such as from exports/imports, managing foreign denominated debt, and owning foreign subsidiaries. 

Types of forex risks for global businesses

Global businesses face a variety of forex risks. Here are the main ones:

Transaction risk

This risk arises from fluctuations in exchange rates between the time a business enters into a contract and the time it settles the transaction. 

Translation risk

Also known as accounting risk, translation risk impacts multinational corporations with subsidiaries or operations in multiple countries. When consolidating financial statements, the translation of subsidiary earnings from local currencies into the parent company's reporting currency can result in gains or losses due to exchange rate movements.

Economic risk

Economic risk, also known as operating exposure or competitive risk, arises from changes in exchange rates that can affect a company's competitive position. If a company's products become more expensive to foreign buyers due to currency appreciation, it may lose market share. 

Supply chain risk

A company with foreign suppliers will see their production costs increase when their domestic currency loses value relative to that of their suppliers. 

Geopolitical risk

Economic and political conditions in individual countries can lead to exchange rate fluctuations. Events such as elections, policy changes, or the release of economic data can all impact a country’s currency value. Political instability in foreign countries can lead to abrupt changes in exchange rates. Sudden currency devaluations or restrictions on currency conversion can make imports cheaper, but also affect the value of assets and investments held abroad.

Interest rate risk

Differences in interest rates between countries can impact exchange rates. Higher interest rates in one country can attract foreign capital, driving up the value of its currency. Interest rates can also be used proactively to manage currency values, which in turn impacts companies with financing or debts in that country. 

Speculative risk

Speculative trading in currency markets can lead to short-term fluctuations in exchange rates. News, rumors, or market sentiment can also influence currency prices.

For international businesses, forex risk is unavoidable. However, a business can control how it mitigates these risks. Each forex risk type requires tailored strategies to effectively manage and hedge. We will explore these strategies later in this article. 

Sources of forex risk

There are many reasons why a company will be faced with forex risk. It is essential for a business to identify each relevant forex risk, and prioritise which to mitigate. This analysis will be unique for every business.

Payment lags

In the realm of international trade, payment lags can pose a significant challenge for companies. When a business engages in cross-border transactions, there is often a time gap between agreeing a price and the actual payment. During this period, currency exchange rates can fluctuate, meaning the final payment received may be less (or more) valuable than initially anticipated.  

Foreign-denominated debt

Companies that borrow funds in foreign currencies expose themselves to foreign exchange risk. If the company’s domestic currency weakens against the currency of the debt, it may face higher repayment obligations, impacting cash reserves and cash flow. 

Foreign subsidiaries

Multinational corporations with subsidiaries in different countries often face translation risk when consolidating financial statements. Translation risk occurs when the earnings and assets of these subsidiaries are converted from their local currencies into the parent company's reporting currency. Exchange rate movements can lead to gains or losses in the consolidated financial statements, impacting the company's financial performance and share price.

Dividends from international operations

Companies with international operations may encounter forex risk when repatriating dividends from foreign subsidiaries. Exchange rate volatility can reduce the expected value of these dividends when they are converted into the parent company's home currency. This can affect a company's ability to distribute profits to shareholders, reinvest in its operations, or fulfil its acquisition strategy.

Foreign competitors

Currency swings can significantly impact the competitive landscape. When a company's foreign competitors experience currency movements, it can alter their pricing strategies and overall competitiveness. A strong domestic currency can make a company's products more expensive in international markets, potentially leading to a loss of market share.

Currency restrictions

Some countries impose capital controls and restrictions on currency conversion and expatriation. This can make it challenging to access and repatriate earnings, which can hinder business operations and profitability.

Supply chain

Currency fluctuations affecting suppliers and customers can have knock-on effects throughout a company's value chain. Changes in the cost of imported materials or the pricing strategies of customers can impact a company's production costs, pricing, and overall profitability. 

Busting common myths and misconceptions about forex risk

Many people believe that forex risk only impacts large multinationals, that mitigation requires complex strategies, or that there are only downsides to currency volatility. Not true. Like other aspects of financial management, forex risk is nuanced and should be understood in the unique context of each company.

In this section we will debunk some of the common myths, and show that effective forex management is something that every company trading internationally can, and should, practice.

Misconception 1: “Forex risk only impacts large multinationals”

It's a common belief that only large multinational corporations with extensive international operations are exposed to FX risk. While it's true that large international companies are often more susceptible to forex risk due to their scale, smaller businesses engaged in international trade also face material risks.

Even a local company importing goods from abroad can be impacted by exchange rate fluctuations. While the size of the business may vary, the risk is proportionate. 

Misconception 2: “It's strictly a finance problem”

Foreign exchange risk isn't just a concern for the finance department. Successful forex risk management requires collaboration across various functions, including sales, procurement, production, and marketing teams. For instance, sales teams need to understand how pricing decisions can mitigate or exacerbate forex risk, procurement should have alternative suppliers in different currency territories, and production should have agile processes that allows fast adaption to changing circumstances in the supply chain.

Cross-functional cooperation is essential for a comprehensive and effective risk management strategy.

Misconception 3: “Forex volatility is unpredictable"

While it's true that the forex market can be volatile, it's a misconception that it's entirely unpredictable. Traders and analysts use various tools and methodologies to identify trends and potential movements in exchange rates. Economic indicators, geopolitical events, and central bank policies all contribute to trends in currency markets. While unforeseen events can cause sudden spikes and falls, these should be regarded as the exception. 

Misconception 4: “Complex hedging is required”

Many companies believe that managing forex risk requires sophisticated and complex hedging strategies. While complex hedging tools have their place, simpler alternatives can be equally effective. Basic tools like forward contracts and options can provide valuable protection against adverse currency movements.

The key is to align the chosen strategy with your company's risk tolerance, objectives, and available expertise.

Misconception 5: “Forex is always a downside risk”

Forex risk is often viewed as a downside risk that can erode profits and competitiveness. However, it's important to recognise that currency price swings can also present opportunities. A weakening domestic currency can make a company's exports more competitive, potentially boosting international sales; while significant profits can be made when trading currency pairs that are performing differently. 

Strategies for managing forex risk

There are a range of forex risk management strategies that a business can employ. The choice of which strategies to prioritise will depend on factors such as the company's sector, competitive landscape, geographic footprint, risk tolerance, and specific currency exposures. Here are five key forex risk mitigation principles you should know about.

Matching currency flows

By matching the currency of payments from customers with the currency of payments to suppliers, businesses can reduce their exposure to exchange rate fluctuations. For example, if a company receives revenue in US dollars from its international customers, it can seek to pay suppliers in US dollars too. The timing of these payments is important, as the longer the window between receipt and payout risks movement in the price of the currency.

Exposure netting

Exposure netting follows a similar principle to matching currency flows, but applies to a group of receipts and payments within the company group. It involves consolidating multiple cross-currency exposures to offset each other. Companies often have both inflows and outflows in various currencies due to international operations. By netting these exposures, a company can reduce its overall currency risk. 

Operational hedging

Operational adjustments involve making strategic changes to a company's sourcing, manufacturing, and pricing decisions to mitigate forex risk. For instance, a business might consider sourcing more materials or components from domestic suppliers to reduce exposure to foreign currency costs. Alternatively, it could adjust pricing strategies in foreign markets to pass on currency-related costs to customers.

Risk transfer

Risk transfer strategies involve shifting the financial impact of exchange rate fluctuations to external parties. This can be accomplished through various financial instruments such as currency swaps, forward contracts, or by purchasing currency options. For instance, a company can enter into a forward contract to lock in an exchange rate for a future transaction, effectively transferring the exchange rate risk to the counterparty. Additionally, companies can explore insurance products designed to protect against currency-related losses.

Diversification

Diversification is a forex risk management strategy that involves spreading exposures across different currencies. Instead of being overly reliant on a single currency, businesses can engage in international operations that involve a variety of currencies. Diversification can help mitigate the impact of adverse exchange rate movements in one particular currency. 

3 effective tactics to mitigate FX risk

While management strategies are important, what really matters is how you apply them. Here, we will take what we learned in the previous section about forex risk mitigation strategies, and build some practical tactics on top.

Invoice in home currency

One straightforward but powerful tactic for mitigating FX risk is to invoice in your home currency whenever possible. By doing this, you effectively transfer the risk of currency fluctuations to your customers or suppliers. For example, if you're a US company with a European customer, you can quote prices and receive payments in US dollars instead of euros. However, you may still incur fees for forex conversion, depending on the payment method used.

Adjust contract terms

Another effective forex risk mitigation tactic method is to adjust contract terms. For example: 

• Invoice faster and with a shorter payment term to reduce the window when the exchange rate could change unfavourably. 
• Conversely, if you’re applying a ‘matching currency’ strategy, then extending payment terms with suppliers can provide more time to secure favourable exchange rates for outgoing payments.
• Include clauses in contracts that allow for periodic adjustments to prices based on exchange rate movements, or a facility to recoup losses incurred by negative currency price moves. 
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Use stablecoins

Stablecoins run on blockchains that operate independently of traditional international payment rails. The leading stablecoins have been proven to hold their value relative to a fiat currency, typically the US dollar. This combination of operational independence and price stability makes stablecoins an attractive alternative to fiat for conducting international transactions.

Businesses can either trade directly in a stablecoin, or use a stablecoin as an intermediary currency to accelerate a forex transaction and reduce FX risk related to slow settlement times. A third-party, such as BVNK, is often required to process the transaction.

If you need to make a future payment in US dollars (USD), you can create a ‘synthetic’ USD position by buying stablecoins, and avoid paying the interest rate differential, which can be expensive.

Learn more about how global businesses are using stablecoins in Using stablecoins for business: the complete 2023 guide.

Working with hedging instruments

Of all the forex risk mitigation strategies available, many consider hedging to be the most complex. So we’re dedicating the next two sections to explain and compare different hedging instruments. 

Hedging involves the use of various financial instruments to protect against the uncertainty of currency exchange rate fluctuations. In this section we will look at four popular hedging instruments; forwards, options, swaps, and collars.

Forwards

A forward contract is a financial instrument that allows two parties to agree to exchange a specific amount of one currency for another at a predetermined exchange rate on a future date. It effectively locks in a future exchange rate, providing protection against adverse currency movements.

• Example: A US company expects to receive payment from a customer in euros in three months. To mitigate exchange rate risk, it enters into a forward contract with a hedging provider to sell the euros and receive US dollars at an agreed rate.
• Pros: Provides certainty and can be customised, in terms of amount, price and date: 
• Cons: Once a forward contract is in place, it's difficult to change or cancel it. If the currency pairs move price more than you expected (either favourably or unfavourably) you are still bound by the predetermined rate.
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Options

Currency options provide the holder with the right (but not the obligation) to exchange one currency for another at a predetermined exchange rate, and on or before a specific date.

• Example: A Japanese exporter expects to receive payment in US dollars in six months. To hedge against potential yen depreciation, it purchases an option, giving it the right to buy dollars at a specified rate.
• Pros: Offers the freedom to choose whether to execute the transaction based on market conditions, and limits risk to the premium paid for the option.
• Cons: Premiums are paid regardless of whether the option is exercised, which can erode profits if overused and under-utilised.
  
  

Swaps

A currency swap is an agreement between two parties to exchange amounts of two different currencies and then re-exchange them at a later date. This instrument can help companies manage currency exposures more efficiently.

• Example: A US company with operations in Europe may use a currency swap to exchange US dollars for euros temporarily to cover its European expenses.
• Pros: Can be used for various purposes, including managing cash flow and funding costs, and avoids the need for multiple ‘spot’ forex transactions for specific purchases.
• Cons: Involves credit risk with the counterparty, and can be legally complex.
   

Collars

A collar is a combination of options that sets a target range for the exchange rate. It involves buying a put option (to limit downside risk) and selling a call option (to generate income) on a particular currency pair.

• Example: A European company with US operations may implement a collar to protect against unfavorable EUR/USD exchange rate movements. It buys a put option to limit losses if the euro weakens and sells a call option to generate income.
• Pros: Limited cost as the premium paid for the put option is offset by the premium received for the call option, and can be tailored to specific risk tolerance levels.
• Cons: The structure caps potential gains if the exchange rate moves in your favour, while elements such as ‘strike prices’ and expiration dates can add complexity.  

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Each hedging instrument has its advantages and disadvantages, and the choice depends on the company's specific needs, expertise, risk tolerance, and market outlook. A well-executed hedging strategy can provide stability and protection in a volatile forex market.

Key considerations for businesses when selecting hedging instruments

Choosing the right hedging instrument requires careful consideration of various factors. In this article, we'll advise what criteria a business should use when selecting the most appropriate hedging instruments. In the next section we’ll discuss how stablecoins can offer a simpler and more cost-effective alternative.

Cost

Cost is a fundamental consideration when selecting hedging instruments. Different instruments come with varying costs, including premiums for options, spreads for forwards, and fees for swaps. It's essential to evaluate how these costs align with your budget and overall financial strategy. Consider whether the potential benefits of the instrument outweigh the associated expenses.

Flexibility

Flexibility is crucial, as market conditions can change rapidly. Some hedging instruments offer more flexibility than others. For example, options provide the right but not the obligation to execute a transaction, allowing you to adapt to changing circumstances. On the other hand, forwards and swaps often require commitment, which can limit your ability to respond to market shifts.

Complexity

The complexity of a hedging instrument can affect its suitability for your organisation. Some instruments, such as collars and complex options strategies, can be intricate and require a deep understanding of financial markets and corporate law. Consider the expertise available within your organisation and whether you can effectively implement and manage complex instruments.

Accounting treatment

The accounting treatment of hedging instruments can impact your financial statements and tax liabilities. Businesses should consult with accounting experts to ensure compliance with accounting standards and tax regulations. Understanding the reporting requirements for different instruments is vital to avoid unexpected financial consequences.

Advantages of stablecoins vs hedging instruments for forex management 

While traditional hedging instruments can be effective, they often come with complexities and costs. Stablecoins can be an alternative to hedging. 

If, for example, you need to make a future payment in US dollars (USD), you can create a ‘synthetic’ USD position by buying stablecoins, and avoid paying the interest rate differential between the base and the counter currency, which can be expensive.

In general, stablecoins offer several other advantages for finance teams, including:

Simplicity

Stablecoins are digital currencies pegged to stable assets, such as a reserve of fiat currency. Their straightforward nature makes them easy to use and understand, even for those without a background in finance.

Cost-effective

Stablecoins typically involve lower transaction costs compared to traditional hedging instruments. This cost efficiency can directly impact a company's bottom line.

Transparency

Blockchain technology underpins stablecoins, providing transparency and auditability. This can enhance trust in financial transactions.

Speed

Stablecoin transactions can be executed quickly, which is crucial for businesses that need to react swiftly to changing forex market conditions.

Global accessibility

Stablecoins are not bound by geographic borders, making them accessible to businesses around the world.

Wrapping up: Protecting your business from forex risk

To thrive in the global economy, companies must proactively manage and protect themselves from the uncertainties of currency fluctuations. In this article we have read how unmanaged currency fluctuations can erode profit margins, turning successful deals into loss-makers, while sudden and adverse exchange rate movements can impact a company’s overall financial health and international competitiveness. 

While forex risk is unavoidable, mitigation is not. Key is for businesses to understand the management strategies and tactics available to them, including hedging instruments, operational adjustments and currency diversification. And then to select the most appropriate strategy for their situation, based on cost, complexity, risk tolerance, and the level of expertise available within the organisation. While traditional hedging instruments can be effective, they often come with complexities and costs that may not be suitable for all businesses. Stablecoins have emerged as a compelling alternative for businesses seeking a simpler and more cost-effective way to manage some types of FX risk.

About BVNK

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