What is FX Risk? An Overview for Global Businesses

If your business operates internationally, you likely have exposure to foreign exchange risk (FX risk). In this article, we give a comprehensive overview of FX risk—what it is, what causes it, who is affected and how to strategically mitigate it.

What is FX Risk?

FX risk – also known as currency risk or exchange rate risk – is the risk of potential losses that may arise due to changes in exchange rates. FX risk is a major concern that can impact cash flow, profits, and competitiveness for companies that operate and transact across international borders.

What Drives FX Risk?

Fluctuations in exchange rates are the main driver behind FX risk, and those fluctuations can be influenced by a variety of market and geopolitical factors, including:

• Interest rate differentials: Central banks adjust interest rates to control economic growth and inflation. This in-tune impacts currency value. Higher interest rates typically attract foreign investment, strengthening its currency.
• Inflation rates: Currencies from countries with high inflation rates tend to depreciate, which in turn, reduces their purchasing power relative to more economically stable countries.
• Geopolitical uncertainty and market sentiment: Instability, trade disputes, and policy changes can all impact currency values.
• Speculative trading and market liquidity: When investors and financial institutions make large volumes of currency trades in reaction to news, economic data, or global events, it can further exacerbate exchange rate fluctuations.

Who is Affected by FX Risk?

FX risk impacts any business or entity that engages in international trade, investment, or financial transactions. Multinational corporations are among the most affected because they transact in multiple currencies. Each currency they transact in comes with its own unique relationship relative to its functional currency (the primary currency in which the company operates and the basis on which it presents financial statements).

Importers and exporters face direct exposure to FX risk as currency movements can increase costs and erode profit margins on every cross-border transaction. Small and mid-size enterprises and even individual consumers can feel the effects of FX risk as those costs and uncertainties are commonly passed on to end-users of given products.

The 4 Types of FX Risk

FX risk can be broken down into four types. The first three are the most commonly cited types of risk. The last one, while less common, is still worth mentioning. Ultimately, these risks can negatively impact cash flows from cross-border transactions and stakeholder perceptions about the health of the company, leading to poorly managed resources and uninformed financial decision-making.

1. Economic Risk: These are the long-term impacts of exchange rate fluctuations on a company’s market value and cash flow. When left uncounted for in a risk management plan, it can affect your company’s profitability in foreign markets.
2. Translation Risk: This occurs when a parent company with foreign subsidiaries consolidates its financial statements into its home currency. If exchange rates fluctuate between reporting periods, it can alter the value of assets and liabilities on financial statements. This can negatively influence investor perceptions even if the business remains stable.
3. Transaction Risk: FX risk can even occur during transactions. Depending on the window between the transaction and settlement date, exchange rates can change, impacting profitability and cash flow predictability.
4. Liquidity Risk: This is a tangential FX risk that refers to the possibility a company may struggle to buy or sell foreign currency at favorable rates due to low market liquidity. This hampers your company’s ability to meet financial obligations due to currency fluctuations, impacting cash flow management and operational continuity.

How to Mitigate FX Risk: 3 Common Approaches

#1. Balance Sheet Exposure Management

Items like loans, receivables, and payables held in foreign currency can change in value when converted to home currency. Balance sheet exposure management is the process of minimizing the impact of those fluctuations, which can reduce vulnerability to currency changes and strengthen financial planning precision. A key advantage of balance sheet exposure management is its ability to optimize hedging strategies, improving cost efficiency. Additionally, it helps stabilize earnings, making the company more attractive to long-term investors.

#2. Cash Flow Exposure Forecasting

Cash flow exposure forecasting focuses on anticipating how future exchange rate fluctuations may affect a company’s projected cash flows from international transactions. By estimating the timing and volume of incoming and outgoing foreign currency, cash flow exposure forecasting helps identify potential risks in advance. This enables treasury teams to implement effective hedging strategies to mitigate adverse currency movements. Additionally, it enhances strategic decision-making, improves the accuracy and timing of hedges, optimizes resource allocation, and supports proactive liquidity management.

#3. Strategic FX Hedging

FX hedging refers to the process of mitigating adverse outcomes caused by exposure to fluctuating exchange rates. Hedging often involves financial instruments known as derivatives that serve to alleviate undesirable impacts on cash flow, enterprise value, or both.

When it comes to hedging FX risk, companies have many options. There is no one-size-fits-all solution to FX hedging. Here are some common instruments companies will use to hedge FX.

• Futures Contracts: Futures contracts are standardized agreements traded on an exchange to buy or sell a specific amount of currency at a predetermined exchange rate on a future date.
• Forward Contracts: Like futures contracts, forward contracts are agreements between two parties to exchange a specific amount of currency at a predetermined exchange rate. The difference is forward contracts are transacted directly with a counterparty, rather than through an exchange.
• Options: Options are financial instruments that give the buyer the right, but not the obligation, to exchange a specific amount of currency at a predetermined exchange rate on or before a certain date.
• Swaps: Lastly, swaps are agreements between two parties to exchange cash flows in different currencies at predetermined intervals. One of the key advantages of swaps is their flexibility in terms of making them highly adaptable to a company’s specific needs.

Better Manage FX Risk with Expert Hedge Accountants

Now that you have a better understanding of FX risk, you can begin to manage it. While that is easier said than done, there are experts that can help. Many global companies with FX exposure turn to specialized hedge accountants to optimize their FX risk management strategy. This approach provides the high-quality tools and expertise needed to manage and account for complex currency exposures effectively and efficiently.

Have more questions about FX risk? Want to get a better understanding of your possible exposure? Book a call with a hedge accounting expert at HedgeStar.