Contents
Key Takeaways
- Foreign exchange exposure, also known as FX risk, currency risk or exchange rate risk, refers to the risk of potential financial losses caused by fluctuations in exchange rates between currencies.
- There are 4 main types of FX exposure: transaction risk, economic risk, liquidity risk and translation risk.
- There are 5 main ways to manage and reduce FX exposure: forward contracts, futures contracts, currency options, currency swaps and natural hedging.
- Neo banks and payment service providers such as Airwallex and PayPal offer competitive FX fees in payment processing to help your business scale globally.
What is FX exposure ?
Foreign exchange exposure, also known as FX risk, currency risk or exchange rate risk, refers to the risk of potential financial losses caused by fluctuations in exchange rates between currencies.
FX exposure is a serious issue for businesses that have cross border operations where they process payments and hold funds in multiple currencies. It can have a significant impact on a company’s cash flow, profitability and competitiveness as they can suffer financial loss when exchanging currencies at an unstable rate.
Let’s take a look at the different types of FX risk and how each affects a business.
Types of Foreign Exchange risk/exposure
- Transaction risk
Transaction risk is the most common type of FX exposure. When a transaction is processed in a foreign currency, there will be a waiting period between the time that the transaction takes place and the actual date of settlement in the business’s local or base currency account.
If a change in exchange rate occurs during that period, the actual dollar value the business would receive or pay in their functional (mainly used) currency can change and result in a loss in profit or an increase in costs.
- Economic risk
Economic exposure is often referred to as the long term risk in foreign exchange on a larger scale. It describes the potential long term impact on a company’s overall market value and cash flow, due to exchange rate fluctuations.
Economic FX risk is associated with macroeconomic factors such as interest rates and inflation. Especially for companies that operate on an international scale, such as trading companies, unexpected FX fluctuations can weaken their revenue and higher the cost in their foreign operations. It can also affect their long term strategies such as foreign investment or market expansion.
- Liquidity risk
Liquidity risk is an essential factor every company should take into account when assessing the impact FX volatility has on its cash flow and operation.
The bottom line for a business’s survival is the ability to pay all the expenses. If your company is not liquid (as in insufficient cash flow) enough to pay all of its bills when there is an unexpected exchange rate change, it is exposed to what is called liquidity risk in FX management.
- Translation risk
Translation risk refers to the potential change in a company’s reported value in its financial statement for its foreign holdings, such as foreign assets, liabilities or income.
When the reporting currency is different from the company’s functional currency, FX fluctuations could lead to a lower earning when reflected on a balance sheet. However, instead of an immediate risk to the company’s cash flow, it is more of an accounting exposure where the company’s foreign earnings would appear to be taking a hit when converted back into its functional currency. This does not mean that the company is actually suffering a cash loss.
How to manage and reduce FX exposure ?
When it comes to mitigating the risk of FX exposure for your business, there are a few ways that you can consider:
- Forward Contracts
A forward contract is a customized, over the counter (OTC) agreement between two parties that locks in the exchange rate or price upfront for future transactions on a certain date or on specific deals. They will buy and sell at the predetermined rate and greatly eliminate uncertainty in FX exposures.
This hedging tool is particularly ideal for businesses that involve exporting and importing. However, signing a forward contract also means a company will not benefit if the FX rate improves.
- Futures Contracts
Similar to forward contracts, futures contracts allow the buyer to buy or sell an asset at a predetermined price on a certain date in the future. However, futures contracts are not customizable, they are standardized and provide less flexibility than forward contracts in terms of matching a business’s exact needs.
- Currency Options
An option is a financial contract that allows the buyer to buy (call) or sell (put) something at a specific price (strike price) on or before a certain date. Currency options refer to contracts that grant you the right to buy or sell a currency at a fixed rate on or before the option’s expiration date.
The biggest benefit of currency options is that you are not obligated to fulfill the contract. This gives the buyer great flexibility and limits his downside risk, since he can decide whether to exercise the option when the rate is bad or let the option expire if the rate improves. However, you are required to pay a premium (the upfront price of the option contract) to purchase an option.
- Currency Swaps
A currency swap takes place when two parties exchange (swap) principal and interest payment in two different currencies. It is useful when a business wants to manage long term FX risk and have easier access to a specific foreign currency, helping businesses to align their expense and revenue in the same foreign currency.
Currency swaps are complex financial derivatives and require significant resources in terms of financial expertise, high liquidity and strict compliance standards. Therefore, currency swaps are generally more accessible for large enterprises.
- Natural Hedging
Natural Hedging refers to cost efficient strategies that help businesses naturally reduce FX exposure by aligning the inflow and outflow of foreign currencies.
Common natural hedging strategies include:
- Matching Flows: Take earnings and pay expenses in the same currency, avoid frequent exchanges between currencies.
- Invoicing: Send invoices in your functional currency, this way the FX risk will fall on the payer instead of you.
Final Note
If you are looking to open a company along with solutions that offer competitive FX fees, please consider Get Started HK.
As the leading company formation agency in Hong Kong, we specialize in Hong Kong Company Registration, Corporate Secretarial Services, and Accounting & Auditing Services. We also have a comprehensive referral network of various neobank and payment solutions such as Airwallex, Payoneer and PayPal, which offer competitive FX fees in payment processing to help your business scale globally.
Frequently Asked Questions
1. What is foreign exposure risk?
Foreign exchange exposure, also known as FX risk, currency risk or exchange rate risk, refers to the risk of potential financial losses caused by fluctuations in exchange rates between currencies.
2. What Are the Different Types of FX Risks?
There are 4 main types of FX exposure: transaction risk, economic risk, liquidity risk and translation risk.
Businesses can manage FX risks with financial hedging tools like forward contracts, futures contracts, and currency options to lock in or limit uncertainty in future exchange rates. Businesses can also use natural hedging strategies as more cost efficient solutions.
