Are you exposed to foreign exchange risk? If you operate an international business, then you are likely to carry out commercial transactions or investments in a currency that is not your own. Therefore, you are subject to foreign exchange risk. But, what is foreign exchange risk and what are the consequences for your company?
What is foreign exchange risk?
By definition, foreign exchange risk is the possibility for a company to be affected by a variation in the exchange rate between its local currency and the currency used in a transaction with a foreign country.
In the foreign exchange market, also known as FOREX, the value of a currency is expressed in terms of the value of another currency, which defines its exchange rate. Exchange rates are determined over the counter, often based on elements that are difficult to anticipate such as interest rate differentials, trade, or even the political stability of a country, which makes them very volatile.
Foreign exchange risk is a major issue for treasurers and finance departments since between the conclusion date of the contract and the cash flow date corresponding to the payment, the exchange rate of currencies will most certainly fluctuate.
Foreign exchange risk: what are the consequences for your company?
Fluctuating exchange rates can affect your business in different ways:
1. Transactional foreign exchange risk
Your company uses euro as its currency, you are carrying out a transaction with a company in the United States. The company buys your service in USD, so you need to take into account the value of one euro in US dollars (USD), expressed as a currency pair (EUR/USD).
Here, the fluctuation of the dollar represents a risk described as a transactional foreign exchange risk, because in case of an unfavourable development of this currency in regard to euro, your company can be negatively affected by an exchange rate loss. This is the most common consequence of currency risk: if left unchecked, it can reduce a company’s margins and contribute to a decline in its profits.
2. Economic risks
Your company has assets in the United States, a factory for example. The risk here would be to face a depreciation of the country’s currency. Fluctuations in the USD exchange rate can impact the future value of your company, the short, medium and long term competitiveness of its products/services.
3. Accounting or consolidation exchange risk
Your company has subsidiaries in different countries around the world, and each year you draw up a consolidated balance sheet. You then pass on the income generated by the subsidiaries to the parent company. This income can be affected by movements in the foreign exchange market when repatriated.
How can you protect your company against foreign exchange risk?
Unfortunately, foreign exchange risk is inherent in most international businesses. If it is not taken into accountand controlled, it can be damaging to the company’s growth.
As a first step, it is interesting to look at the foreign exchange position currency by currency and to determine, depending on the type of transaction, what foreign exchange policy should be applied.
This policy, which is generally drafted by the treasurer, must then be approved by the ad hoc governing body.
It will then enable the treasurer to know what foreign exchange risk protection should be carried out, and in what proportion (20% of the risk, 80%, 100%?).
On the basis of this diagnosis, you will be able to decide on the best covering solution for you. A foreign exchange covering solution allows, among other things, to lock in the exchange rate, different options exist depending on the need (one-off or recurrent) and the type of cover required (simple or complex).
5 types of foreign exchange cover
- Forward contract: allows the foreign exchange rate of a transaction to be locked in at a predetermined date, e.g. when the invoice is issued
- Foreign exchange swap: this is a reciprocal credit agreement (Loan/Borrowing in one currency against a Loan/Borrowing in another currency). This allows two foreign exchange transactions (spot and forward) to be combined simultaneously on dates defined with the bank and at rates determined in advance
- Foreign exchange option: gives the company the possibility of buying or selling a given amount of foreign currency on a given date and at a rate predetermined, in return for the payment of a premium
- Indexation clauses: can be fixed in a purchase or sale contract and allow the terms of sharing or taking on the foreign exchange risk between the buyer and the seller to be defined if there is a variation in the foreign chosen currency exchange rate
- Foreign exchange insurance: a contract to be taken out with a financial institution which guarantees protection against the foreign exchange risk throughout a transaction.
