17 November 2020

Understanding the Fundamentals of Foreign Exchange Risk in 5 minutes

Doing business on a global scale comes with certain risks. If you’ve got five minutes, we’ve got all you need to grasp the basics of foreign exchange risk.

Transactions in foreign currencies put you at the mercy of fluctuations in exchange rates. If they go one way, you could reap the rewards. If they go the other way, your profits could take a hit.

To help you navigate the risk of overseas transactions in uncertain times, we’ve summarised the essential info you should bear in mind.

Four examples of foreign exchange risk

Importing

 

Exporting

 

Investments

 

A mixture

 

Six ways to manage your foreign exchange risk

Quantify your FX risk

You can’t manage your FX risk unless you’re aware of every part of your business that involves foreign currency. Make a list of everything that isn’t in your base currency, e.g.:

  • Overseas revenues
  • Paying remote freelancers and employees in their own currencies
  • Importing raw materials
  • Investments in global stocks, funds, and bonds
  • Large one-off expenses, such as opening an overseas office

For each item, list the amount it’s currently worth according to the exchange rate between your home currency and the foreign currency. You can use these figures to run various scenarios and test how fluctuations could help or hurt your revenue. For example, what would happen if your home currency suddenly dropped by 20 per cent against the other currencies to which you have exposure? Could your cash flow survive, or would you need more working capital to stay afloat?

Require payment in your domestic currency

This puts the onus of bearing fluctuations in the exchange rate on your customers. It’s a simple solution but could make it harder to do business if competitors are willing to offer customers less risky transactions in their home currency.

Prioritise prompt payments

Setting shorter payment terms can limit the amount of time you’re exposed to the currency market. You should also aim to close the gap between agreeing on deals with your customers, clients, and suppliers and settling transactions for those deals.

Charge more to account for potential fluctuations

If a client’s currency fluctuates by around 3 per cent per year relative to your currency, you could charge 3 per cent more in that country. It might not work if it changes by more than 3 per cent or the market won’t support the increase, but otherwise, it could help you manage the risk.

Consider important risk metrics

The most common tools for measuring FX risk are:

Value-at-Risk (VaR) - An estimate of how much you might lose or gain under normal currency market conditions over a set period.

Cash-Flow-at-Risk (CFaR) - How future cash flow may change over a set period as a result of FX market fluctuations.

Earnings-at-Risk (EaR) - How much your income may change over a set period based on previous earnings figures. The longer the time period, the higher the FX risk.

These calculations are worth looking into if a large proportion of your business relies on imports, exports, or foreign investment.

Lock in a fixed rate

There are financial products you can use to set an exchange rate so you know exactly how much a transaction will be worth when you make it.

A forward exchange contract locks in an exchange rate for a future transaction, thereby protecting against a disadvantageous movement. However, if the rates move in a way that would have saved or made money, you have to stick to the rate you agreed with your bank.

If you want to find out how your transactions could be affected by the pandemic, or are looking to expand your business into new markets, there are several options to help manage your FX risk. Should you wish to discuss how HSBC may assist you or your business in respect of any of the matters discussed in any of these articles, or anything else, and you are not already an HSBC customer, please contact us by clicking on the “Get In Touch” button below.

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