Defining and Addressing Foreign Exchange Risk

Defining and Addressing Foreign Exchange Risk

Foreign exchange risk is an ever-present threat for any business that operates in multiple currencies, including small import-export firms, multinational corporations and everything in between. What seems to be a deceivingly simple concept, foreign exchange risk, can actually be subdivided into three distinct risks that occur when operating in multiple currencies: cash flow risk, translation risk and economic risk. This article will cover all three types of foreign exchange risk below. 

What is cash flow risk?

An example of cash flow risk is when a company buys products from a supplier in another country and the price is set in local currency. If the supplier’s currency gains in value against the importers before the importer pays the invoice, the importer will have to pay more of their own currency for the goods acquired.

Beyond the importer example, cash flow risk applies equally to incoming (accounts receivable) and outgoing (accounts payable) payments when the payment is in a foreign currency.

As a part of what is referred to as transaction risk, cash flow risk occurs whenever payments are not made simultaneous to the transaction. This means the exchange rate can change to your disadvantage after a deal is made and before it is paid. The more time that elapses between entering into and settling a deal, the more risk that is incurred. Methods for reducing cash flow risk include the use of hedging as well as other means. What all solutions have in common: they require advance planning to contain the risk.

What is translation risk?

Sometimes businesses can lose money due to foreign currency exchange movements without any underlying cash-flow transactions taking place. In essence, this risk is mainly an accounting risk. Hence, there is a risk associated with the scope of assets and liabilities, and less with actual commercial trading. For instance, it exists when a company has branches or operations overseas that use a foreign currency but the company records and presents its financial statements in another currency. The exchange rate for translating the foreign operations’ assets and liabilities changes from reporting period to reporting period.

This accounting problem can affect profit and loss, the balance sheet and cash flow statements, which are the basis for the ratios used in credit ratings, loan covenants and credit fundamentals. This makes this aspect of foreign currency risk important to note, and often companies will show their results with and without the impact of exchange rate fluctuations on sales and profit in their financial presentations.

What is economic risk?

Lastly, there is economic risk. This refers to the impact exposure to unexpected currency fluctuations has on a company’s future cash flows, foreign investments and earnings and, therefore, the impact can be quite substantial. Unlike cash-flow risk, this risk is mainly derived from future ongoing business operations, that have yet to be invoiced or recorded in the financial statements. In theory, all companies have some sort of operating exposure to foreign currency economic risk, and with globalization the economic risk of foreign currency fluctuations has increased for all companies.

Economic risk is difficult to hedge against, but there are other strategies businesses can use to minimize their operating exposure. For example, a company could diversify its costing and pricing methods to different currencies.

What foreign exchange risk are you dealing with?

Whatever the extent of your foreign exchange risk, it is useful to divide into these three categories: cash flow risk, translation risk and economic risk. Each category of exchange risk implies a problem of a different nature that will likely require different solutions than another category of foreign exchange risk. So do your homework and figure out what is the root of your problem before seeking out solutions.