Foreign Exchange Risk: Basic Guide for UK Businesses

Is your business exposed to foreign exchange risk? You are vulnerable to foreign exchange risk when you do business with foreign companies and perform international financial transactions.

If that is your case, read through this guide, where we will explain the following topics:

Table of contents:
What is foreign exchange risk? When does foreign exchange risk occur? External factors that can result in foreign exchange risk Types of businesses with most exchange risk Types of foreign exchange risk, with examples How to mitigate foreign exchange risk? Go global with Wise Business Account

What is Foreign Exchange Risk?

Foreign exchange (FX) risk - also called currency exchange risk or exchange rate risk - is the potential loss of money due to currency exchange rate fluctuations in international financial transactions¹. Unless the exchange rate between the currencies involved in those foreign transactions is fixed, this creates a risk for all parties involved.

When does foreign exchange risk occur?

The foreign exchange risk mainly affects businesses that import and export goods or services and investors that trade in international markets.

Foreign exchange risk occurs when a company agrees to settle an international payment at a later date. The difference between the exchange rate on the date the contract is signed and the date when the receipt or payment is made likely results in a loss for one of the two parties involved.

External factors that can result in foreign exchange risk

Government policies: Any Increase or decrease in the interest rate set by the government affects the exchange rate². Reducing it means people and businesses can borrow for less, which increases consumer spending and economic growth. But, this may lead to inflation and weakening of a currency. On the other hand, an increase in interest rate attracts foreign direct investment, which creates demand for a country’s currency and strengthens it.

Economic factors: If a company has assets in a foreign country, then economic factors like inflation significantly impact exchange rates. Inflation is a general increase in prices over time. Higher inflation rates negatively affect a currency’s value and its foreign exchange rate. Stocks, bonds and commodity prices are some of the other economic factors that affect a country’s exchange rate.

Credit Risk: This risk can arise for any financial transaction, and correspond to the failure of one of the parts to settle the payment as agreed. For foreign transactions this risk acquires complexity due to the volatility of the currency pairs involved in the exchange³.

Types of businesses with the most foreign exchange risk

Businesses that carry out frequent or large international financial transactions and multinationals with significant investments in foreign currencies carry the most foreign exchange risk.

Below, we will look at the types of foreign exchange risk and how they affect companies the most with examples.

Types of Foreign Exchange Risk

There are three types of foreign exchange risks. They impact businesses in different ways, as outlined below:

1) Transaction Risk

This arises when a company agrees with a foreign company to buy or sell goods or services with the following conditions:

• The company agrees to make or receive payments in the foreign company’s national currency.
• It agrees to settle receipts or payments at a later date.

💡 Example:
A British company agrees with a French company to buy goods worth 120,000 euros on 1 June 2022 when the exchange rate is 1 GBP = 1.2 Euros. The two companies agree that the payment will be made upon delivery on 30 June 2022. Suppose the exchange rate on 30 June 2022 changed to 1 GBP = 1 Euro. This will result in a loss of 20,000 GBP for the British company.

One way UK businesses can mitigate transaction risks is to open a Wise Business Multi-Currency account. It allows international companies to hold money in 50 different currencies, receive it like a local in 10 currencies, and convert it using the mid-market exchange rate.

2) Translation Risk

This risk is also called translation exposure and is an accounting risk for a company headquartered in one country with its subsidiaries in other countries. When the values of foreign subsidiaries’ holdings are converted into the parent company’s domestic currency, inconsistencies can arise due to continuous changes in exchange rates.

This can lead to a distorted view of a company’s international holdings if foreign currencies appreciate or depreciate considerably compared to the home currency.

💡 Example:

A British company’s subsidiary in China buys an asset worth 800,000 Yuan on 1 December 2021 when the exchange rate is 1 GBP = 8 Yuan. So, the value of that asset converted into pounds is 100,000 GBP. On 31 March 2022, the company converts all its foreign holdings into pounds to present consolidated accounts to its shareholders. Now, if the exchange rate on that day changes to 1 GBP = 10 Yuan, the value of the foreign asset will fall to 80,000 GBP.

3) Economic Risk

Macroeconomic conditions like political and economic instability impact a company’s market value. If a company has subsidiaries abroad and their currencies depreciate, this will reduce its market value.

💡 Example:
A British company manufactures and sells laptops locally in the UK. If the pound strengthens and imports become less expensive, it will face competition from local importers of laptops. Likewise, if the pound weakens and the exports become less expensive, it will face less competition locally and can look to expand overseas.

How to mitigate foreign exchange risk?

Foreign exchange risks can deteriorate a business’ financial position. Many multinational companies now employ FX experts to mitigate these risks. Some ways they do that are as follows:

Transaction risk can be mitigated using financial instruments like forward exchange contracts and currency options. A forward contract lets a company lock in a predetermined exchange rate of a future foreign currency payment today by entering into a contract with a third party like a bank or a financial institution⁴. A deposit is usually required for this at the commencement of the transaction, and a premium on the spot price.

A currency option allows a company the right, but not the obligation, to buy or sell a currency at a specific exchange rate on or before the option expires. The company has to pay a premium for this, but it allows the company to take advantage of the option if its exchange rate is more favourable on future payment date than the spot rate; otherwise, it can let it expire.

Translation risk can be managed through currency swaps, futures contracts or by asking the foreign company to pay in the parent company’s currency. Many accountants report translation risk as foreign exchange gains or losses in the parent company’s financial statements⁵.

To an extent, economic risk can be mitigated by a business diversifying its portfolio in different countries. So the depreciation of assets in one currency may cancel out the appreciation of assets in another.

Go Global with Wise International Business Account

Businesses can benefit from Wise Business Multi-Currency Account to manage finances more efficiently and mitigate foreign exchange risks.

• Get local bank details and receive money in 10 currencies from your customers quickly and efficiently.
• Hold and convert money from more than 50 currencies using the mid-market exchange rate and without high conversion fees.
• Send money to 80 different countries.
• Spend with the debit card online or in-store without incurring foreign transaction fees.
• Manage employee expenses with ease using the expenses card.

Get started with Wise Business

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Foreign exchange risks pose a real threat to any business involved in international financial transactions. To reduce potential monetary loss arising from these risks, businesses must mitigate them using financial instruments. One of the best ways to reduce exchange rate risks is to open a Wise Business account.

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Sources used in this article:

1 - Currency Risk: What It Is and Hedging Against It, With Examples
2 - National Interest Rates: Currency Value and Exchange Rates
3 - Tools for Mitigating Credit Risk in Foreign Exchange Transactions
4- Clear Treasury
5- ACCA global

Sources checked in 24/10/2022