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Understanding FX Risk

Foreign exchange (FX) risk, also known as currency risk or exchange rate risk, exists because the currencies involved in a transfer constantly fluctuate against one another.

For example, once two international parties have agreed the cost for goods or a service, should the currency pair swing negatively by the time of the payment date, then the value of the buyer’s investment decreases.

This risk is particularly pronounced in international business transactions, where businesses must navigate the complexities of many different currency environments. 

Businesses that have a greater proportion of international revenues and international expenses, naturally leads to a greater level of FX risk.

Effective management of this risk is crucial, not just for large corporations but also for small and medium-sized enterprises (SMEs) that participate in global trade.

This article will explore the various types of FX risks, and explain why choosing the right currency partner to manage your international transfers can help manage this risk.

We strongly recommend working with a currency broker, as you’ll have more hedging tools at your disposal, as well as first class guidance from your own dedicated currency expert.

But first, let’s get a better understanding of the types of FX risks to be aware of.

Types of FX Risk

Transaction Risk 

This risk exists in the time between the inception and settlement of a contract, during which the value of the purchasing currency may fluctuate significantly. 

This typically impacts the buyer only, as they are purchasing in the selling company’s currency. If the supplier’s currency appreciates by the time they come to settle, then the buyer is paying more in their own currency to meet the agreed selling price.

Translation Risk

This occurs when a business consolidates its financial statements from various countries. 

Fluctuations in exchange rates can lead to significant variation in the value of a company’s equities, assets, liabilities and income.

This, of course, can hugely impact a company’s financial reporting, particularly parent companies with overseas subsidiaries in a number of different countries. 

Economic Risk

This type of risk is very broad, referring to the impact of currency exchange rate changes on a company’s overall financial strategy. 

Multinational companies that deal with a large number of foreign currency transactions are those with the greatest exposure to economic risk but that’s not to say the impact on small businesses can’t be massive. 

In volatile economic climates, which is more common in many developing countries, these risks can be particularly severe, necessitating government intervention and support for large-scale infrastructure projects.

This can be a very difficult type of risk to mitigate, as many of these changes in FX rates are unexpected, therefore harder to prepare for.

Take a look at Turkey for example. In just six months during mid-2023 the value of the Turkish Lira fell by roughly 33% against the British pound. 

This has a huge impact on importers and exporters in both countries, either making trade drastically cheaper, or drastically more expensive.

Now you have a better understanding of the various types of FX risk, let’s look at how you can mitigate this risk, and why we recommend choosing a currency broker to help you do so. 

How currency brokers help you mitigate your FX risk

Make the smart choice to work with a currency broker for your international transfers, and they’ll play a pivotal role in your FX risk management.

By offering a variety of financial products like forward contracts, alongside stop loss and limit orders, you can leverage your account manager’s strategic advice, based on expert market analysis to better manage FX risk. 

Their expertise is particularly beneficial if you’re trading currency pairs with significant volatility.

To help you hit the ground running, it’s extremely beneficial to enter this relationship with a basic understanding of the different FX tools and techniques used to manage exchange rate risk. 

Strategies for Managing FX Risk

Hedging Techniques: These are critical for managing FX risk!

  • Forward Contracts: these allow you to set a fixed exchange rate for future transactions for a set period of up to 2 years, providing certainty and stability in unpredictable currency markets. 

This strategy is especially important in emerging markets, where currency volatility can significantly impact trade.

  • Currency Options – stop loss and limit orders: here you have the flexibility to buy or sell currency at a predetermined rate, offering protection against adverse movements while allowing participation in favourable shifts.

A limit order lets you specify a desired FX rate, and if the rate improves to this level, your currency pair is automatically bought/sold. If you can afford to wait for a better rate, a limit order is a vital tool in the armoury.

A stop loss order involves setting a lower rate to protect from downside movements in the currency exchange. If there’s a rate that you know you absolutely cannot afford to go lower than, use a stop loss order.

  • Natural Hedging: This involves balancing currency inflows and outflows within a business’s operations. By using revenues generated in a foreign currency to pay expenses in that same currency, you can effectively neutralise your FX risk. 

Natural hedging strategies include purposely holding balances of multiple currencies. 

Let’s say you receive a significant payment in Euros but you know that you need to pay a large invoice later that year, also in Euros.

Instead of converting your Euros received into GBP, only to convert that back into Euros for your payment, you’d simply hold the Euros to avoid any FX whatsoever.

Additionally, a business might buy and hold a particular currency while the rate against their home currency is attractive. This avoids having to accept an unknown FX exchange rate in the future at the time of the transaction, thus mitigating the FX risk.       

Policy Development

If you’re dealing with a lot of international trade, crafting a comprehensive FX risk management policy is essential. 

This involves defining acceptable risk levels, identifying FX exposure, selecting appropriate hedging strategies, and establishing robust systems for monitoring and reporting. 

Such policies must be adaptable to the dynamic nature of global currency markets.

A good currency broker will take the time to understand the level of FX exposure your business has and develop a strategy that is unique to your business.

What’s more, today’s technology does a fantastic job in assisting policy development and FX risk in general.

Role of Technology

Technology has transformed FX risk management in recent years, empowering individuals and businesses to formulate stronger risk management strategies, make smarter decisions, and initiate better timed trades.

Real-time access to data has been a huge driver for this change, as people are able to either capitalise on opportunities faster, or protect themselves quicker from high risk markets. 

Risk management software has also become far more sophisticated, helping individuals to make better informed decisions themselves, as well as allowing account managers within currency brokers to provide far greater guidance that’s driven by better insights. 

Even with access to the most cutting edge technology and real-time data, past trends do not always act as a reliable predictor for the future. 

This is why choosing to work with an established currency broker with a solid reputation is your best bet. Their reputation speaks as a testament to their success in utilising the tools and knowledge available to them at the time. 

Ask yourself…

Why wouldn’t I want free guidance from some of the leading currency experts in the market? 

Who, as well as having a lot of experience, leverage the latest technology to give you the best possible guidance in managing currency exposure.     

Choosing the Right Partner

Now you have a better understanding of FX risk, you can appreciate how important choosing the right provider is.

To help manage FX risk, you’re looking for a currency broker that has a comprehensive suite of hedging tools and one that is well versed in trading in the currency pairs you require

Obviously, you’ll want a provider that has very competitive exchange rates too, which all of our recommended providers do. 

A huge plus of building a long term relationship with your currency broker is that you’ll be able to negotiate better rates over time. 

In addition, as you whittle down your shortlist, customer service could well be the determining factor in choosing a partner to help manage FX risk. 

This is why moneycorp is our #1 recommended currency broker.  

Moneycorp were at the inception of the non-bank currency transfer industry in the late 70’s, and have remained top of the pile to this day, receiving a number of prestigious awards along the way. 

Yes they offer a strong selection of hedging tools and great exchange rates, but what sets them apart is their emphasis and execution on delivering a highly bespoke service.  

Another two providers that deserve an honourable mention are the British-headquartered TorFX, and global giants OFX. 

TorFX is also a veteran currency broker, one of the biggest in the UK, that places a similar emphasis on providing an outstanding level of customer service to their clients.

OFX is an Australian-based powerhouse in the money transfer industry that, over time, has evolved into an all inclusive cross-border payment system. 

Despite offering great online and app solutions for customers transferring low amounts, their strength remains in servicing high value and business customers, and having one of the best teams of dedicated currency experts in the industry.

By choosing an experienced broker with a global presence, you’ll benefit from their unique perspective of how other countries and regions have dealt with FX risk.  

Case Studies and Global Perspectives

Examining global practices, as seen in countries like Brazil, Colombia, Chile, Argentina, and Peru, provides valuable insights into managing FX risk. 

These countries have developed unique strategies, from innovative government policies to sophisticated financial instruments, all to attract foreign investment and mitigate FX risk. 

For example, in some Latin American countries, concessionaire’s credit rights are dollar-indexed, allowing them to access international capital markets more effectively. 

Such practices offer valuable lessons for policy makers in other countries too.

Conclusion

FX risk management is an integral aspect of international business. 

Understanding the various types of risks and employing effective strategies is crucial for protecting your business from the volatility of currency markets. 

This is particularly important for SMEs, which may be more vulnerable to the impacts of currency fluctuations. 

Whatever type of business you are part of, choosing to partner with a leading currency broker to help manage your FX risk is the smartest choice you can make.

By building a relationship with your broker, you can develop a bespoke strategy to mitigate your FX risk. 

This strategy is designed with use of the latest technology and executed via a broad suite of currency hedging tools, all while being guided by an industry expert.