What is currency risk?

Article reviewed by Fred Allatt - Managing Director - FX Sales, Americas- StoneX Pro

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Currency risk, or exchange rate risk, is a type of financial risk faced by companies or investors that operate in international markets. It refers to the potential for losses due to unpredictable changes in one currency’s value relative to another.

Multinational companies and institutional investors mitigate this risk through currency hedging strategies such as FX forwards, options, and currency swaps, or by diversifying across markets. See our range of FX liquidity

What is a currency risk, and how does it affect businesses?

Currency risk, also known as foreign exchange risk, arises when fluctuations in currency values affect a business’s international transactions, investments, or operations. These currency fluctuations can affect the real cost of imported goods, exported products, or planned foreign expansions. For companies engaged in international trade, even small changes in exchange rates can significantly impact costs, revenues, and profits.

Currency risk can be caused by currency appreciation, depreciation, or a combination of both. It can be a concern for companies involved in imports, exports, or businesses expanding into foreign markets.

For example, consider a business in the U.S. importing goods from Europe. The U.S. company agrees to pay €500,000 for a shipment. If the euro’s value drops against the dollar before payment is made, the company pays less in dollars and benefits from the change in currency values. If the euro strengthens, however, the shipment will become more expensive and reduce the company’s profits.

Currency risk can affect financial reporting as well as transactions. For example, if a Canadian company was earning revenue in Chinese yuan, it must convert those earnings to Canadian dollars. Any fluctuation in the yuan-to-dollar exchange rate can affect the reported earnings, regardless of actual sales performance.

Many companies and institutional investors rely on hedging strategies, such as options, futures, and currency swaps, to manage currency risk and offset against currency fluctuations.

Currency risk example

Imagine an American coffee importer agreeing to purchase 10,000 kilograms of premium coffee beans from a Brazilian supplier for BRL 50 per kilogram for a total of BRL 500,000. At the time of the deal, the exchange rate is 1 Brazilian real (BRL) = $0.20, so the importer expects to pay $100,000 in total.

The beans will take three months to arrive. During that time, the U.S. dollar weakens against the Brazilian real and the exchange rate shifts to BRL 1 = $0.25. When the coffee is delivered, the importer still owes BRL 500,000, but the cost in U.S. dollars has increased to $125,000.

This means the company loses $25,000 due to currency risk – demonstrating how fluctuations in exchange rates can significantly affect a company’s costs and profitability.

How does foreign exchange risk impact international transactions?

Foreign exchange risk can have a major impact on international transactions for both businesses and investors.

For businesses, exchange rate fluctuations can directly affect the cost of imports and exports, which in turn affects profit margins and global competitiveness. For example, a weaker domestic currency increases the cost of importing goods while a stronger currency can make a company’s exports less attractive to international buyers. Multinational corporations may also deal with additional complexities when consolidating financial statements since earnings in foreign currencies must be converted into the company’s home currency.

For investors, exchange rate fluctuations can affect the returns on investments held in foreign currencies. For example, a stronger domestic currency can reduce gains from foreign investments, while a weakened domestic currency can potentially increase returns.

What are the main types of currency risk in B2B finance?

There are three types of currency risk in B2B finance: transaction risk, translation risk, and economic risk.

Transaction risk

Transaction risk occurs when one company buys products from a company located in another country, with the price set in the seller’s currency. If the seller’s currency strengthens relative to the buyer’s currency, the buyer will need to pay more in their country’s currency to meet the contracted price. In essence, transaction risk comes from the time delay between initiating and settling a financial transaction in foreign currencies.

For example, if a French company agrees to pay a Chinese supplier CNY10,000 for goods, but the exchange rate shifts unfavorably before payment is made, the company may need to pay more in its base currency to fulfil the contract. This risk can be mitigated with tools like forward contracts or currency options.

Translation risk

Translation risk, also known as translation exposure, is relevant to companies that own subsidiaries or assets in foreign currencies. When a foreign entity’s financial statements are converted into the parent company’s currency, exchange rate changes can potentially affect the company’s reported earnings.

For example, if a Canadian parent company owns a subsidiary in China, its earnings may appear to be reduced if the Chinese yuan weakens against the Canadian dollar.

Economic risk

Economic risk, or forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to currency fluctuations. It’s often tied to macroeconomic factors like geopolitical instability or changes in government policies.

For example, if a German car manufacturer exports vehicles to the U.S. and the euro strengthens against the dollar, the company’s cars will become more expensive for American buyers. This can reduce their competitiveness in the U.S. market, leading to decreased market share.

How can businesses manage exchange rate risk effectively?

Businesses employ various strategies to mitigate currency risk, including natural hedging, financial derivatives, currency diversification, and centralized currency risk management.

Natural hedging

Natural hedging involves balancing cash inflows and outflows in the same foreign currency to reduce potential losses. For example, if a U.S. business sells products in Brazil and also buys supplies from Brazil, it can use the money earned from Brazilian sales to pay for its BRL-denominated expenses. This naturally hedges currency risk and reduces the impact of currency fluctuations.

Financial derivatives

Derivatives are financial contracts that allow businesses to lock in exchange rates for future transactions to protect against unfavorable currency movements. The most common financial derivatives used to hedge currency risk include:

• Forward contracts: These are customized contracts between two parties to buy or sell a currency at a predetermined rate at a future point in time. Forward contracts are traded over-the-counter (OTC) and can be suitable for companies with fixed future obligations in foreign currency, such as import payments or export receipts.
• Currency options: These give businesses the right, but not the obligation, to buy or sell currencies at a set price within a certain timeframe. Currency options are more flexible than forwards, allowing companies to hedge against unfavorable shifts in exchange rates while still benefiting from favourable movements. Businesses pay a premium for this flexibility.
• Currency swaps: Currency swaps involve two parties exchanging cash flows in different currencies over a specific period of time. They’re often used by multinational corporations to manage exposure to loans or investments. For example, if one company has a debt in U.S. dollars and another has a debt in euros, they can use a currency swap to pay the interest on each other’s debts.

Currency diversification

Some companies diversify their operations, assets, and revenue streams across multiple currencies to minimize exposure to unfavorable movements in any single currency. For example, a company with revenue streams in dollars, euros, and yen can potentially offset losses in one currency with gains in another to reduce overall currency risk.

Centralized currency risk management

Businesses exposed to currency risk can establish a dedicated team to manage hedging activities and carry out risk assessments. For example, they may partner with an institutional liquidity provider to access deep liquidity and expertise across FX markets. These partnerships can help a company execute currency transactions more efficiently and support company-wide currency risk mitigation.

What is the importance of hedging in managing foreign exchange risk?

Hedging plays a vital role in managing foreign exchange risk as it can protect businesses and investors from potential losses caused by unpredictable currency fluctuations. Companies engaging in international transactions can use tools like forward contracts, options, or currency swaps to protect profit margins and maintain more accurate financial planning.

What role does currency risk play in cross-border investments?

Currency risk plays an important role in cross-border investments as it can significantly affect returns. Businesses and investors can experience either gains or losses when converting foreign earnings back to their domestic currency. For that reason, currency hedging and cross-border investments often go hand-in-hand.

What tools are available to mitigate currency risk in corporate finance?

Tools used to mitigate currency risk in corporate finance include currency options, forward contracts, and swaps. These tools are often facilitated by deliverable FX brokers, who help companies lock in exchange rates and make foreign currency payments while reducing the risk of overpayment due to unfavorable currency movements.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.