What it means
Exchange rates are set by the foreign exchange market, where banks, companies, investors and governments trade currencies. Rates move constantly in response to interest rates, inflation, economic growth, trade balances, political events and market sentiment.
For a company, the effect is felt in three ways. Transaction exposure arises on individual deals, such as an invoice in a foreign currency that will be paid in 60 days, and translation exposure arises when foreign subsidiaries' accounts are converted into the group's reporting currency.
Economic exposure is the longer-term effect on competitiveness, for example when a stronger home currency makes exports dearer. Exchange differences on transactions are generally recorded in the income statement as gains or losses, while differences arising on translating foreign operations are normally taken to equity.
Finance teams therefore need to know which type of exposure they have in order to report and manage it properly. Businesses manage the risk in several ways.
They can invoice in their own currency, match foreign income with foreign costs, or use hedging instruments such as forward contracts, which fix an exchange rate today for a payment in the future. Hedging gives certainty but also gives up any favourable movement, and it has a cost.
Not all movement is bad news. A weaker home currency can make exports cheaper and increase the value of overseas earnings, while a stronger one can lower the cost of imported materials.
The risk is uncertainty, which makes budgeting and pricing harder and can surprise investors who expected steady results. A sensible policy sets out which exposures to hedge, how much, and who may authorise trades.
Without one, businesses either ignore the risk until it hurts or take speculative positions they do not understand, and both approaches can be expensive.
In practice
Real-world examples
Example 1
A UK furniture maker buys timber priced in dollars. When the pound falls against the dollar, the same timber costs more pounds, squeezing margins unless the company raises its prices or has hedged. The finance director reviews the rate every week during busy purchasing periods.
Example 2
A software company with 40% of its revenue in euros reports its results in dollars. A weaker euro reduces the dollar value of its European sales, even though the number of customers has not changed. Management therefore reports growth both as reported and at constant exchange rates.
Example 3
An importer agrees to pay a supplier 500,000 euros in three months. To remove the uncertainty, it buys euros forward at a fixed rate, which fixes the dollar cost of the order from the start.
Think of it
Think of currency exchange rates like the tides at the beach. Sometimes the water level is high and sometimes it is low, and you cannot control the movement. If you leave your beach towel too close to the water, a rising tide might wash it away before you notice.
Formula
Calculation
Percentage change in exchange rate = (new rate - old rate) / old rate
Value in home currency = foreign amount x exchange rate
A US company invoices a European customer 250,000 euros when the rate is $1.20 per euro, so it expects 250,000 x $1.20 = $300,000. By the time the customer pays, the rate has fallen to $1.08 per euro, so the company receives 250,000 x $1.08 = $270,000. The percentage change is ($1.08 - $1.20) / $1.20 = -$0.12 / $1.20 = -10%, and the loss is $300,000 - $270,000 = $30,000.Case study
Seen in the real world
Saltmarsh Outdoor Gear is an illustrative, fictional manufacturer that sells tents to retailers in three countries and buys fabric priced in a fourth currency. For years, the finance team ignored exchange rates, simply converting each month's figures at the current rate.
In one year, the company's home currency strengthened by 8% against its main selling currency, and the dollar-equivalent value of its export sales fell by about $640,000 on sales of $8,000,000. Its fabric costs, meanwhile, were unchanged, so profit fell sharply although volumes were up.
The board adopted a hedging policy to cover 70% of expected foreign currency sales for the next six months using forward contracts. In this illustrative case, results became more predictable, and management could focus on the business instead of the exchange rate.
Watch out
Common mistakes
- Ignoring currency risk because it is outside the control of the business, when it can be managed with pricing, matching and hedging.
- Hedging everything or nothing, instead of agreeing a policy based on the size and timing of the exposures and the company's appetite for risk.
- Judging performance on reported figures alone, when a change may be caused by exchange rates and not by trading, which leads to the wrong praise or blame.
Questions
People also ask
What causes currency fluctuations?
Differences in interest rates, inflation and economic performance, along with trade flows, political events and investor sentiment, all move supply and demand for currencies.
What is a forward contract?
It is an agreement to buy or sell a currency at a fixed rate on a future date, which removes uncertainty about the amount that will be paid or received.
Do currency movements always hurt businesses?
No, a movement can help or hurt depending on whether the business is a net buyer or seller of the foreign currency, which is why exposures need to be measured.