What it means
Currency risk arises whenever there is a gap in time between agreeing a price in a foreign currency and actually receiving or paying the money. During that gap the exchange rate moves, so the amount that lands in the bank differs from the amount that was planned.
Nothing about the underlying deal has changed, yet the profit on it has. This matters because exchange rates can move several percentage points in weeks, which is often larger than the entire net margin on a contract.
An exporter can win business on price, deliver on time and still lose money on the transaction purely because of the rate at settlement. Finance teams usually split the exposure into three types.
Transaction exposure covers specific invoices and contracts, translation exposure covers the effect of converting a foreign subsidiary's accounts into the group's reporting currency, and economic exposure covers the slower competitive effect of a persistently stronger or weaker home currency. Managing it starts with measurement: listing expected foreign currency inflows and outflows by month and netting them off, since a euro payable partly cancels a euro receivable.
Whatever remains is the net exposure, and that is what gets hedged with forward contracts, options or by borrowing in the same currency as the revenue. The common nuance is that hedging removes uncertainty rather than guaranteeing a good outcome.
A forward contract locks in a rate, so if the market moves favourably the business gives up that gain, which is the price of knowing the number in advance.
In practice
Real-world examples.
Example
A furniture importer buys containers priced in a foreign currency with 90-day payment terms and sells in its home market at fixed retail prices. A 7% adverse rate move between order and payment wipes out most of the gross margin on that shipment, so the company now hedges every purchase order above $250,000.
Example
An engineering firm bidding on an overseas project quotes in the client's currency to win the work. It buys an option that lets it sell that currency at a set rate if the bid succeeds, so a rate move between bid and award cannot turn a profitable contract into a loss-making one.
Example
A group with a large subsidiary abroad funds part of that unit with a loan in the same local currency. When the currency weakens, the reduced value of the subsidiary's assets is partly offset by the reduced value of the debt, smoothing the effect on group equity.
Think of it
“Currency risk is the danger that exchange rates move against you-affecting the value of foreign money.
Formula
Calculation
Currency gain or loss = foreign currency amount x (rate at settlement - rate at the time of the transaction).
A US company signs a contract to receive EUR 5,000,000 in six months. At signing, the rate is 1.20 US dollars per euro, so the expected receipt is EUR 5,000,000 x 1.20 = $6,000,000. That is the figure used in the forecast.
Six months later the euro has weakened to 1.08. The actual receipt is EUR 5,000,000 x 1.08 = $5,400,000.
Currency loss = $5,400,000 - $6,000,000 = -$600,000, a 10% shortfall against the planned amount. Had the company instead sold EUR 5,000,000 forward at 1.19, it would have received EUR 5,000,000 x 1.19 = $5,950,000 regardless of where the rate ended up, trading $50,000 of upside for certainty.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Calderwood Optics, an invented manufacturer of camera lenses, sold roughly 60% of its output overseas and bought most of its glass domestically, leaving a large one-way exposure.
For three years the home currency drifted lower, flattering results, and management came to regard the gains as part of normal trading performance. When the trend reversed and the currency strengthened by 14% over eight months, reported export revenue fell even though unit volumes were slightly up, and the board was caught without a plan.
Calderwood introduced a rolling hedging policy covering 75% of forecast foreign currency receipts twelve months ahead, and began reporting trading results and currency effects on separate lines. In this illustrative story the hedging did not make the company more profitable, but it made the profit predictable enough to plan around.
Watch out
Common mistakes.
- Assuming only exporters are exposed. A purely domestic retailer that buys imported stock, or one whose competitors import, carries currency risk through its cost base and its pricing.
- Hedging the gross exposure instead of the net one. Paying to hedge a foreign currency receivable that is already matched by a payable in the same currency is a needless cost.
- Judging a hedge by whether it made money. A hedge that ends up below the market rate has still done its job, because its purpose was to fix the outcome rather than to beat the market.
Questions
People also ask.
Should a small business hedge at all?
If foreign currency flows are small relative to profit, the cost and administration of hedging may outweigh the benefit, and simply invoicing in the home currency is often the practical answer.
What is a forward contract?
It is an agreement with a bank to exchange a set amount of currency on a future date at a rate fixed today, which removes the uncertainty for that specific amount.
Can currency risk be removed completely?
Not entirely, because forecasts of future foreign currency flows are never exact and the competitive effects of long-term rate shifts cannot be contracted away.
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