How to manage foreign currency risk

Does your business regularly make and receive international money transfers? If so, you are exposed to foreign currency risk, which can decrease your profit margin, create uncertainty and make it harder for you to conduct business abroad. 

However, with careful planning and the right product, companies can mitigate (or hedge) currency risk, minimising their losses and preserving margins. With many types of payment being made or received for goods, services, products, materials and international personnel, a variety of products can be deployed for several cases, including:

• Locking in a minimum and maximum range for a future transfer (Limit orders or stop-loss orders)
• Fixing a future rate for actual payment or receipt (Forward contracts)
• Setting a specified rate for a potential future payment or receipt: (Option contracts)

Specialist currency brokers provide a wide range of tools that help reduce exposure to rate movements by allowing companies to set the rates they will pay. But first of all, what is currency risk? And why is it such an important factor to consider for your company’s bottom line? 

Contents

• What is currency risk?
• Why you need to manage foreign exchange risk
• Steps to manage currency risk
• Picking the right currency risk management option
  • Forward contracts
  • Limit orders
  • Stop-loss orders
  • Option contracts
• Risks and issues of currency risk management

What is currency risk?

Currency risk is the risk that businesses and individuals are exposed to as a result of unfavourable currency fluctuations. When currency values change, this has a positive or negative impact on money being sent and received internationally, which, in turn, can affect a business’s bottom line. 

Let’s say business A is sending money regularly to business B, which is in a different country. If the currency that business A uses goes significantly down in value, that could have a serious impact on its expenses when converting the money into the currency used by business B. 

Equally, if business B is receiving payments from business A and the currency business B is using goes down in value, the conversion will affect business B’s profit margin due to an unfavourable exchange rate. 

In short, currency risk can seriously affect a business’s profit, particularly if they are: 

• Regularly making money transfers to companies in other countries
• Regularly receiving money transfers from companies in other countries
• Have subsidiaries earning money in different currencies abroad (which then need to send the money back over borders)

Why you need to manage foreign exchange risk

Whether your business has just begun making international money transfers or if it is expanding across markets worldwide, you need to consider currency risk. Otherwise, you might end up putting a huge dent in your profits, and will create uncertainty around your budgets that make it impossible to plan ahead. 

Currency risk management products can reduce exchange rate volatility and increase predictability for any company that makes or receives payments in other currencies. By using limit and stop-loss orders, forward and option contracts, a company may benefit in several ways, such as:

• Managing and reducing forex risk: Currency risk typically grows in proportion to the time elapsed between agreement and execution. Fixing a more favourable and known exchange rate beforehand allows for more accurate financial forecasting and could improve your transaction margins.
• Reducing fees: By planning ahead with a specialist broker to develop tailored currency solutions, you can agree lower fees (and sometimes waive fees altogether) for your international transfers. The overall cost will be much lower than the typical rates and fees charged by the banks for such transactions.
• Gaining a competitive advantage: You can give your customers or other businesses you work with better prices by using their currency and managing the currency risk, instead of effectively obliging the other party to do so.

Steps to manage currency risk

Not all businesses have the same requirements when it comes to currency risk, and there are a few steps in order to get the right product to protect your profit margins. We’ve outlined these steps below. 

Analysing whether your business needs currency hedging solutions

First of all, it’s worth considering if you actually need a currency hedging solution in the first place. It all depends on the amount of money your business is sending abroad and how often you are sending it.

If your company is looking to make a specific, one-time international money transfer in a currency that is usually stable, it may be more cost-effective to make an immediate transfer (known as a spot transfer), instead of trying to limit exposure with a hedging solution.

However, if your business regularly sends and receives international money transfers, hedging your currency risk becomes much more important. Particularly if you are operating with a smaller margin and a small currency rate fluctuation could significantly reduce or even wipe out your profits. 

As a first step, go over your accounts and assess your current level of currency exposure. How often are you sending/receiving money from abroad, and from which segments? Where is the potential for your company to suffer from foreign exchange risk? Are there aspects of your business that could benefit from currency hedging, and others where it’s unnecessary? Only when you’ve answered these questions will you find the right solution – but you don’t have to go it alone.

Speak to a foreign exchange specialist 

There are a number of currency hedging options out there, including forward contracts, limit orders and stop-loss orders. This can make it overwhelming when you are trying to figure out which hedging options (or indeed, which combination of products) will work best for your business.

The good news is that many of the foreign exchange specialists we are partnered with can help you on your currency risk management journey, maximising your profits and getting you the best possible return on your international money transfers. We’ve reviewed several of the top FX brokers here, and you can even compare provider’s prices for specific money transfers using our special comparison tool.  

Picking the right currency risk management option

You can find a basic overview of what forward contracts, limit orders and stop-loss orders are on our International Payments page. However, we’ve taken a deeper dive into some case studies below to see how each of these products work in action. 

Some of the main options for managing currency risk are below:

Forward contracts

Forward contracts allow you to lock in a favourable exchange rate, while actually making an exchange at a later date. This makes it particularly useful for avoiding future uncertainty over exchange rates, as we explain in this case study. 

Limit orders

Limit orders allow you to choose the ideal exchange rate for your money transfer, and if the condition is met your transfer will be made automatically. As long as you don’t need to transfer money imminently, limit orders can be extremely useful for helping you get the best possible rate (see our case study here).

Stop-loss orders

Stop-loss orders allow you to schedule a future payment, but if the exchange rate falls to a certain value, you can send the money earlier. When used in combination with limit orders, stop-loss orders can help you get the best possible deal, as we find out in this case study. 

Option contracts

Option contracts give a buyer or seller the right (but not the obligation) to execute an exchange of a particular currency at a predetermined rate at or by a future date. We’ve looked at why option contracts are beneficial here. 

Risks and issues of currency risk management

As we’ve talked about, there’s an element of risk in every forex transaction, especially when dealing with a future exchange with unknown rates. Luckily, specialist currency brokers can guide you through these currency movements and build in risk mitigation solutions via limit and stop-loss orders, forward contracts and options.

Businesses must, however, bear in mind that there are risks associated with these techniques. For example, with forward contracts, any upside from an improvement in the exchange rate before the contract is executed may be lost. Options involve a fixed up-front cost, which cannot be recovered in the event that the option is not taken up, whilst mitigating downside risk.

Be sure to talk through any of these products with a specialist currency provider before making any decisions and choosing your final product. The providers listed on our site that offer these products are happy to go through any questions you may have. Register for free with one today and begin the conversation as to how to manage your currency risk.