What are the risks of foreign exchange transactions and how can you manage them effectively?

1 Transaction risk

Transaction risk is the risk that the exchange rate between two currencies will change unfavorably between the time you agree to a contract and the time you settle it. For example, if you are a US exporter who sells goods to a European customer for 100,000 euros, and the exchange rate is 1.2 USD/EUR when you sign the contract, you expect to receive 120,000 USD when you deliver the goods. However, if the exchange rate drops to 1.1 USD/EUR when you receive the payment, you will only get 110,000 USD, losing 10,000 USD in the process. Transaction risk can affect your cash flow, profitability, and budgeting.

2 Translation risk

Translation risk is the risk that the value of your assets and liabilities denominated in foreign currencies will change due to exchange rate movements. For example, if you are a US company that owns a subsidiary in Japan, and the exchange rate is 110 JPY/USD when you report your financial statements, your subsidiary's assets and liabilities will be converted to USD at that rate. However, if the exchange rate rises to 120 JPY/USD in the next period, your subsidiary's assets and liabilities will be worth less in USD terms, reducing your net worth and equity. Translation risk can affect your balance sheet, income statement, and shareholders' equity.

3 Economic risk

Economic risk is the risk that changes in exchange rates will affect the competitiveness and demand of your products or services in foreign markets. For example, if you are a US manufacturer who exports to Canada, and the exchange rate is 1.3 CAD/USD when you set your prices, your products will be affordable and attractive to Canadian customers. However, if the exchange rate falls to 1.2 CAD/USD, your products will become more expensive and less appealing to Canadian customers, who may switch to cheaper alternatives. Economic risk can affect your sales, market share, and growth potential.

4 How to manage foreign exchange risks

Managing foreign exchange risks requires a tailored approach, as different businesses have different exposures, objectives, and preferences. Hedging, diversification, matching, and pricing are some common strategies to consider. Hedging can reduce uncertainty and volatility, but involves costs and trade-offs. Diversification increases resilience and flexibility, but requires more resources and coordination. Matching simplifies cash management and accounting, but limits opportunities and choices. Pricing enhances margins and market position, but depends on your pricing power and customer behavior. Ultimately, foreign exchange transactions can be a valuable tool for businesses when managed effectively through the appropriate strategies to optimize exposure and achieve financial goals.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?