As your business has grown, you’ve found yourself dealing with more vendors, more customers, and more partners from every corner of the world. You might also be looking to make the most of your international trade.
As international opportunities become available to trade and expand your business, you should set your business up to accept foreign currencies—as well as ensure that you avoid fees with regard to exchange rates. Exchange rates change, so you could see costs increase and profits shrink.
There are three main types of exchange-rate exposure companies face transaction, translation, and economic exposure. In this post, Bound platform will go over each of these in detail below.
Transaction Exposure
Transaction exposure is the risk of foreign exchange rate changes in your company’s cash flow or asset base resulting from the timing and the size of exchange transactions.
You can mitigate transaction exposure by keeping a flexible and liquid balance sheet to avoid financing the business with currency mismatches, using the company’s credit lines to take care of foreign exchange transactions and using a treasury management system with an online platform to control currency transactions efficiently.
Transaction exposure can also be mitigated by:
Selling locally-grown products to customers in your home base. For example, you could sell locally-grown tomatoes to customers in the United States.
Having multiple locations in the US. You could sell the tomatoes to a number of farmers’ markets or supermarkets in the US.
Reducing the exchange risk by spreading the risk between two assets. You could sell the tomatoes at several locations and then diversify the risk by purchasing a property in the US.
Translation Exposure
Translation exposure, in contrast, results when the exchange rate fluctuates during the time that it takes to complete a transaction, resulting in a difference between the amount of the transaction (in the original currency) and the amount of expenses later incurred to settle that transaction.
Translation exposure can be reduced by ensuring a buffer between the amount of cash generated by the transaction and the exchange rate at which the transaction takes place. It’s also important to value transactions at a point in time when the exchange rate is known and to evaluate the company’s cash flow.
Translation exposure can also be mitigated by:
Dealing in terms that are shorter in duration than the payment terms of the agreement.
Having the transactional value of the agreement linked to the market price of the asset or service. For example, if you’re a pharmacist, you could sell pharmaceuticals at a price that’s adjusted to the exchange rate, with the pharmacy focusing on the number of pills sold.
Leasing assets to foreign companies with payment terms that are linked to the payment terms of the lease.
Having the purchase price of a foreign company’s shares be linked to the exchange rate.
Operating or Economic Exposure
Economic exposure deals with the impact of exchange-rate fluctuations on a company’s financial position, including the purchasing power of cash outflows and inflows.
You can mitigate economic exposure by planning currency movements; for example, hedging the weak currency and converting the strong one or avoiding tying up large amounts of cash in high-cost currencies.
You can also mitigate economic exposure by:
Linking the company’s assets and liabilities to a single, stable currency.
Using a currency management system with a single currency that stays the same, regardless of changes in the value of other currencies.
What Are the Risks of Dealing with Foreign Currency Exposure?
The risks of not dealing with foreign currency exposure include:
Conversion Risk
If your company holds cash in foreign currency and attempts to convert it to your home currency at a later date, the value at that time could be lower.
Liquidity Risk
If your company holds cash in foreign currency and attempts to convert it to your home currency at a later date, the value at that time could be lower.
Unearned Margin
If your company is a supplier, holding foreign currency might not be to your advantage because it might not lead to increased sales. It might also be a risk for a company that receives revenue in a foreign currency. Understanding the currency exposure lets you adjust your prices accordingly.
For example, suppose that a company receives payments in a foreign currency from its customers. If the company has to pay its suppliers using the same foreign currency, it might need to convert the funds into its home currency at a later date.
How You Can Mitigate Risks
Here are some tips to make sure you’re better positioned financially to take advantage of opportunities abroad.
Transact in Your Local Currency as Much as Possible
Local currency transactions have the least amount of risk because the exchange rate doesn’t change. Keep an eye out for opportunities abroad, and make sure you’re not getting stuck with a hefty bill at the end of a long transnational business trip. If feasible, it’s best to pay with credit on your Visa or MasterCard.
Keep Your Currency Fluctuation Plans Up to Date
If your business trades in multiple currencies, your revenue, payments, and expenses will be affected by exchange rates. To be prepared, keep your company’s currency fluctuation plans up to date, even as your business grows.
Look for Currency Management Platforms and Treasury Management Systems
With an online platform, you can easily keep track of currency fluctuations around the world. These platforms will also be able to help you make the most of your company’s currency movements by helping you track, predict, and mitigate currency exposure.
Keep track of currency exchange rates. If you’re running a business with foreign operations, consider keeping cash in foreign currency deposits or in bank accounts in different countries. Be aware that exchange rates fluctuate over time.
Currency markets are constantly changing. It is important to keep track of economic news and currency trends. There are other ways to stay informed, such as:
Reading the daily news
Using a currency converter
Monitoring currency charts
Consider Currency Diversification
Suppose you have multiple foreign currency transactions or use funds in foreign currencies. In that case, you could benefit by treating your currency exposure as a strategy to diversify your investments and reduce your risk.
In the long term, holding foreign currencies can reduce risk by counterbalancing the effects of your domestic currency’s value.
In the short term, holding foreign currencies can help you reduce risk, but it’s generally not a good idea to hedge against currency fluctuations. The currency holdings need to be carefully managed because, over time, the currency that increases in value could also decrease in value.
Build Protection into Your Contracts
If you’re working with a company that your company does business with, try to negotiate your contracts to incorporate local currency for both parties. One approach to try is to ask the vendor simply to convert the denominated invoice amount into local currency amounts at the exchange rate that existed at the time the invoice was issued. The other approach is to convert the entire amount of the invoice into local currency. Both methods have their pros and cons and should be discussed with your accountant.
Consider Natural Foreign Exchange Hedging
Hedging your foreign currency exposure means locking in the exchange rate, so you know how much you’ll get in the future; this way, you won’t have to worry about the exchange rate on the day you make the final payment.
For example, if you plan to buy $1 million in equipment for a factory in Italy, you could lock in the exchange rate and buy euros.
If the dollar becomes stronger, the exchange rate will be locked in; and if the dollar weakens, you could buy more euros with your dollars than you could have when you purchased the euros in the first place. If the dollar becomes weaker, you might not want to lock in the exchange rate because you might be able to get more dollars in the future.
If you’re exporting a product overseas, you can lock in the exchange rate to buy that foreign currency, even if you have to pay a premium. It’s also possible to buy future discounted currency in the U.S. but is a more complicated process.
Hedging Arrangements Through Financial Instruments
In addition to natural hedging, you can use financial instruments like futures, options, cross-currency swaps, and foreign currency forwards to hedge exposure.
Futures contracts can be used to create a hedge position. If a company has a contract to sell 10 million pounds sterling in six months, they can purchase 10 million pounds sterling futures contracts in six months. At that time, they will receive the sale proceeds and settle the futures contracts. The sale of the futures contracts will give the company the foreign currency while they are waiting for the sale to take place.
If you’re operating internationally, you can use currency options to hedge against losses. Currency options give the holder the right, but not the obligation, to buy or sell a currency at a specified strike price at a predetermined date. In order to hedge against losses, a company could buy currency options to protect against any losses as the currency’s value fluctuates.
Cross-currency swaps work to swap payments in two currencies for a profit or loss. For example, if you were waiting to make a payment in one currency and had cash in another currency, you could enter a cross-currency swap and receive a regular, fixed payment. In exchange, you’d have to pay the other party a floating, floating amount periodically.
Using forward contracts, you can secure a rate without actually having to swap currencies. For example, you could agree to purchase $1 million five years in the future and exchange it for the current spot rate. At that time, that rate would essentially be locked in. If the rate is locked in, you must deliver the foreign currency to the counterparty, or the counterparty must deliver the foreign currency to you if the market rate is higher.
How Do You Calculate Currency Exposure?
The calculation for currency exposure is relatively straightforward. The primary practice for most companies is to use the forward currency exchange rate for accounting purposes when converting transactions between foreign and domestic currencies.
The forward currency exchange rate is the principal rate used when a contract’s value is determined in advance. If you’re not currently using forward rates, you can use your company’s average exchange rates over the last few years to calculate your currency exposure.
To understand this concept more easily, we'll look at a simple example. Suppose a company that exports to Japan face a $1 million transaction in two months. If the company received $1 million in U.S. dollars today, it could exchange the money for yen at the current rate and use it to make the purchase in two months.
The exchange rate at that time is locked in, and there’s no risk of losing any money with a forward exchange rate because the exchange would occur at a forward rate. The company would receive yen equivalent to $1 million at the time of the transaction, and it would be sent dollars at the forward exchange rate at the time of the transaction.
If the company used the average rate over the last three years to make the transaction, the company would only lose out if the yen went up relative to the dollar. This can be calculated by using the following formula:
(1 + current rate/ average rate) - 1
With an average rate of ¥98 per dollar over the last three years, this would amount to $1,000,000 x (1 + ¥100 / 98) - 1 = $990,000.
By using this formula, you can get a sense of how much your company is losing in exchange rate risk.
Conclusion
Foreign currency fluctuations can potentially have a significant impact on your business. It can be difficult to know exactly how to manage your global currency risk. But there are a number of steps you can take to prepare for the impact of foreign exchange rates on your company.
With accurate data and the help of a professional risk manager, you can use currency exposure as a way to diversify your investments, reduce your risk, and potentially increase your returns.
Bound is a reliable, auto hedging platform that makes currency protection easier and better for businesses of all sizes. Sign up today and give Bound a try!
